Thursday, June 7, 2012
Global financial crisis: it's the banks, stupid!
Following in the footsteps of the Bank of England's Mervyn King, a Guardian editorial looks at the ongoing financial crisis in Europe and concludes it is the banks.
Regular readers know we are dealing with a global bank solvency led financial crisis.
At the beginning of this crisis in 2008/2009, EU, UK and US policymakers and financial regulators chose the Japanese model for handling a bank solvency led financial crisis. This model is based on pretending the banks have capital when they do not and praying for a miracle that will restore bank capital levels.
Naturally, a model based on lies and prayer has little chance for success. History shows that it has never worked. Japan has provided 2+ lost decades of proof.
At the beginning of this crisis and even today, policymakers and financial regulators could have chosen or could still choose the Swedish model for handling a bank solvency led financial crisis. This model is based on requiring banks to recognize the losses on all the excess debt in the financial system today. Subsequently, banks rebuild their book capital levels.
Naturally, a model based on curing the underlying problem has a long history of success in both the US (breaking the back of the Great Depression) and Europe (see Sweden).
So the question is, will the EU and Spain abandon the Japanese model and adopt the Swedish model?
Lined up in favor of adopting the Swedish model are the EU taxpayers and the real economy.
Society favors the Swedish model because it ends the drag on the real economy from the excess debt in the financial system. As a result, the economy grows, jobs are created and governments do not adopt austerity policies that rewrite the social contract.
Lined up against adopting the Swedish model are the bankers. They have a significant stake in the outcome of this decision. Namely, if the Swedish model is adopted, their cash bonuses will be minimal for the foreseeable future.
Naturally, the bankers are claiming armageddon will occur if they are required to recognize their losses. This is true for their bonuses, but not for banks supporting the real economy.
In a modern financial system with deposit insurance and access to central bank funding, banks can continue to operate and make loans even while they have negative book capital levels. Of course, while their bank capital levels are below regulatory requirements, banks have to retain all earnings and pay bonuses in stock while they rebuild their book capital levels.