Tuesday, May 22, 2012

Institute for International Finance report shows why banks can rebuild their book capital without bailouts

The Institute for International Finance (the IIF), an association of about 450 banks, put out a report showing the underlying earnings power of the Spanish banks and an estimate of the expected losses from the bad debt currently hidden on and off the Spanish banks balance sheets.

These numbers are very useful because they confirm the point that there is no economic reason that the Spanish government should recapitalize the banks today when the banks are perfectly capable of generating and retaining sufficient earnings in the future to recapitalize themselves.

This confirmation of the earnings power of the banks is important as it breaks the link between bank recapitalization (source is the banks) and sovereign debt issuance (state not on the hook for recapitalizing the banks).

The conclusion from the IIF reports is that the Spanish government should adopt the Swedish model with ultra transparency.  

Under this policy, Spanish banks will be required to recognize all of their losses on the excess debt in the financial system today.  Subsequently, they will rebuild their book capital through retention of future earnings.

Banks will be required to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details.  With this information, market participants can confirm that banks realized all of their losses and exert discipline so that the banks do not take on excessive risk while rebuilding their book capital.
Taking guidelines from how badly Ireland's banks were hit in its financial crisis, economists at the global banking institute said they expect the losses to be in the range of between €216 and €260bn.
Moody's and other independent analysts have loss projections of 380 - 400 billion euros. If these higher estimates are correct, it simply adds to the time it takes for the banks to generate and retain future earnings to recapitalize themselves.
"A number of factors suggest that the losses could be nearer the upper end of this range. Spain's macroeconomic prospects are worse than those faced by Ireland, especially as regards growth and unemployment," it said in a new review of the global economy.
"The bulk of the losses would be generated by the commercial real estate loan portfolio, which is concentrated in the cajas," the Spanish savings and loan banks, it said....
The IIF said the banks were able through the end of last year to find enough capital internally to put aside €110bn for loan loss reserves, and some will be able to keep generating capital internally to meet needs.  
This statement confirms what your humble blogger has been saying about the ability of banks to recapitalize themselves through retention of future earnings and why governments should never bail them out. 

If losses were closer to 400 billion euros, the IIF report suggests that it would take the Spanish banks less than four years to generate the capital internally to rebuild their book capital levels.
 But not all of them.
"Substantial divergences between individual banks suggest that government assistance will be needed for a significant number of banks, mainly the cajas," the IIF said.
Some banks may take more time than others to rebuild their capital.

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