Europe's bank recap strategy has hit its limit

In his Breakingviews column, Peter Thal Larsen makes the argument that Europe's bank recap strategy has hit its limit and that until Europe's banks clean up all of the bad debt hidden on and off their balance sheets no one will trust them regardless of the book capital ratios they show.

This is true and the only way that anyone will believe the banks have cleaned up all the bad debt is if they banks provide ultra transparency to prove it.  Under ultra transparency, the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can independently confirm that the banks have addressed all their bad debt.

Without this information, market participants have to assume that banks have something to hide or otherwise they would provide ultra transparency.

Europe’s bank recapitalisation strategy has reached its limits. The continent’s lenders have added 94 billion euros to their capital buffers since the end of September, comfortably exceeding demands set by the European Banking Authority. Yet they are not yet in the clear. To restore trust, banks will have to clean up their loan books – and hope the euro zone can solve its sovereign woes....

Moreover, banks used relatively few tricks to hit their targets. Most of the improvements to capital came from banks issuing equity and convertible bonds; buying back hybrid debt at a discount; retaining earnings; or offloading assets. True, some banks tweaked risk models to reduce their risk-weighted assets, but this sleight of hand accounted for just 10 percent of the total capital raised. Concerns that banks would respond to the EBA’s demands by shrinking their balance sheets proved wide of the mark. Total loans contracted by just 0.62 percent. 

But anyone who expects faith in Europe’s banks to be magically restored will be disappointed. Not only are funding markets largely closed to the continent’s lenders, many are dangerously dependent on the European Central Bank for liquidity. 

Regular readers know that until banks provide ultra transparency they are 'black boxes'.

As 'black boxes', banks with deposits to lend cannot evaluate the risk of the banks looking to borrow.  The result is that interbank lending market remains frozen.

If banks cannot evaluate the risk of an investment in another bank, how can any other source of funding be expected to evaluate the risk of an investment in a bank?  They cannot and as a result, funding markets remain largely closed.

Rebuilding confidence will require banks to clear out the bad assets still clogging up their balance sheets. And Spain’s bank bailout illustrates the extent to which domestic regulators have allowed lenders to keep their problem loans hidden from view. 

Without ultra transparency, how can investors tell if the banks have cleared out the bad assets still clogging up their balance sheets?

As Spain shows, the regulators are not forcing the banks to address the bad assets.

Such a clean-up would clear the way for the creation of a pan-European banking union, backed by joint deposit insurance. That would help to break the toxic embrace between euro zone banks and governments.

Please re-read the highlighted text as your humble blogger has made exactly this argument in my blueprint for fixing the financial system.

Our financial system is designed so that banks can protect the real economy by acting as a shock absorber and absorbing the losses on the excess debt in the financial system.

Banks can do this because of deposit insurance and access to central bank funding.  Deposit insurance and access to central bank funding allow banks to continue to operate and support the real economy even if the banks have low or negative book capital levels.

Deposit insurance effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.

Hence, it is important to insure that depositors 'trust' the guarantee.  In Europe, this trust has been shaken by the threat to a) boot Greece from the EU ... this has created redenomination risk and b) the possibility of sovereign bankruptcy ... this has created doubts as to whether the deposit guarantee will be honored.

To insure that depositors 'trust' the guarantee, I have argued that the European Financial Stability Fund and the European Stability Mechanism should backstop the sovereign's deposit guarantee.  This should be the only use for these funds.

Please recall that the funds are not needed to bailout the banks.  Banks that are capable of generating earnings can rebuild their book capital levels over time.  Banks that are not capable of generating earnings can be merged into healthier banks or closed.

This completely severs the toxic link between bailing out the banks and their host government's access to funds.