'We must find a solution to our banks' ... look here

As Spain's deputy prime minister said, 'we must find a solution to our banks'.  This applies not just to the banks in Spain, but to the banks in the EU, UK, US, China and Japan.

The facts are clear.  Pursuing the Japanese model for handling a bank solvency led financial crisis has failed.

Under the Japanese model, bank book capital levels have been protected under the mistaken idea that high capital levels are synonymous with either depositor confidence in the banking system or the ability to make loans.  This protection has included regulatory forbearance which has allowed bad assets to be hidden on and off the banks' balance sheets and bailouts.

It hasn't worked.  Across the EU, they are busily bailing out the banks and the deposits are busily running to Switzerland or to the only perceived safe-haven, Germany.

It hasn't worked.  Across the EU, there is a credit crunch.

We now find ourselves in the interesting situation where there isn't a big enough pot of funds under government control left in the world to tap in order to continue bailing out the banks and supporting the payment of bonuses to bankers.

As Spain's deputy prime minister said 'we must find a solution to our banks'.

Regular readers know that there is a solution to the banking problem.  The solution is to adopt the Swedish model for handling a bank solvency led financial crisis with ultra transparency.

The Swedish model doesn't require governments or more specifically taxpayers to bailout the banks.  Instead, it takes advantage of the features of a modern banking system, specifically deposit insurance and access to central bank funding, to allow the banks to bail themselves out using retention of future earnings.

Ultra transparency enhances the effectiveness of the Swedish model.  By requiring the banks to disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details, market participants can see for themselves that the banks absorb the losses on the excesses in the financial system.

With ultra transparency, market participants can independently assess the riskiness of each bank and adjust both the amount and price of their exposure to reflect this risk.  There are four benefits to the financial system from this.

• It ends contagion as each participant will limit their exposure to what they can afford to lose given the risk of the bank;
• It puts market pressure on the banks to keep risk at a minimum as higher risk will raise the cost of funding across the entire capital structure of the bank;
• It ends reliance on the financial regulators by ending their information monopoly; and
• It shines a bright light into all the opaque corners of the financial system.

Since it was first tried and according to the NY Fed broke the back of the Great Depression, the Swedish model has proven its effectiveness.