Ireland tells Spain not to copy Ireland

The Irish Times reports that Spanish officials called Mike Aynsley, the head of Irish Bank Resolution Corporation, to talk about setting up a bad bank.  Mr. Aynsley recommended that Spain not copy Ireland as there was always the perception that the banks had not been entirely cleaned up.

Regular readers know that there is only one way to prove that the banks have been cleaned up.  That is to require the banks to provide ultra transparency and have them disclose their current global asset, liability and off-balance sheet exposure details.

It is only with this information that market participants can independently confirm that all of the bad loans have been removed from the banking system and transferred to one or several bad banks.

The failure to require the banks to provide ultra transparency is the equivalent of the government waving a red flag and announcing that the banks still have something to hide.  If they didn't, then why aren't they providing ultra transparency?

As a practical matter, if the bad loans are going to be transferred at their current market value, it makes sense to have the banks provide ultra transparency first.  That way the market participants can help determine what is the current market value of the bad loans.

Spain would want to transfer the bad loans at current market value because this minimizes the taxpayers' exposure to losses.

In an interview with The Irish Times, Mr Aynsley said he has been in contact with senior officials within the Spanish authorities as Madrid attempts to deal with its deepening banking crisis and devise ways of purging soured loans from its struggling lenders. 

He advised them to be “broader minded” and consider setting up bad banks, not just one bad bank as Ireland did with the National Asset Management Agency. 

“What you are really looking at doing is a clean-up of the banking system, not a partial clean-up of the banking system,” he said. 

Cleaning up the banking system does not require setting up a bad bank.

It simply requires that the banks are required to provide ultra transparency.  Market discipline will force the banks to recognize all the losses currently hidden on and off their balance sheets.

While this will clearly lower the amount of book capital that the banks have, modern banks are designed to continue operating and supporting the real economy even if they have negative book capital levels.

Modern banks are able to do this because of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers are the silent equity partners when banks have negative book capital levels.

“Looking back for Ireland, yes it [Nama] was the right place to start but it wasn’t, in retrospect, a broad enough look at the extent of the problems that were emerging in the banking sector.” 

The failure to remove all the problem loans from the Irish banks froze new lending and created a perception the banks were still broken, said Mr Aynsley.

Of course the bad bank creates this perception if it is not accompanied with ultra transparency.  Without ultra transparency, how does anyone know that the banks have been cleaned up?

This led to a flight of bank deposits and a drain on the European Central Bank, which pressed the last government to apply for a EU-IMF bailout to reduce the ECB’s exposure to the Irish banks. 

“These are the series of unintended consequences not from negligence but from unawareness of the extent of the emerging problems and the breadth of the required response to the problems,” said Mr Aynsley. 

“In structuring its response, [Spain] can do that with a far better knowledge base than Ireland had at the time.”

A knowledge base gained by requiring the banks to provide ultra transparency before setting up any bad banks.

The Australian banker said the power to stem the euro crisis lies with Germany. 

“Until the Germans come to the table and resolve this problem once and for all, we are going to lurch from one short-term fix to another. This is all about the long-term transfer of value from one part of the euro zone to another,” said Mr Aynsley.

This is a point that your humble blogger has been making since the beginning of the financial crisis.

By pursuing the Japanese model for handling a bank solvency led financial crisis, all that is happening is the transfer of value from the real economy to bankers who knew better than to extend credit beyond the capacity of the borrowers to repay.

As Iceland has shown, by requiring bankers to absorb the losses on the excess debt they should never have originated, the financial crisis can be quickly ended.