Thursday, August 2, 2012

ECB demonstrates that central banks don't have the tools to solve bank solvency problem

A week after promising to deliver a solution that would solve the Eurozone financial crisis, the Wall Street Journal reports that ECB President Mario Draghi announced that maybe the ECB would resume buying sovereign debt in the secondary market.

This has been tried before without success and there is no reason to believe that it will be successful now.

Typically, when you make a promise and then break the promise your credibility goes down.  There is no reason to expect that will not happen with the ECB and Mr. Draghi.

What you humble blogger has not understood since the beginning of the financial crisis is why we continue to use monetary policy tools that are designed to fight a liquidity crisis to fight a bank solvency led financial crisis?

The tool you fight a bank solvency crisis with in a modern banking system that has deposit guarantees and access to central bank funding is transparency.

By requiring the banks to disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details, banks step up and recognize all of their on and off balance sheet losses.

This in turn takes the burden of the excess debt in the financial system off of both the state and the real economy.  As a result, rather than direct funds to debt repayment, the funds are instead directed towards economic growth.

This economic growth in turns creates new loan demand that helps the banks generate the earnings necessary to rebuild their book capital levels.

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