Tuesday, May 1, 2012

Fixing Europe's financial system takes creativity not billions of euros

The Dallas Fed published a presentation, Choosing the Road to Prosperity, that highlights the choice faced by global policymakers:  continue on our current path of protecting the banks and end up with economic stagnation or stop protecting the banks and end up with prosperity.

Specifically, the choice faced in Europe, the UK and the US is between the Japanese and Swedish models for handling a bank solvency led financial crisis.

Under the Japanese model, bank book capital levels are protected.  The losses on the excesses in the financial system are inflicted on the real economy.  As a result, the real economy stagnates under the burden of an excessive debt load.

The Japanese model is also known as Main Street rescues Wall Street.

Under the Swedish model, banks are required to recognize the losses on the excesses in the financial system today.  They subsequently rebuild their book capital levels by retaining future earnings.  As a result, the real economy continues to prosper.

The Swedish model is also known as Wall Street rescues Main Street.

As pointed out in the Dallas Fed presentation, all market participants, including regulators and prominent economists, practice willful blindness.

The human tendency to see what we want to see or are conditioned by our life experience to see.
Willful blindness leads directly to how Too Big to Fail is thought about.  The Dallas Fed describes TBTF as
The unwillingness of a government entity to abruptly close an insolvent company and force its creditors to sustain sizable losses due to the company’s size, complexity, interconnectedness and general significance within the financial system.

Related:   If taxpayer funds are used to prolong the life of the company, it is generally labeled a bailout.  
This definition hinges on the term 'insolvent' [the market value of the bank's assets is less than the book value of its liabilities] and the idea that when this occurs for a bank some action has to be taken.  This action is a choice between a bailout or inflicting losses on shareholders and unsecured creditors.

Where creativity comes in and willful blindness ends is in recognizing that in a modern financial system no action is necessary as banks can continue operating even when they are insolvent.  Insolvency being a temporary and not necessarily permanent condition.

In fact, banks are designed so they can continue in operations even though they are insolvent.  They are supported in this by both deposit insurance and unlimited liquidity from central banks.

As a result, banks are able to and should be required to absorb the losses on the excesses in the financial system to protect the real economy while they continue to supply any additional credit the real economy needs to grow.

Between the Loans to Less Developed Countries crisis and the US Savings and Loan crisis, there is amble evidence to support this insight into the design and role of banks in a modern financial system.

  • Financial institutions that were insolvent continued to operate and make loans to support the real economy.
  • Losses on the LDC loans were absorb by bank book capital and this book capital was subsequently rebuilt without resorting to government bailouts. 

Where creativity also comes in and willful blindness ends is in recognizing that the common characteristic shared by every area of the financial system that broke down during the recent financial crisis is opacity.

Banks, structured finance, Libor being prime examples.

Bringing ultra transparency back to the financial system and requiring the banks to absorb the losses on the excesses in the financial system does not require billions of dollars or euros, just a little creativity.

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