Recapitalizing banks without first determining precise losses is waste of money

Reuters reports that 'recapitalizing the Spanish banks without first determining precise losses' could be a waste of money.

Regular readers know that a modern banking system is designed so that it does not need governments to bailout the banks.

With deposit guarantees and access to central bank funding, banks can operate and support the real economy for years while they have negative book capital levels.  As a result, bailouts are unnecessary as banks can rebuild book capital levels through retention of 100% of future pre-banker bonus earnings.

However, the idea that the losses the banks are currently holding should be precisely determined and realized today is important.

Regular readers know that precisely determining and recognizing the losses hidden on and off the banks' balance sheet is the first step in implementing the Swedish model for handling a bank solvency led financial crisis.

The Advisory Scientific Committee said in a report to the European Systemic Risk Board (ESRB), that if losses at the Spanish banks were not determined and balance sheets not cleaned up then EU funds may well be insufficient for recapitalisation. 

"Adding capital without knowing what the assets are actually worth and how much capital is really needed entails a serious risk that the funds may simply be lost as the necessary resolution of the banks is delayed further," the committee said in a report to the ESRB published on Tuesday. 

The first loans are not expected to be handed out until October and Spain will have to restructure its banks in return for the money. 

The committee also backed the controversial principle that all debtholders of a bank, including unsecured senior bondholders, should be forced to take a hit to shore up an ailing bank. 

So far in the financial crisis, senior bondholders have been largely shielded, with shareholders and junior bondholders bearing the brunt of a bank failure. 

"The examples of Ireland and Spain suggest, already at the national level, that the full protection of all senior creditors may exceed the government's fiscal capacity," the committee said. 

"The buyers of such debt should know what they are letting themselves in for, and should have the strongest possible incentives to assess the creditworthiness of, and exercise discipline over, their debtors," the report said.

In theory, buyers of senior debt should have the strongest possible incentives to assess the creditworthiness of and exercise discipline over the banks.

In practice, this is impossible as the financial regulators have a monopoly on all the useful, relevant information that investors need to independently assess the risk of the banks.  Remember, banks are in the words of the BoE's Andy Haldane "black boxes".

Furthermore, the stress tests create a moral obligation on the part of the government not to inflict losses on the senior debt holders.  If the financial regulator says the stress tests show that a bank is solvent, it is reasonable for investors to rely on this representation.

In equally blunt terms, it criticised the "vagueness" of plans by EU leaders to turn the ECB into the supervisor for euro zone lenders, saying they fell short of giving Frankfurt the power to close down ailing lenders.

"Unless the power to close a bank is effectively transferred from national to supranational institutions, the 'single supervisory mechanism in the euro area' will not be effective," the committee of academics and finance industry officials said. 

In such a case, the use of the bloc's bailout funds could very expensive without actually solving the problems, the committee added.

The only banks that need to be closed are those that do not have a franchise that allows them to generate earnings with which to rebuild their book capital levels.