BoE says that Lloyds and RBS need billions more in capital

The Telegraph reports that the Bank of England has said Lloyds and RBS need billions more in capital to shore up their balance sheets.

This "news" confirms that the Swedish Model and not the Japanese Model is the appropriate choice for handling a bank solvency led financial crisis.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt in the financial system.  This protects the real economy and eliminates the need for policies like austerity that undermine the social contract.

A modern financial system is designed so that banks can protect the real economy by absorbing the losses on the excess debt.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

This combination allows the banks to continue operating and supporting the real economy while they have low or negative book capital levels because deposit insurance makes the taxpayers the silent equity partners of the banks.

The need for billions more in capital is an explicit confirmation that a modern financial system works as designed.  These banks have been operating with we now find out were low or negative book capital levels for the last several years after the losses hidden on their balance sheets have been taken into account.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  One of the policies adopted to achieve this goal was to bailout the banks.

The need for billions more in capital also confirms that the bailouts under the Japanese Model were unnecessary.  Again, the banks operated just fine with the taxpayers as silent equity partners.

Finally, the need for billions more in capital confirms that the only beneficiaries of the Japanese Model are the bankers.  Think of all the money paid as cash bonuses by these banks since the beginning of the financial crisis.

Cash bonuses that would not have been paid had the Swedish Model been pursued and banks required to retain 100% of their pre-banker bonus earnings until their book capital levels had been rebuilt.

UK regulators have given Royal Bank of Scotland and Lloyds Banking Group until March to begin dealing with a black hole that Brooks Newmark, a Tory member of the Treasury Select Committee, suggested could be as large as £30bn. 

Bank officials refused to quantify the capital shortfall in evidence to the TSC yesterday, but they confirmed it was substantial. Michael Cohrs, a member of the Bank’s Financial Policy Committee, said it was “a big number” while Andy Haldane, the Bank’s executive director for financial stability, agreed it was “material”. 

The warning came as regulators admitted that the government had overpaid when rescuing the banks in 2008 and that the taxpayer would never make as large a profit from the bail-outs as the US, if at all. 

Asked whether returns for the UK taxpayer might match the 15pc made in the US, Mr Cohrs said: “I don’t think the UK taxpayer will get those returns.” Pressed on whether the taxpayer would make a profit at all, he added: “I don’t know.” 

Sir Mervyn King, the Bank’s Governor, said: “The sad truth is, in 2008, the idea of focusing efforts on recapitalising the banking system was a UK idea. We got there first but, like many UK ideas, the Americans developed it faster and better.”...

Given that both the UK and US have modern financial systems, the bailouts were unnecessary in the first place.

Although RBS and Lloyds will have to take action to boost their capital, the taxpayer may not have to inject any more than the £65bn already invested, the regulators said. 

The two banks can sell assets or “reduce their investment bank balance sheets, for instance”, Andrew Bailey, head of prudential regulation at the Financial Services Authority, suggested....

Of course there is a third alternative, the banks can boost their capital by retaining 100% of pre-banker bonus earnings.

The UK’s other banks and building societies are under similar regulatory scrutiny, following the FPC’s warning in November that the industry had up to £60bn of hidden losses on its balance sheet – from understated bad debts to underestimated provisions to cover fines and compensation for Libor rigging and other scandals. 

Lloyds and RBS need billions more in capital despite a taxpayer funded bailout that supposedly took into account all the losses hidden on and off their balance sheets.

Given that the UK financial regulators appear to have under-estimated the true amount of capital Lloyds and RBS needed, there is no reason to believe that the FPC's estimate does not suffer from the same problem.

The only way market participants will ever know if the banks are solvent again is if the UK requires its banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency will give UK banks a global competitive advantage.  Market participants will be able to assess the risk of the banks and adjust the amount and pricing of their exposure to the banks based on each bank's risk.

At the same time, market participants know that any bank not providing ultra transparency is undoubtedly hiding something and is far riskier than the UK banks.  As a result, market participants will require a higher return to provide capital to these banks.  This gives the UK banks a competitive advantage until the other banks also provide ultra transparency.

The FPC wants capital positions reinforced to support economic growth....

Regular readers know that it reinforcing bank capital positions is not necessary to support economic growth.  The solution so that credit is available to support economic growth is the originate to distribute model with transparency.

Under this model, structured finance securities ranging from covered bonds to securitizations provide observable event based reporting on all activities like payments or delinquencies on the underlying assets by the beginning of the next business day so that investors can know what they own.

It is the ability to know what you own or know what you are buying that will bring investors back to the structured finance securities and insure that there is sufficient capacity to support economic growth.

Sir Mervyn argued the best course of action was to deal with a lack of capital “straight away”. “Banks have two options – either they raise more capital or they restructure... Investors may not like it, but they will be better off over time,” he added.

Sir Mervyn is wrong.

The best course of action is to adopt the Swedish Model and the originate to distribute model with transparency.

Mr Bailey said: “If you want to sell the Government’s shareholding [in RBS and Lloyds], you have to have a balance sheet and business model that have a stable future.” The taxpayer owns 41pc of Lloyds and 82pc of RBS.