UK regulator warns that 'banks will always blow themselves up'

As reported by the Telegraph, Michael Cohrs, a member of the Bank of England's Financial Policy Committee, observed

Policymakers will simply have to learn how to deal with banks that blow themselves up because it may be impossible to stop them.

Please re-read the highlighted text as it is very important to realize that it is virtually impossible, and probably not desirable, to stop banks from blowing themselves up.

The question is not how to prevent banks blowing up, but how to limit the impact on the real economy when they do.

Ultra transparency is the key to both minimizing the chances that banks will blow up in the first place and insuring that when they do the impact on the real economy is minimized.

Regular readers know that with ultra transparency under which banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details market participants can independently assess the risk of each bank.

Market participants can use this risk assessment to set both the amount and pricing of their exposure to each bank.

In setting the amount, market participants consider both the risk of the bank and the participant's ability to absorb losses given this risk.

In setting the price, market participants consider the risk of the bank and what they need to be compensated in return given this risk.  Naturally, as risk increases, so will the bank's cost of funds.  It is this market discipline that should minimize the chances a bank will blow up in the first place.

However, if a bank fails, there is no need to shift the burden of the bad debt on a failed bank's books onto the real economy as investors in the bank know that they are responsible for the losses and have only committed what they can afford to lose.

Michael Cohrs, a former Goldman Sachs banker who now sits on the Financial Policy Committee, said regulators may be trying too hard to “re-fight the last war” and that “allowing financial companies to blow themselves up, and then try and deal with the fall-out, may be – whether we like it or not – the reality of where we end up”.

With ultra transparency, there is little fallout as the equity and debt investors absorb the losses (I assume that regulators will close the institution before the level of losses causes the taxpayer to incur losses as a result of the deposit guarantee).

Speaking at the University of the West of England, he also warned the authorities against forcing banks to increase lending, saying it was “no silver bullet” for the current economic malaise. Higher lending risked weakening the banks as most households and businesses were trying to pay off their debts and those wanting more debt were the least creditworthy. 

“If we push too hard on the lending theme, we will simply raise default levels, as more of the borrowers will not be creditworthy,” he said. “There is no silver bullet to quickly fix the current economic situation.”

Actually, the silver bullet is the adoption of the Swedish Model and requiring the banks to absorb upfront the losses on the excess debt in the financial system.  Freeing up capital that is currently being used to service this excess debt will immediately lead to economic growth.

Drawing attention to the wide variety of financial crises over the past 200 years, Mr Cohrs said: “We shouldn’t pretend we can eliminate financial crises completely. Nor that the next crises will necessarily be a carbon copy of the last one.” 

Actually, the Great Recession was a carbon copy of the Great Depression in that opacity in the financial system meant that risk was mis-priced.  In both financial crises, this mis-pricing of risk led to too much debt in the financial system.

The turning point of the Great Depression was when the FDR Administration required banks to absorb the losses on the excess debt.

When will this turning point occur for the Great Recession?

In a subtle dig at the Chancellor, he argued that unless the structural reforms proposed by Sir John Vickers were implemented fully – including “17pc-20pc loss absorbing capital and a leverage ratio of 4.06pc" – he did not “believe they will necessarily make financial institutions much less likely to fail”. The Chancellor has watered down the leverage ratio. 

Ultra transparency is the best method for making financial institutions less likely to fail.

When market participants can see the risk that banks are taking, the bank's cost of funds reflects this risk.  As a result, market participants restrain bank risk taking.

However, acceptance that banks will fail does not mean the taxpayer can not be protected, he stressed.

This is accomplished by investors adjusting the amount of their exposure based on their independent analysis of risk using the information disclosed under ultra transparency.

He suggested that “too big to fail” banks should be forced to pay “penalties or taxes to create insurance funds” to be used to cover the costs of a major bank collapse “and to create an economic incentive for the firms to downsize”.

The “penalty” should be “in addition to the 2.5pc capital surcharge” global regulators have recommended. In addition, he said: “We must accept that both shareholders and debt holders should suffer losses when a financial company goes into receivership.”...

Shareholders and debt holders will only agree to accept a loss if there is ultra transparency and they have the data they need to evaluate the risk of an investment in each bank.

Without ultra transparency, shareholders and debt holders are blindly betting and "trusting" the regulators when they say the banks are solvent.

He added that there was no need to wait until 2019 to get on with reform as banks can “downsize and delever without unduly impacting their ability to provide necessary services to their clients if they so wish”, by dumping trading-related assets.

And most importantly, banks can provide ultra transparency well before 2019.