Mervyn King effectively calls for adoption of Swedish Model: No recovery until banks own up to their bad debts

Mervyn King, the Governor of the Bank of England, effectively called for the adoption of the Swedish Model to handle a bank solvency led financial crisis when he observed that there will be no recovery until banks own up to their bad debts.

He went on to say that the banks also have to be recapitalized.  However, as regular readers know, it is unnecessary to recapitalized the banks to have them provide the loans that are necessary to support the real economy.

The reason that banks don't need to be recapitalized to make loans is that the activity of making a loan is separate from the activity of funding the loan.  Funding for a loan can come from a lot of sources like pension funds, insurance companies, mutual funds, hedge funds or even other banks.

The British economy will not recover until the banks own up to their bad debts and are recapitalised again, the Governor of the Bank of England has warned. 

Raising the prospect of rights issues or even another taxpayer bail-out for the state-backed lenders Royal Bank of Scotland and Lloyds Banking Group, Sir Mervyn King said UK banks have “insufficient capital” to protect against undeclared losses on their books.

His statement that banks have insufficient capital to protect against undeclared losses clearly indicates that a) banks have more undeclared and disclosed losses than book capital and b) that banks cannot operate with low or negative levels of capital.

While I agree with Mr. King that the banks are hiding their losses, I disagree with Mr. King that banks cannot continue to operate and support the real economy while they have low or negative capital levels.

In fact by design, banks can continue to operate when they have low or negative capital levels.  They can do so because of deposit guarantees and access to central bank funding.

With the deposit guarantees, the taxpayers become the banks silent equity partner during periods when the banks have low or negative book capital levels.  As their silent equity partner, the taxpayers require that the banks retain 100% of pre-banker bonus earnings to rebuild their book capital levels.

He also ruled out suggestions that the Bank should try to boost growth by simply giving the public cash or cancelling the government debt it has bought through quantitative easing (QE).

I agree.  It would be much better to have banks fund the central bank's government debt portfolio with non-interest bearing excess reserves as the way to effectively reduce government debt outstanding.

Warning that the next generation may have to live with the consequences of past excesses “for a long time to come”, he said Britain’s banks needed to drop the “pretence” that their debts will be repaid. 

“I am not sure advanced economies in general will find it easy to get out of their current predicament without creditors acknowledging further likely losses, a significant writing down of asset values, and recapitalisation of their financial systems,” he said.

“Only then will it be possible to return to a more normal provision of the vital banking services so crucial to an economic recovery... Just as in 2008, there is a deep reluctance to admit the extent of the undercapitalisation of the banking system in parts of the industrialised world.” 

He compared the situation to the “pretence that debts could be repaid” in the 1930s and added: “We must not repeat that mistake.”

Please re-read the highlighted text as Sir Mervyn King has just laid out the case for pursuing the Swedish Model for handling a bank solvency led financial crisis.

Four years since Lehman Brothers collapsed, UK banks still need taxpayer help as they “find it expensive to borrow” without central bank support, he claimed. ...

The reason the banks need taxpayer help to borrower inexpensively is because the lack of transparency into the banks' exposures means no market participant can assess the risk of the banks.

As shown by the frozen interbank lending market, when a lender cannot assess the risk of the borrower, the lender either doesn't lend or charges a significant premium.

Bank analysis shows that UK lenders have eased lending terms for struggling businesses and households on £175bn of debt. Sir Mervyn hinted that it is a problem, saying: 

“Perhaps forbearance by banks has allowed inefficient firms that might otherwise have had to contract to continue.”

This is just part of the burden placed on the real economy by protecting bank book capital levels and banker bonuses at all costs.

Additional burden is placed on the real economy through pursuit of monetary policies like quantitative easing.

Despite warning there was “no shortcut” to recovery, he said the economy was showing “encouraging signs” in comments that appeared to lower the chances of more QE in November.

Actually, as Iceland has shown, there is a short cut to recovery.  Make the banks recognize upfront the losses they would expect to realize if the £175bn of debt in forbearance went through the long bankruptcy/workout process.

This eliminates the excess debt in the financial system, protects the real economy, promotes growth in the real economy as funds that were being used for debt service are used to buy goods and services, keeps families in their homes and protects social programs.