Friday, May 25, 2012

Is Euro zone heading towards true bank reform?

In a Reuters' article, ECB Executive Board member Peter Praet suggests that the pressure of a financial crisis might be what it takes to enact true reform.

If so, there is hope that ultra transparency will be adopted and that regulators will end the Euro zone credit crunch by backing off the enforcement of a meaningless 9% Tier 1 capital ratio.
"Decisive and far-sighted reforms like these, unrealistic until a short while ago, are now gaining support. Reacting to the pressure of events may seem unattractive, but it may also be the only way forward," he said in the text of a speech prepared for a financial conference in Milan....
The current crisis meant that deleveraging by banks - which curtails credit provided to companies and consumers - could not be avoided, but liquidity provided by central banks could to some extent ease the process, said Praet, who oversees the ECB's economics department....
Unless of course, the regulators abandon the meaningless 9% Tier I capital target.  In which case, bank deleveraging and its related credit crunch stops.

But what to put in place of the Tier I capital ratio to show that banks are solvent?

Regular readers know the answer is require the banks to provide ultra transparency and disclose on an on-going basis all of their current asset, liability and off-balance sheet exposure details.  Market participants can use this information to see for themselves whether the banks are solvent or not.
Praet said it was important to break the link tying banks to sovereign risk, but added this was complicated. 
Lenders in debt-laden euro zone countries have increased their exposure to sovereign risk by stepping up purchases of domestic government bonds and making up for the shrinking take-up by foreign investors.
Ultra transparency plays a role in breaking the link between banks and sovereign risk.

In a modern financial system with deposit guarantees and access to central bank funding, sovereigns don't have to bailout the banks as they can operate and support the real economy for years with negative book capital levels.  With ultra transparency in place, the market can exert discipline on the banks to be sure they do not take on excessive risk while rebuilding their book capital.

Since the sovereign no longer has to bailout the bank, this helps the bank because the sovereign's credit improves (one of the factors weighing on the sovereign is the possibility it will be influenced by its banking advisors to bailout the banks).  As sovereign credit quality improves, so to does the interest of private investors.

No comments: