Thursday, May 31, 2012

Since ECB will only lend to solvent banks and all EU banks are insolvent, its time to run

According to a Bloomberg article, ECB President Mario Draghi says that the ECB will continue to lend to only solvent banks.  Since every bank in the EU is insolvent, by definition, the ECB is done lending.

Regular readers know that Mr. Draghi's statement is in direct contradiction to the rules for central bankers laid out by Walter Bagehot in the 1870s and discussed on this blog.

Rule number one for central bankers is that in times of crisis they are suppose to lend freely against good collateral at high interest rates.  This rule says absolutely nothing about whether the bank that is borrowing the money is solvent or not.

In fact, by writing the rule the way he does, Mr. Bagehot shows that he understands that bank solvency can change over time as it is defined as the current value of the bank's assets minus the book value of its liabilities.

In times of financial panic, assets tend to be valued at substantially less than they would be in more normal times.  As a result, a bank that is solvent in normal markets could be insolvent in a financial panic.

U.C. Berkeley Professor J. Bradford DeLong confirmed my reading of Mr. Bagehot in his article This Time, It Is Not Different.

As for the statement that all EU banks are insolvent, there are a number of different pieces of information that confirm this observation.

First, one need look no further than the latest EU stress test that showed that both the Netherlands bank Dexia and the Spanish bank Bankia passed.  Both has subsequently been nationalized.  In short, everyone knows that passing the stress tests does not equate to a bank being solvent.

Second, we have policymakers taking actions to bailout the banks.  For example, the Greek bailout was designed so that the money from the EU would flow directly to the banks.  A clear sign that the policymakers don't think the banks are solvent.

Third, we know that under regulatory forbearance the banks are hiding losses on and off their balance sheets (please note, if a bank were not hiding losses, it would provide ultra transparency to let market participants confirm this point and show that it can stand on its own two feet).  What this means is that the banks themselves cannot tell who is solvent and who is not.  As a result, the interbank lending market has frozen.

Fourth, we know that banks are still interconnected.  Are German banks really solvent if the insolvent Greek, Spanish and Italian banks trigger insolvency in the French banks too?

Given that Mr. Draghi says the ECB is only going to support solvent banks, then it is pretty clear what the prudent course of action is for EU depositors.  Run to their bank and withdraw their money before the system collapses.

Perhaps the ECB and Mr. Draghi would like to rethink their position...

European Central Bank President Mario Draghi said policy makers will keep focusing their crisis support on solvent euro area banks as he reiterated it’s not the ECB’s job to fix the cause of the region’s turmoil. 
“The ECB will continue lending to solvent banks and will keep the liquidity lines active and alive with solvent banks,” Draghi told a European Union Parliament committee in Brussels today....
 So much for lending to any bank in the EU.
When pressed on whether the ECB can step up action to tame financial turmoil and help cap widening bond spreads, Draghi said that “it’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front.”

Draghi signaled the ECB is in no rush to introduce a third three-year loan program as the turmoil hasn’t arrived at “the same levels reached in November 2011,” when such aid was first mooted. While the ECB’s lending can help improve bank liquidity, it cannot address risk aversion and capital shortages in the banking sector, he said. 
Apart from funding “there are two other issues that are now hampering credit flow, one is risk aversion” and “the second is lack of capital,” Draghi said. “We cannot do much about the two other reasons about the slowing in credit.”
Keep in mind, Mr. Bagehot says that central bankers should never, ever look at a bank's capital position.

Central banks are senior secured lenders who haircut any collateral they take prior to extending a loan.  As a result, the only issue the central bank should focus on is correctly valuing the collateral.

This is a point Paul Volcker made several years ago when he said that central banks should evaluate the collateral pass the point of no return.  Central banks should assume that the bank will default.
Draghi hinted that he is in favor of using the permanent bailout fund, the European Stability Mechanism, to be used to inject capital into banks. 
“People are actually working on finding ways that the ESM could be used to recapitalize banks,” he said. “ The issue is not so much the use of ESM money to recapitalize banks but whether this could be done directly without having to go to governments.”...
A far more effective way to use the ESM is as a backstop to deposit guarantees.
He said one of the lessons drawn from the Bankia (BKIA) group’s need for a 19 billion euros capital injection is that “further centralization of banking supervision is needed,” as national governments and supervisors tend “to first underestimate the importance of the problem, then come out with a first assessment, then a second, then a third, then a fourth” and “all countries have done the same thing.” 
This is “the worst possible way of doing things” as even though in the end they do the “right thing, but at the highest possible cost and price,” he said. He also urged governments to “err on the high side” when recapitalizing banks.
Actually, the lesson is that banks should be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this information, the market will assess the banks and determine the extent of the problems.

The ability to use the market's assessment of the problem saves the government from destroying its credibility when it consistently underestimates the true extent of the problem.

Finally, in a modern banking system with deposit guarantees and access to central bank funding, there is no reason for a government to step in and recapitalize a bank.  The banks are perfectly capable of rebuilding their book capital levels through retention of future earnings.

It is only when a central bank stops lending based on a bank's current solvency status that a modern banking system collapses.

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