Mohamed El-Erian: Wall Street banks are still sicker than you think

In an article in the Atlantic, Pimco's Mohamed El-Erian claims the banks have largely recovered from the financial crisis and sees three issues that must be resolved before banks will be able to complete their recovery.

As analysts pour over the details of the recent earnings announcements by U.S banks, one thing is clear: The banking system has largely overcome a complex set of self-inflicted injuries.... 

Banks fueled the worst of the 2008 global financial crisis with a combination of three crippling, self-created problems: too little capital, too many doubtful assets and a risk-taking culture gone mad.... 

With exceptional public sector support from the Federal Reserve and other government agencies .... 

Meanwhile, popular anger remained high, fueled by what many considered as an overly lenient treatment by the U.S. Treasury and the Federal Reserve.  

And it sure did not help that some banks were inclined to quickly resume some highly controversial practices.

The recent set of earning announcements by banks point to significant progress in overcoming the three big problems. Capital cushions are now big and deep, asset quality has improved significantly, and internal incentives are being re-aligned. In addition, banks seem to have placed part, though not all, of their litigation risk behind them.

Given that the banks are 'black boxes', there is no way for Mr. El-Erian to prove his assertion that 'capital cushions are now big and deep, asset quality has improved significantly'. [With the suspension of mark-to-market accounting and adoption of regulatory forbearance, bank book capital and asset quality, think 'zombie loans', is overstated.]

What we do know is that the interbank lending market remains essentially frozen.  This is a market where banks with deposits to lend provide unsecured funding to banks looking to borrow.

The reason that the interbank lending market froze at the beginning of the financial crisis was that the banks with deposits to lend knew the banks looking to borrow were holding doubtful assets.  There was a real question about the solvency of the borrowing banks and their ability to repay the unsecured debt.

The only way to answer this question is to provide the banks with deposits to lend the necessary information for assessing a bank's solvency.

Nothing has happened since August 9, 2007 to provide this information and banks with deposits to lend continue not to lend.

Mr. El-Erian lays out his three big remaining issues

(1) Most important among these is the still-unresolved debate on whether and how to break up large banks that are "too big to fail," "too complex to fail, "too interconnected to fail" and"too big to manage." 

(2) Regardless of where they find themselves on the size issue, banks are yet to fully re-align their operating models with current-day realities.... 

(3) Because banks got off way too easily in 2009-2010 -- even escaping a windfall profit tax -- society remains suspicious of bankers and their motivations....

Do not under-estimate the importance of these three factors. 

Absent their timely and comprehensive resolution, the funding of the real economy will remain sub-optimal, liquidity in capital markets will continue to contract, and gains in financial soundness will come at the cost of significant efficiency losses.

Regular readers know that all three of Mr. El-Erian's issues can be easily solved by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency addresses "too big to fail", "too complex to fail", "too interconnected to fail" and "too big to manage" through the use of market discipline.  Specifically, once market participants have the information they need to assess the risk of each of these banks, each bank's cost of funds will move to reflect its risk.

Banks that are too complex, interconnected or un-manageable will pay a much higher cost to access funds than banks that are not complex, have limited their interconnections to what they can afford to lose and are manageable.

This higher cost of funds (and the related lower stock price) is the market's way of disciplining the banks.  Rather than pay this higher cost of funds, banks have an incentive to shrink.  This takes care of the too big to fail problem.

Ultra transparency also helps to align the banks' operating models with today's reality.  Specifically, it ends activities like manipulating benchmark interest rates (see Libor) and taking proprietary bets (disincentive to gamble because market can trade against positions so as to minimize their profitability).

Finally, ultra transparency addresses society's suspicion of bankers and brings with it a new cultural reality.  Market participants know that sunshine is the best disinfectant as bad behavior by the bankers is immediately exposed and can be effectively disciplined.