British (EU and US) banks still face the financial precipice

In reporting on the Bank of England Paul Tucker's statement that "gentlemen, by Christmas it could all be over", the Telegraph's Harry Wilson provides a terrific summary of why the western banking system is still on the financial precipice.

Regular readers know that the financial crisis would be over if the policymakers and financial regulators were to pursue the Swedish model for handling a bank solvency led financial crisis with ultra transparency.

Under the Swedish model, the modern banking system is used as it was designed to be used an it absorbs all the losses on the excesses in the financial system to protect the real economy and society.

Instead, policymakers and financial regulators continue to pursue the Japanese model which protect bank book capital levels and banker bonuses at all costs.

The result is an endless stream of bailouts as the losses in the financial system are transferred to the taxpayers and the real economy.  This in turn deprives the real economy of the capital it needs to support growth or reinvest to maintain its current level.

As reported by Mr. Wilson,

"Gentlemen, by Christmas it could all be over". These are the words of the Bank of England’s deputy governor at a key meeting of banks late last year. Why was he so worried?.... 

Attempts to bolster market confidence had failed. Stress test after stress test was doing little to disprove the widely-held belief among investors that the problems of the European banking sector were vast and that bank debt was a needlessly risky purchase. 

Everyone knows that market confidence is the result of providing market participants with access to all the useful, relevant information in an appropriate, timely manner.  It is transparency that allows market participants to make independent assessments.  Confidence flows because market participants trust their own independent assessments.

Everyone knows that there is no reason to trust the analytical ability of the financial regulators.  They did not see the financial crisis coming (if they did, why didn't they do their jobs and prevent it?).  The stress tests followed by nationalization of banks that pass the tests confirms the lack of analytical ability.

Once the titans of finance, many of Europe’s largest banks now found themselves in the strange and uncomfortable position of being unable to raise money from the large institutions they had made billions of pounds from over the previous two decades.

Who would invest in a 'black box'?  It is no mystery why no one would want to invest in Europe's or anyone else's largest banks.

In the absence of ultra transparency and the ongoing disclosure of their current global asset, liability and off balance sheet exposure details, banks are black boxes.  Who would invest in a black box where they cannot assess the risk of their investment?

To central bankers the problems were more than bad, they were terrifying. To those charged with managing the financial system, the potential calamity they saw on the horizon was not just as bad asLehman Brothers’ collapse three years earlier – it was worse. 

The September minutes of the Bank of England’s Financial Policy Committee (FPC) spoke euphemistically of “severe strains” in funding markets. In part, this reflected the fact that British banks were in a relatively better position compared with many of their Continental rivals, having already spent two years cutting risk and building up capital and liquidity buffers to withstand any new shock. 

However, to those fluent in central banker-speak, the tone of some of the language was shocking, suggesting that despite all the preparations, the British banking system was far from the fortress that was being portrayed.... 

Isn't the problem a lack of transparency?  Why should the financial regulators be in a position to portray the condition of the financial system as something it is not.

Inside the Bank of England something close to panic had gripped the institution. Among senior managers a sense of foreboding had taken hold. ... 

In late October, the Bank made clear its fears to the heads of Britain’s major lenders. The Old Lady of Threadneedle Street was worried the UK’s biggest banks could be swept away by the financial calamity it saw building up in the eurozone banking system.

At a meeting at the Financial Services Authority’s Canary Wharf headquarters at the end of October, Paul Tucker, deputy governor of the Bank of England and the man responsible for the financial stability of the British financial system, shocked the assembled banking elite as he opened the private session. 

“Gentlemen, you could all be out of business by Christmas,” Mr Tucker, a candidate to be the next Governor of the Bank, said to his shocked audience. 

He went on to explain the situation he saw developing and how threatening he thought it could be to even the largest and most financially strong of institutions. Repeating the September minutes of the FPC, Mr Tucker urged all the banks to build even larger liquidity buffers and raise yet more capital. 

“We were left scratching our heads,” said one senior banking executive present. “As soon as I got out, I reported back what Paul Tucker had said and I immediately called my team in to go through every risk exposure we had to see if there was anything we had missed.”

Of course, what has been missed since before the financial crisis is that in the absence of ultra transparency no bank can independently assess the risk or solvency of any other bank and as a result, they cannot properly adjust the amount and price of their exposures to other banks.

Others present were less than impressed by Mr Tucker’s dramatic warning and critical of the Bank’s performance in the months after the meeting. 

“They certainly made some strong statements to us, but they then did very little about it,” complained one banker also present at the meeting. 

“It was obvious the financial system was in a very difficult place, but it’s not exactly constructive to predict doom and gloom and then do nothing.”...

There should be no surprise that the financial regulators did nothing, it is up to the individual banks to be assessing risk and making the appropriate adjustments.

If there was transparency this could and would occur.  It would occur because the market could and would exert discipline on banks to restrain their risk taking.

However, in the absence of ultra transparency, everyone is left to guess what the real level of risk is and what steps they should be taking to reduce their risk exposure.

What happened in France last year is an object lesson in what happens when confidence evaporates. As euro break-up fears flared, attention had begun to focus on the large potential losses lenders such as Credit Agricole, BNP Paribas and Societe Generale would have should Greece exit the currency.... 

In a matter of months, funds more than halved their exposure to the French banking system, removing a crucial short-term source of dollar funding to the banks. For the banks, this raised several problems, as they relied to a greater or lesser extent on the money market funds to provide the liquidity that supported the US investment banking operations they had all developed over the previous two decades.

However, it was not just money market funds that were getting nervous about France. In mid-September, a Deutsche Bank call for clients hosted by analysts saw bankers peppered with questions from Middle Eastern companies, including oil giant Saudi Aramco, about the health of French banks....

It is impossible to know the composition of a bank’s corporate deposits, however Middle Eastern wealth funds and conglomerates have hundreds of billions of dollars in cash held with banks around the world. The hint they could be getting ready to pull their money could spell death for any bank....

But whatever banks were doing themselves to salvage the situation – and with the UK looking into the abyss as well – for central bankers the risks had grown far too great, and on November 30, six central banks, including the Bank of England, the Federal Reserve and European Central Bank, led by Mario Draghi, announced a co-ordinated intervention to provide cheap dollar funding to lenders....

Naturally, the financial regulators jumped in with another bailout.

Although the banks had made it past Christmas, the cost was immense and the various schemes have not removed the fundamental problem for many banks that are still loaded up with toxic loans likely to cost them billions of euros in losses over the coming years. 

British banks have done more than most to come to terms with their toxic legacy, but few think they are out of the woods yet and the prospect of a new crisis is an ever-present worry for central bankers and regulators. 

Mr Tucker’s warning remains: “Gentlemen, you could all be out of business by Christmas.”

Please re-read the highlighted text as we are destined to repeat this cycle of financial crisis requiring bailouts until such time as the banks are required to provide ultra transparency and as a result recognize all the losses on the excesses in the financial system.