Since the adoption of regulatory forbearance and with it regulatory permission for banks to engage in 'extend and pretend' tactics to keep zombie borrowers alive, the credit markets have been in a downward spiral.
The reason for this downward spiral is simple: it is easier for a zombie borrower to get credit than it is for a creditworthy borrower.
The creditworthy borrower is up against two obstacles.
First, the uncertainty in the value of the collateral they have to pledge for a loan. The banks know how much in the way of similar collateral is supporting zombie loans. The bankers have to figure out what the likely value for this collateral is if they are ever required to recognize the losses on the zombie loans and their collateral was sold.
The result is a gap between what the creditworthy borrower wants to borrow against the collateral and what the bank is willing to lend based on collateral value.
Second, the regulators' focus on a 9% Tier I capital ratio makes it unattractive to make the new loan.
As Liam Halligan said in his Telegraph column,
To be sure, making these policies work will be difficult. How can the Bank of England ensure that banks fulfill their lending promises. The “Project Merlin” targets have been all-but abandoned amid enforceability disputes. What is to stop the banks “gaming” the system, by reclassifying loans to themselves as “credit extended”?
One got the sense, listening to King, that his heart wasn’t really in the measures he was trying to promote. That is because, as the Governor himself admitted, the problem the banks have isn’t one of liquidity but “one of solvency”.
We should note that King told the Mansion House, referring to Europe’s entire banking sector, that “until losses are recognised, and reflected in balance sheets, the current problems will drag on”.
The only way to solve Europe’s banking crisis, of course, is root-and-branch recapitalisation, involving closures, restructuring and a full clean-out of the Augean stables.Please re-read the highlighted text as this is what I have been saying since the beginning of the financial crisis.
This full clean-out and root-and-branch recapitalization takes two steps.
Today, adoption of the Swedish model with ultra transparency. Under the Swedish model, the banks are required to recognize all the losses hidden on and off their balance sheets. Under ultra transparency, the banks have to disclose their current asset, liability and off-balance sheet exposure details so that market participants can confirm that fact.
Over the next several years, the banks then recapitalize themselves through retention of pre-banker bonus earnings . Those banks that do not have a franchise that permit them to generate the earnings to recapitalize themselves are closed.