George Osborne: 'We will not prop up EU banks'; so EU is free to adopt Swedish model to end bank solvency crisis

In his column in the Sunday Telegraph, UK Chancellor George Osborne defended the UK's right not to prop up the EU banks and in doing so explicitly frees up the EU to adopt the Swedish model for ending its bank solvency crisis.

As everyone knows, if you are not willing to put up your own money, then you have no say in the solution chosen by those whose money is at risk.

Therefore, the EU no longer has to follow the UK and US lead and pursue the Japanese model and its needless bank bailouts.  Instead, the EU can end its bank solvency led financial crisis by adopting the Swedish model with ultra transparency.

Under the Swedish model, all of the EU banks, not just Spain's, will recognize the losses on the excess debt in the financial system.  This will immediately create growth in the real economy across the EU as the drag on the real economy from supporting zombie borrowers is removed and creditworthy borrowers gain access to funding again.

Yes, the EU banks will have significant negative book capital levels.  But the modern financial system is designed so that these banks can continue to operate and support the real economy even with negative book capital levels.  Banks are able to do this because of the combination of deposit insurance and access to central bank funding.

Until such time as the banks have rebuilt their book capital levels, 100% of pre-banker bonus earnings should be retained.  Yes, this will eliminate cash bonuses to bankers for a number of years, but think of how valuable the stock they will receive instead will become (although the issue of how much stock they will receive has to be negotiated with the shareholders).

As for how long it will take to rebuild bank book capital levels, an IIF report suggested that Spain could do so in as little as four years.  This is less time than has passed since the beginning of the credit crisis on August 9, 2007.

With ultra transparency, confidence will be restored to the EU financial system as market participants trust their own independent assessment of each bank.  Not only that, but market discipline and restraint on bank risk taking is reintroduced to the banking system after a nearly 8 decade absence as investors are able to adjust the amount and pricing of their exposure to each bank to reflect their assessment of the current risk of the bank.

We are approaching a moment of truth for the eurozone....

Despite our huge budget deficit and massive banking system, our economy is benefiting from safe-haven status because of this Government’s credible plan to deal with Britain’s debts – we have reduced the deficit by more than a quarter in just two years. Along with countries such as Germany and the US, investors are putting their money into the UK, driving down the interest rates on our government debt....

Apparently Mr. Osborne prefers to ignore the massive quantitative easing bond buying programs being implemented by the Federal Reserve and the Bank of England.  Programs that are designed to drive down long term interest rates.

Germany's safe haven status comes as a result of investors trying to escape losses from having their deposits redenominated into a weaker currency should the EU breakup.

The latest bout of uncertainty has been focused on the future of the Spanish banking system. 

There are already signs that a solution will be found. We should acknowledge that as each wave of the crisis has reached its peak, the countries of the eurozone have taken some very difficult decisions to defuse the pressure. But the lesson of the last two years is that treating the latest symptom does not cure the underlying condition....

Please re-read the highlighted text as I have been making this point since the beginning of the financial crisis.

There is only one way to cure the underlying condition:  adopt ultra transparency.  Requiring banks to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details will allow market discipline to force the adoption of the Swedish model where banks recognize all of their losses today.

The question for us in Britain is what approach we should take to these developments. 

The Government is clear that it is strongly in Britain’s interests for our biggest export market to succeed; the risks for us of a disorderly outcome are huge. We will also not stand in the way of further political integration among the eurozone countries that any successful solution will require, including a banking union. 

At the same time it’s entirely reasonable for us to seek safeguards that protect British taxpayers and preserve the single market for all EU members....  

Equally, further pooling of sovereignty – for example over fiscal policy and financial supervision – must be limited to the countries in the eurozone. If countries in the eurozone cannot meet their liabilities, for example to protect bank depositors, then it is natural for the other eurozone nations to stand behind them. In return, it is understandable that those countries would want a say in how banks across the eurozone are supervised and dealt with in a crisis. That is why a banking union is a natural extension of a single currency. If other non-eurozone countries in the EU, who unlike the UK have a legal obligation to join the euro, want to opt in to a banking union then that is up to them. 

But we are clear that Britain will not take part. British taxpayers will not stand behind eurozone banks, and British voters want their government to be in charge of supervising our own banks, especially in a crisis.

One of the benefits to the EU of adopting ultra transparency is that all market participants can assess the risk of each bank that is hosted by an EU country.  Included in all market participants are the financial regulators.  As a result of their risk assessment, the regulators might want to exert discipline on their banks to reduce their risk.  This is easily achieved by increasing the charge for deposit insurance to reflect this risk.

A by-product of regulators exerting discipline on the banks they host is they are effectively supervising the banks in the other countries.  Why, because as these banks see their access to funding reduced and the cost of the funds increased, they are given an incentive to reduce their risk profile.

Ultra transparency sets off a race to the top among financial regulators with the most risk-adverse regulator determining the acceptable level of risk for the banking system.