Fixing Europe's banks

The steps necessary to fix Europe's banks are well known.  Getting the Financial-Regulatory-Academic Complex (FRAC) to take them is the difficulty.

For readers who are new to this blog, let me review the steps for you:

Step 1:  Require banks to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, all the bad assets hidden on an off the bank balance sheets can be a) identified and b) valued (except, of course, for opaque, toxic structured finance securities which need to have transparency in the form of observable event based reporting on the underlying assets if the market is to value them).

This disclosure provides the good information that Patrick Honohan, the governor of the Central Bank of Ireland, says is critical if the financial system is to be credibly cleaned up.

This good information is available to all market participants.

Step 2: Set up an EU deposit insurance fund while Step 1 is being implemented.

Modern banks are designed to absorb the losses on the excess debt in the financial system and to continue operating and supporting the real economy.  

They can do this because of deposit guarantees and access to central bank funding.  With the deposit guarantees, taxpayers effectively become silent equity partners of the banks while they are rebuilding their book capital levels from low or negative levels.

This works so long as the depositors believe that the country making the deposit guarantee is going to make good on its deposit guarantee.

However, in the EU, policies have been pursued that have raised doubts about the ability of the country to perform on the guarantee and, if the country does perform, whether the guarantee will be honored in euros or a currency worth considerably less.

As a result, the EU needs an EU deposit insurance fund to stand behind each country's deposit guarantee.  This fund should be the European Stability Mechanism.


Step 3:  Once banks are providing ultra transparency, require the banks to recognize the losses on the excess debt in the financial system as quickly as possible.  This should happen across the EU in one quarter.

This protects the real economy as the alternative of not recognizing the losses continues to place the burden of the excess debt on the real economy.  As we have seen, despite enormous amounts of fiscal and monetary stimulus, the burden of this excess debt is causing the real economy to contract.

With the disclosure from Step 1, market participants can exert discipline on the banks to ensure they quickly resolve all their bad exposures after having taken the losses through their financial statements.

Iceland implemented the following program which they felt gave a reasonable estimate of the losses that banks would ultimately recognize if they went through the traditional channel of default, foreclosure and bankruptcy.

• For the household sector, debt in excess of 110% of the fair value of each property was written off.  Specific relief measures (administrated by a bank or a new debtors ombudsman) applied for those that could not service a reduced loan. 

• Low-income, asset-poor  households with high-interest mortgage payment got a temporary subsidy from the government. 

• Small to medium sized firms could apply for debt relief if they could credibly document positive cash flow from future activities.  

The firm had to be willing to re-engineer its operation so as to make best use of its assets. Given those conditions, the firm could expect its debt to be written down to equal the discounted value of future earnings; or alternatively, written down to the amount that the bank or other financial firm could expect, in the best of circumstances, to gain from taking the assets over and realizing their monetary value.  

Hence the debt relief programmes did not create new equity on the balance sheets of firms or households....

The bottom line is that the government, the financial sector and the business sector collectively created a situation that leaves the financial sector with as good a result in terms of total debt collection as possible without the pain of sending most of the firms and many families into bankruptcy, unemployment and dispossession. 

As I said, the steps are well known.

As you can imagine, the Financial-Regulatory-Academic Complex is fighting taking these steps.  Each participant in FRAC has their own reasons for resisting taking the steps.

Bankers resist because it means the end of their cash bonuses until such time as the banks have rebuilt their book capital levels to levels that the market finds acceptable.

Regulators resist because it means the end of both their information monopoly on all the useful, relevant information on their country's banks and replacing the market with their complicated rules and regulations.

Academics resist because it means the focus will shift to how did the economics profession fail to see the financial crisis coming and why did the economics profession not embrace these three simple steps.