Banks must be honest about their losses

In his Telegraph column, Liam Halligan expresses his and your humble blogger's satisfaction with the Bank of England Financial Policy Committee's recognition that banks are hiding losses on and off their balance sheet and, more importantly, its call for action.

Specifically, that the banks disclose all the information that market participants need to independently assess that the bank has disclosed all of its losses and that the bank has taken adequate reserves to cover these losses.

In essence, the FPC called for the banks to provide ultra transparency and disclose all of their current global asset, liability and off-balance sheet exposure details.  It is only with this level of disclosure that market participants can independently confirm that all losses are disclosed and reserves taken.

Perhaps more importantly, the FPC's call signals movement away from the Japanese Model for handling a bank solvency led financial crisis to the Swedish Model.

The FPC is saying that the time has come to end protecting bank book capital levels and banker bonuses under the Japanese Model by following policies of regulatory forbearance (think extend and pretend for bad debt) and ending mark-to-market accounting.

The first step of the Swedish Model is requiring the banks to recognize upfront their losses on the excess debt in the financial system.  This is exactly what the FPC is calling for.

Regular readers know that what Mr. Halligan says applies to the EU and US as well.

Vindication comes in the form of the latest Stability Report from the Bank of England's Financial Policy Committee, published last Thursday. 

For a long time, this column has focused on the multi-billion pound undeclared losses on the balance sheets of the UK's largest banks as the major reason why our economy remains moribund and unable to stage a recovery. The FPC has just shown that it not only agrees with that view but wants to take some action. 

Ever since the sub-prime crisis exploded, Western banks have been harbouring huge hidden liabilities, burying them using off-balance sheet vehicles, complicit auditors and a host of obfuscation tactics. 

Financial markets know this, which is why banks have been trading at extremely low "price-to-book" valuations – with many priced at less than the value of their tangible assets. 

If the UK economy is to fire on all cylinders again, our banks badly need to raise fresh capital, so providing finance to the creditworthy businesses that will pull us out of the recession danger-zone. Our politicians stick with the "growth versus austerity" soap opera, trading ideological jibes as they argue over future taxation and spending plans that are anyway largely fiction. 

The genuine cause of our economic torpor, meanwhile, is that banks aren't raising the new private sector capital needed to kick-start investment and commerce. That, in turn, is because no one trusts their accounts given the huge smouldering sub-prime related losses which bank executives are pretending don't exist. 

What's needed is "full disclosure", forcing the banks to recognise such losses, taking the hit, and moving on. Some banks would fail, of course, executive egos would be bruised and reputations would suffer.

Banks would be restructured, while protecting retail and commercial deposits, with the weak being taken over by the relatively strong. Then, though, banks could recapitalise, the wheels of finance could once again start turning, and capitalism's "creative destruction" would be able to take its course.

Please re-read the highlighted text as Mr. Halligan has nicely summarized the both the need for ultra transparency and how it complements the Swedish Model for handling a bank solvency led financial crisis.

Regular readers recall that the Swedish Model is the only policy response that has ever worked to end a bank solvency led financial crisis (it worked in the US to end the Great Depression, it worked in Sweden and most recently it worked for Iceland).

Over the past year or so, the FPC has been emphasising that UK banks need to maintain capital buffers against unexpected losses. Such "provisioning" is crucial in any economy. On paper, British banks are generally reporting acceptable capital ratios. 

But last week, Bank Governor Sir Mervyn King basically accused them of failing to tell the truth. 

While this is something financial markets have suspected and acted upon for a very long time – and some commentators have dared to articulate – it's a very big step for the Bank of England to give voice to such concerns. 

"In judging whether banks are adequately capitalised, we need to ensure that reported capital ratios do, in fact, provide an accurate picture of banks' health," boomed Sir Mervyn, as he introduced the FPC report. "At present, there are good reasons to believe they do not." 

The Governor went on to spell out the dire economic implications of this lack of faith in banks' balance sheets. "Investors need confidence that banks have adequate buffers against stress in order to be willing to fund them at the low rates necessary to support a recovery. We need banks to be more clear and more accurate about their positions."

Please re-read Sir Mervyn King's comments as they are unambiguous in their call for ultra transparency and adoption of the Swedish Model.

The FPC is now openly raising concerns about banks understating their future losses on many of the unwise loans they extended and investments they made in the run-up to the sub-prime debacle. 

Regulators worry aloud that capital ratios, with risk-weighted assets as the denominator, are understated – not least as banks are still permitted to use their own in-house models to measure risk. That means such risks are understated, so less provisioning capital is put aside.

ie, bank book capital levels and ratios are currently meaningless.  A point that was made by the OECD and your humble blogger frequently since the beginning of the financial crisis.

In addition, the FPC judges that UK banks are seriously under-estimating the cash they need to pay compensation related to the recent slew of bank scandals – not least the mis-selling of payment protection insurance and the Libor manipulation. 

While Sir Mervyn didn't quantify the level of capital banks need to raise, he described it as "material". The Bank's internal research suggests a shortfall of up to £50bn. Many investors think the damage could be much higher. But that's the point – nobody truly knows. And until they do, our banking sector will remain paralysed, acting as a brake on recovery.

And the only way to find out is to start by having the banks provide ultra transparency.

One of the side benefits of ultra transparency is it also changes the culture of the banks to supporting the real economy rather than using the veil of opacity to extract excess return from the real economy.

Keen to avoid panic, but nevertheless determined to press for change, Sir Mervyn weighed his words very carefully. But his overall message was clear. "Our aim is to get to the point where private investors again have confidence in banks," he said, "so banks have the confidence to lend". Precisely.

As I have been repeating since the beginning of the financial crisis, it all starts with the banks providing ultra transparency.

The fact that this hasn't been in the case, with zombiefied banks allowed to hang on when they should have been dismantled, is the major reason why the UK – like so many other Western nations – has been so economically fragile in recent years. 

Sir Mervyn has vowed to implement a tougher approach...

Ultra transparency is the ultimate in tougher approach as it brings with it market discipline.  Market discipline that has been absent from the banking sector for several decades.