Hierarchy for resolving bank insolvency

The bail-in of uninsured depositors in the Cyprus banks highlights the need to establish a global hierarchy for resolving insolvent banks.

Your  humble blogger would suggest the following hierarchy for apportioning the pain of recapitalizing the bank or absorbing the losses.

1. Future earnings generated by the bank;
2. Common stock holders;
3. Preferred stock holders;
4. Junior unsecured bondholders;
5. Senior bondholders;
6. Uninsured depositors;
7. Host country taxpayers through the deposit guarantee;
8. Foreign taxpayers.

What distinguishes this hierarchy is that it explicitly recognizes that a bank can transition between solvency and insolvency and back to solvency as the market value of its assets changes between greater than to less than to greater than the book value of its liabilities.

As I describe in an earlier post explaining why a bank never needs to be bailed out, we can determine if a bank has a viable franchise by looking at whether its assets after recognizing its losses on its excess debt exposures generate enough interest income to exceed the interest expense on its liabilities.  

If interest income exceeds interest expense, the bank franchise is viable and the bank can generate the earnings to rebuild its book capital levels.  If interest income is less than interest expense, the bank should be resolved.  It is only then that we go past step 1 in the hierarchy.

Naturally, bankers are going to fight against adoption of this hierarchy.  The reason they will fight adoption is that it puts the pain for the losses currently hidden on and off the bank balance sheets directly on the bankers.

Specifically, while a bank is generating earnings to absorb the losses, banker pay is likely to be highly restricted.  As oppose to the current situation where taxpayers are absorbing the losses and bankers are paying themselves near record levels of pay.

Of course, from the standpoint of everyone lower down in the hierarchy, including taxpayers, they prefer to maximize the amount of future earnings generated by the bank that are used to absorb the losses.

This preference for maximizing future earnings to absorb losses highlights a critical issue:  how quickly do banks need to be recapitalized after they become insolvent?

A modern banking system is designed so that banks can operate for years, even decades, with low or negative book capital levels.  

Banks can operate and support the real economy as a result of the combination of deposit guarantees and access to central bank funding.  With deposit guarantees, taxpayers effectively become the banks' silent equity partner when the banks are in the process of generating earnings to rebuild their book capital levels. 

Regular readers know that to prevent bankers gambling on redemption to restart their bonuses sooner and to ensure that banks absorb all the losses on the excess debt in the financial system, banks must provide ultra transparency.  With disclosure of the banks' current global asset, liability and off-balance sheet exposure details, market participants can exert discipline on the banks to clean-up their exposures and restrain their risk taking.

But what about the fact that banks are going to have negative or low levels of book capital?

It is the deposit guarantee that makes bank book capital levels irrelevant to insured depositors.  A lesson learned from their parents when they opened up their first bank account as a child and asked how could they trust that the bank would give them their money back.

Yes, uninsured depositors, bondholders and stockholders are going to be concerned about the level of book capital.  The low level is a source of market discipline as it gives them a vested interest in making sure that banks minimize their risk while rebuilding book capital levels.

But if banks have low or negative book capital levels, how can they support the real economy by lending?

A distinction must be made between a bank's ability to originate a loan and its ability to fund the loan on its balance sheet.

Banks can always originate loans.  When they are rebuilding their book capital levels, they are restricted in their ability to fund the loan on their balance sheets.

This is okay because banks can always sell the loan to investors like insurance companies, pension funds, hedge funds and better capitalized banks that would like to hold the loan.

Ernst & Young predicts that banks will have to be more transparent

As reported by the Telegraph's Harry Wilson, based on a survey of corporate executives, Ernst & Young is predicting that banks will have to be more transparent about their risks.

The EU's using deposits to recapitalize the Cyprus banks has reinforced the need corporate executives see for transparency.  It has reinforced the need for transparency as corporate executives don't want to put their working capital at risk by keeping it in a bank that is likely to need to be bailed out using deposits.

Regular readers know that the only way corporate executives and other market participants can have access to the information they really need to evaluate the risk of a bank is if the bank provides ultra transparency.  It is only by disclosing its current global asset, liability and off-balance sheet exposure details that a bank's risk can truly be assessed.

More than half of top executives at some of the world’s largest companies think their banks are still taking too many risks five years on from the financial crisis, according to a survey by Ernst & Young. 

Just 43pc of executives said they were completely confident their banks were taking acceptable risks, while less than a third said their banks shared adequate information on its risk, capital and liquidity.

Among the businesses taking part in the survey were the drinks maker, Diageo, Google, the internet search provider, and the energy company, Total, with executives complaining about a lack of transparency from their banks. [bold added]

Please re-read the bolded text as it nicely summarizes how the lack of transparency prevents banks from being subject to market discipline.  Top executives think, but don't know, that their banks are taking too much risk.  The executives would like to know so they could manage their exposure based on the actual level of risk at each bank.

Banks become subject to market discipline when the risk the banks take is reflected in the amount and cost of their funding.  Clearly, corporate executives would like to exert market discipline on the banks, but are prevented by a lack of transparency.

“The lingering after-effects of the 2008 financial crisis and the ongoing challenges in the eurozone have forced corporations to focus on the stability of their core banking teams. 

Counterparty risk and exposure from banks have become heightened concerns for large corporates and, as a result, we predict that banks will have to be more transparent about their risk profiles and portfolio concentration,” said Steven Lewis, a global banking analyst at Ernst & Young....

It is nice to have Ernst & Young confirming the need for banks to provide more transparency.

If deposits safe in EU, Schaeuble should have banks provide transparency to prove it

Reuters reports that German Finance Minister Wolfgang Schaeuble says that deposits are safe in the eurozone and won't be used to bailout insolvent banks.

If this statement is to be believable after uninsured depositors were effectively wiped out in Cyprus, Mr. Schaeuble should have the banks provide transparency and prove that they are not insolvent.

Naturally, the first banks to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details should be in Germany.

It is only with this information that market participants can assess the solvency of each bank and assess the risk that they might be called on to bailout an insolvent bank.

The failure of Mr. Schaeuble to back up his claim that deposits are safe by insisting that eurozone banks provide transparency is the equivalent of waving a big red flag and saying of course the banks have something to hide and we need depositors to keep their money in the banks so that we can seize it.

German Finance Minister Wolfgang Schaeuble has said savings accounts in the euro zone are safe, adding that Cyprus is a "special case" and not a template for future rescues....

"Cyprus is and will remain a special one-off case," Schaeuble said. 

"The savings accounts in Europe are safe."

Prove it! 

Require the banks to provide ultra transparency so that market participants can confirm this statement.

Schaeuble said the problem in Cyprus was that two large banks in Cyprus were in effect no longer solvent and the Cyprus government did not have enough money to guarantee savings. 

"That's why the other euro zone countries had to help," he said. "Together in the Eurogroup we decided to have the owners and creditors take part in the costs of the rescue - in other words those who helped cause the crisis."... 

"Yes, you could see that during the Cyprus crisis," he said. "The entire turbulence did not have any impact on the other countries in Southern Europe."...

Except for the fact that uninsured depositors are now quickly figuring out how to reduce their exposure so that all their deposits are insured.

Perhaps the Department of Justice knew something when it didn't prosecute the banks; judge dismisses Libor case

For those of us who are not lawyers, it certainly appeared after the Too Big to Fail banks confessed to and paid fines for manipulating the benchmark interest rates, Libor in particular, that investors who suffered losses as a result of the manipulation would be able to recoup their losses.

Turns out that we were wrong.

As reported by the Wall Street Journal, the judge presiding over the case decided that because the banks agreed to cooperate in manipulating the rate the investors shouldn't be reimbursed.

With this ruling, the judge single-handedly validated the US Department of Justice's decision not to pursue any of the bankers for their misbehavior.

It turns out that the DoJ understood that no matter how strong the fact set, and the banks saying they are guilty of manipulating the benchmark interest rates for their benefit and paying a fine is a pretty strong fact set, judges would let the banks off.

This ruling appears to confirm that the Too Big to Fail truly are Too Big to Jail and they are in a position to engage in any illegal conduct that they would like.

A federal-court judge on Friday agreed to dismiss claims that the 16 banks targeted by the suits broke federal antitrust laws through alleged suppression of the London interbank offered rate, or Libor. 

In a 161-page ruling on the banks' motions to dismiss the leading suits seeking class-action status, U.S. District Judge Naomi Reice Buchwald allowed some of the claims to proceed, including allegations the banks breached commodities laws. 

But if her ruling stands, it would take out a central plank of the litigation. The federal antitrust claims that the judge threw out can pay up to triple damages.... 

Judge Buchwald said her ruling was based on the conflicting legal arguments affecting the suits, rather than whether the underlying allegations of rate-rigging were true.... 

Judge Buchwald ruled that the banks' alleged conduct didn't breach federal antitrust laws, partly because the Libor-setting process was a "cooperative endeavor" and "never intended to be competitive."

That means even if the banks did subvert the Libor process by putting in fake estimates, any losses suffered by investors and other plaintiffs would have resulted from the banks' "misrepresentation, not from harm to competition," the judge wrote.

Just wondering, but could any bank have become a participant in the Libor-setting process or was there a restriction, say based on size, on who could participate?

Transparency and the end of crony capitalism

Since before the financial crisis started, your humble blogger has been building the case for bringing transparency to all the opaque corners of the global financial system.  These opaque corners include, but are not limited to, banks and structured finance securities.

As part of building the case, I have cataloged the benefits of transparency.  One benefit is that it puts an end to crony capitalism.

Why?

Because sunshine is the best disinfectant.

It reveals each banks' detailed exposures and let's everyone know who is receiving preferential treatment.  It is one thing to engage in a shady transaction behind the veil of opacity and quite another to engage in these transaction when both bank and recipient will be immediately identified.

Cyprus is a case study in why banks must provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details so that crony capitalism ends (I understand this applies to Slovenia too - hat tip Yves Smith @ NakedCapitalism).

If Cyprus banks had been required to provide ultra transparency, do you think that the activities documented below by Keep Talking Greece (hat tip Anat Admati) would have occurred?

As I said, ending crony capitalism is one of the benefits of transparency.

A major political earthquake shakes Cyprus after a list containing names and written-off loans by banks was handed out to the Parliament. Politicians from three major parties and government officials took loans from the Bank of Cyprus and Cyprus Popular Bank (Laiki) and had them written-off after having paid back only a small part of it -in best case.

Former and current politicians (except from EDEK and Ecology party), wives or relatives took loans of several thousands euro and achieved significant remission of the debts by the banks.

A parliamentary investigation will have to show how and why this special treatment occurred and thus by boars of the financial institutions that were appointed by the same politicians who took the loans.

The list was handed out by the directors of a major Cypriot website 24H to the general prosecutor on Wednesday afternoon.

Greek daily Ethnos published the list on Friday however omitting the full names of the politicians and the companies. 

“Politicians’ names on the list of the big looting”

Indicative examples for deleted loans by the Bank of Cyprus:

A hotel company “affiliated to AKEL-PEO” had the total loan of  €2,813,000 deleted in May 2012.

Pancypriotic Labor Federation (PEO) had deleted 193,000 euro from a 554,000 euro loan in May 2012.

Company «N.M.G.» “affiliated to AKEL official, had 110,000 euro being deleted from 1,830,000 euro loan in March 2007 and January 2008.

Former DHSY MP paid back only 67,000 euro to a loan of 168,000 euro. The rest was deleted.

A company belonging to brother of former DHKO minister paid back only 310,000 euro for a loan of 1,595,000 euro. The rest was deleted in May 2011.

The son of former AKEL-minister had 2,000 euro deleted in May 2012. The total loan was 5,000 euro.

Similarly the Cyprus Popular Bank (Laiki) and the Hellenic Bank had deleted loans to active ambassadors, former and current wives of foreign ministry officials, but preferably loans given to former lawmakers.

The most striking case seems to be this of a company of a famous politician in the Cypriot scene (owns 51% of company shares). He appears to have made a deal with COP to delete a loan 0f 5.8 million US-Dollars. The loan delete was planned for 2014.

The scandal explodes like a bomb in the country amid a severe economic crisis with the two banks on the verge of bankruptcy and depositors having to come up for their losses.

The real mistake over Cyprus bailout would be to think it can't happen here

In his Telegraph column, Graeme Archer asks the question of whether depositors living in the UK could find themselves, like Cypriot depositors, suddenly losing their money to bailout the UK banks.

It no longer feels unimaginable that we could wake up one day, and find our interconnected banking system had hit another glitch, cutting us off from “our” money. 

As the European Commission announced on Thursday: “In certain circumstances, the stability of financial markets and the banking system in Cyprus constitutes a matter of overriding public interest and public policy justifying the imposition of temporary restrictions on capital movements.” 

In other words, a ban on cheques and a limit of 300 euros a day on withdrawals. 

Couldn’t happen here? 

In Britain, where incomes have stagnated, prices have risen, and the workings of the banks remain as opaque as the inner sanctum of that mysterious money-god’s temple? Where those who rely on other people’s money remain in utter denial about the new reality?...  

How can our politics work, when so many voters are affected by the restrictions on public expenditure, restrictions that are required to stave off those supra-national impositions on private expenditure, which would follow failure to get to grips with the problem?... 

would it be more likely, or less, that Britain’s future would resemble Cyprus’s present? [bold added]

As your humble blogger has repeatedly observed, if policymakers and financial regulators are going to use depositor bail-ins to recapitalize the banks, the policymakers and financial regulators must first require the banks to provide ultra transparency.

With each bank's current global asset, liability and off-balance sheet exposure details, depositors have access to the information needed to independently assess the risk and solvency of the banks.

Depositors can do this independent assessment themselves or hire a third party expert to do the assessment for them.  An examples of investors relying on third party experts are mutual fund portfolio managers.

Regardless of who assesses this information, based on this assessment, the depositor can determine how much exposure they want to a bank.

As your humble blogger has repeatedly observe, the global financial system is based off the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

 Simply put, it is only fair if an investor is responsible for all losses on the investment that the investor have access to the all the information needed to make a fully informed decision and can therefore limit their exposure to what they can afford to lose.

ECB's Knot backs banks providing transparency before depositor bail-ins

Reuters reports that the ECB's Klaus Knot supports the EU template that includes having uninsured depositors helping to bail-in undercapitalized banks.  However, he wants the banks to provide transparency before any uninsured depositor bail-ins.

A point that your humble blogger first presented!

Mr. Knot recognizes that the problem is not that uninsured depositors are a source of funds for recapitalizing the banks.  The problem is that in the absence of transparency there is both a perception and reality that the deposits are being "seized".

What further exacerbates this perception and reality of deposit seizure is the governments have made an investment representation about the banks through the announcement of the results of the stress tests.

By announcing that the banks passed a solvency-focused stress test or need a modest amount of additional capital, the government creates a moral obligation to protect depositors who could reasonably rely on these results when making a decision to keep funds at a bank.

Regular readers know that the government announcing the results of a stress test would not be a problem if the banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Under the FDR Framework, which is the basis for the global financial system, investors are responsible under the principle of caveat emptor (buyer beware) for all losses on their investment exposures.  This gives investors the incentive to not rely on the government's representation, but to independently assess the disclosed information and make an investment decision based on the results of their own assessment.

Your humble blogger supports Mr. Knot and would ask that the EU policymakers declare a moratorium on deposit bail-ins until a) the banks provide ultra transparency and b) depositors and other investors have had 6 months of access to this information to assess the risk and solvency of the banks.  After the 6 months has ended, all new uninsured deposits along with unsecured debt and equity is subject to being used to bail-in and recapitalize the banks.

European Central Bank Governing Council member Klaas Knot said on Friday there was "little wrong" with Eurogroup chair Jeroen Dijsselbloem's recipe for dealing with future euro zone banking crises, a newspaper reported. 

Dijsselbloem, the head of the euro zone's finance ministers and like Knot a Dutchman, said on Monday the rescue program agreed for Cyprus - the first to impose a levy on bank deposits - would serve as a model for future crises.....

But Knot, who sits on the bank's main decision-making body, said: "There is little wrong with Dijsselbloem's remarks. 

"The content of his remarks comes down to an approach which has been on the table for a longer time in Europe. This approach will be part of the European liquidation policy."...

"Firstly, there has to be transparency about losses in the banking sector. Secondly, banks have to wind down their loss-making operations," Knot said.

Walter Bagehot and the math behind why banks designed to absorb losses without needing bailouts

Regular readers know that your humble blogger has been saying that a modern banking system is designed to absorb the losses on the excess debt in the financial system without requiring a sovereign bailout of the banks.

Today, one of the pre-eminent financial columnists in the world said to me:  prove it using numbers my readers can understand.  So here goes.

The following shows the current condition of a bank if it were not hiding its non-performing loans through 'extend and pretend' or its underwater securities.

                                                       Bank with Bailout                   Bank absorbs losses
 Assets before losses recognized
         Cash                                                         0                                                 0
         Performing Assets                                  60                                               60
         Non-performing Assets                          40                                               40
                 Total assets                                   100                                             100

 Liabilities plus Equity
        Borrowing from Central Bank                   0                                                 0
        Insured Deposits                                      75                                               75
        Purchased funds                                      20                                               20
        Equity                                                        5                                                 5
                Total Liabilities and Equity           100                                             100

Under both scenarios, the losses on the non-performing assets need to be realized.  These losses equal the amount the non-performing assets need to be written down by so that the borrower can afford to service the remaining debt.  For simplicity, we will assume a 50% write-down [40 of non-performing assets becomes 20 of performing assets].

In the bailout scenario, the taxpayer absorbs the loss by injecting enough capital into the bank to cover the losses on the non-performing assets [the injected capital is added to both cash (20) and equity (beginning balance of 5 minus 20 for loss on non-performing assets plus 20 for taxpayer capital injection)].

The following shows the condition of the bank after loss recognition and, in the bailout scenario, the injection of funds by the taxpayer.


                                                       Bank with Bailout                   Bank absorbs losses
 Assets after losses recognized
         Cash                                                       20                                                0
         Performing Assets                                  80                                               80
         Non-performing Assets                            0                                                0
                 Total assets                                   100                                              80

 Liabilities plus Equity
        Borrowing from Central Bank                   0                                                 0
        Insured Deposits                                      75                                               75
        Purchased funds                                      20                                                20
        Equity                                                       5                                              (15)
                Total Liabilities and Equity           100                                               80

Let me make a couple of observations.

First, whether the bank is bailed out or it absorbs the losses, the bank has the same amount of assets that are performing and generating income.

Second, under either scenario, the bank has the same liabilities and the interest expense on these liabilities is unchanged.

Conclusions:

• We can determine before a sovereign bailout whether the bank has a viable franchise or not.  After restructuring the non-performing assets, either the bank's interest income on all its performing assets (including loans and investment securities) exceeds its interest expense or it does not.  If it does, then the bank is viable as it can generate earnings to rebuild its book capital level.  If it does not, then the bank is not viable and should be closed.

• If a bank has a viable franchise after restructuring its non-performing assets and its interest income exceeds its interest expense, it does not need a sovereign bailout.  Why inject funds into a bank that is capable of rebuilding its book capital without assistance?

Given that we have the same interest income and interest expense under both scenarios, why do bankers prefer a bailout over recognizing their losses?

Because with a bailout, the losses are socialized and it is the taxpayer who pays.  When banks absorb the losses, it is the banks and the bankers that pay.

Bankers understand this and therefore will try to paint a picture of why a bailout is necessary.

For examples, bankers assert that banks need a bailout otherwise they won't be profitable.  With or without a bailout, banks have the same interest income and interest expense.

Another reason that bankers give for needing a bailout is to stop a potential run on the bank.

By definition, the insured depositors don't care about the bank's book capital level because their money is guaranteed by the government.  Depositors learned to trust the government guarantee from their parents.  When they opened up their first bank account as a child and were worried about getting their money back, their parents assured them the government would get their money back for them.  So the depositors aren't going to run.

This leaves the purchased funds from the wholesale funding markets.  With a bailout, the purchased money can run and take the bank's cash with it (see below).

With the bank absorbing losses, the purchased money can also run.  This is where Walter Bagehot and his concept of the central bank as the lender of last resort comes in.  The central bank lends the bank the money so it can pay out the departing purchased funds.  The central bank borrowing and repayment of the purchased funds is shown below.


                                                      Bank with Bailout                   Bank absorbs losses
 Assets after losses recognized
         Cash                                                   0                                                 0
         Performing Assets                            80                                               80
         Non-performing Assets                      0                                                0
                 Total assets                               80                                              80

 Liabilities plus Equity
        Borrowing from Central Bank           0                                                20
        Insured Deposits                               75                                               75
        Purchased funds                                 0                                                 0
        Equity                                                5                                              (15)
                Total Liabilities and Equity      80                                               80

In this example, the central bank has access to performing collateral worth 4 times what it lends to the bank.  So the central bank's loan is very safe.  In fact, there is plenty of capacity for additional central bank loans to satisfy any demand from the insured depositors.

Exchanging the central bank loan for purchased funds only has a negative impact on banks if the central bank follows Mr. Bagehot's advice and lends at high rates of interest that exceed the cost of the purchased funds.

Yet another reason that bankers give as to why banks need to be bailed out is that without a bailout they would have to stop lending and supporting the real economy.

Clearly, with the bailout, assuming that the purchased funds don't run, bankers have cash on their balance sheet that they can lend.

However, not having cash available on its balance sheet, doesn't stop the bank that absorbed the losses from lending.  What it stops is the bank from holding the loan on its balance sheet.

In this case, the bank with no capacity to hold the loan on its balance sheet has to sell the loan on to someone who would like to hold the loan like a pension fund, insurance company, hedge fund or a bank with capacity on its balance sheet.  This is something that goes on everyday for decades even when a bank has capacity to hold a loan on its balance sheet.

I could go on and debunk the rest of the bankers' reasons for needing a bailout.  However, that is unnecessary as the real reason that bankers prefer bailouts over having the banks absorb losses is that with a bailout there is no interruption in the bonuses that the bankers receive.

What we have witnessed since the beginning of the financial crisis is that bankers have paid themselves at or close to record levels.  They could not have done so if the banks had absorb their losses and had to rebuild their book capital levels.

Slovenia to make banks pay for existing losses out of their future earnings

Reuters reports that Slovenia has rejected the EU model of confiscating deposits to pay for losses currently on its bank balance sheets and has decided instead to make the banks pay for these losses out of their future earnings stream.

Regular readers know that your humble blogger has been arguing that in a modern banking system, banks are designed to absorb existing losses in the financial system and recapitalize themselves through retention of future earnings.  It is nice to see my ideas are gaining international attention and acceptance.

Clearly, the Slovenia government accepts my premise.

As for the implementation...

Slovenia has been thrown into the spotlight as the next eurozone country likely to seek an international bailout, given the fragile state of its banking sector.... 

Part of the uncertainty still surrounding the country is due to adjustments that the new governing coalition - led by Prime Minister Alenka Bratusek - has pledged to make to the original 'bad bank' proposal put forward by the previous Janez Jansa administration. 

One of the key tweaks now under consideration, according to RBS, is the creation of internal bad banks within each of the country's largest financial lenders, postponing any transfer of toxic assets to an external bank asset management company to a later date. 

"Initially, bad assets would be transferred to the internal bad banks and backed simply by government guarantees," said Abbas Ameli-Renani, an emerging market strategist at RBS.

By keeping the bad assets on the bank balance sheets, the source for paying off the losses on the bad assets is future bank earnings and not the taxpayer.

Under the original proposal, assets would have been transferred immediately to the BAMC in exchange for newly-issued government bonds.

This would have taken the banks and bankers off the hook for paying for the losses on the bad debt and instead socialized the losses and made the taxpayers pay for the losses on the bad debt.

While there will be a simultaneous recapitalisation of banks under both arrangements, the new version would not result in an immediate spike in the government's debt level, because the authorities would initially provide banks with guarantees rather than newly issued securities. 

One of the downsides, however, is that the plan will keep bad assets on banks' balance sheets and under the same management.

Keeping the bad assets on banks' balance sheets is not a 'bug', but a feature.  By making the banks absorb the losses on all the excess debt in the financial system, the government is establishing how much in the way of future earnings must be retained to recapitalize the banks.

Going forward, the banks will retain 100% of pre-banker bonus earnings until they have rebuilt their book capital levels.

As for the new guarantees, because of deposit insurance, the guarantees are effectively already in place.


Please note, market participants already know a) that the banks are hiding significant losses and b) that the Slovenia government is standing behind its deposit guarantees.  This is why the banks are still operating despite the fact that they would have a low or negative book capital level if the losses were recognized.

To avoid the bankers gambling on redemption or trying to hide the losses on the bad assets, going forward the Slovenia government should require that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert restraint on bank management behavior and ensure that the banks rebuild their book capital levels without excessive risk taking.

SEC battled with JP Morgan over its disclosures involving the "London Whale" trade

Reuters reports that the SEC engaged in a tug of war with JP Morgan to get it to make fuller disclosure to investors concerning its "London Whale" trade.

For months after JPMorgan Chase & Co executives first admitted that they had wrongly brushed off questions about the "London Whale" derivatives losses, officials at the U.S. Securities and Exchange Commission pressed the company to disclose more to investors about risks it was taking. 

The SEC's Division of Corporation Finance, which is charged with making sure companies provide investors with enough information to make good decisions, pushed the bank from at least July to February to revise disclosures about changes it had made in models used to calculate value it put at risk in its derivatives portfolio [emphasis added].

Please re-read the highlight text as it critically important.

The SEC's Division of Corporation Finance is charged with making sure companies provide investors with enough information to make good decisions.

What does this mean for a bank?

Your humble blogger and the banking industry in the 1930s answer that banks must provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Banks do not currently provide ultra transparency.  Instead, banks provide disclosure that the Bank of England's Andrew Haldane says leaves them looking like a 'black box'.

By definition, the contents of a black box cannot be assessed.  So investors do not have enough information to make good decisions.

Why is the SEC's Division of Corporation Finance allowing banks to be black boxes?  The correspondence between the SEC and JP Morgan provides the answer.

Correspondence between the SEC and the bank released on Wednesday shows the bank made incremental changes to increase its disclosures at the SEC's urging. 

The highly technical exchanges were conducted even as JPMorgan vowed to be more transparent with investors....

In July, the SEC told JPMorgan to expand its future disclosures about its risk models and to explain further what it had said earlier in the month about changes it was making in company risk controls. 

JPMorgan responded in a letter in August that described how it tracked risk and noted that it was disclosing more about its models in its new quarterly financial report. 

The SEC came back with more questions in November about JPMorgan's response and about the company's views on how much regulations require it to disclose about details of risk model changes. 

JPMorgan responded in December, received the last questions from the SEC in February and added more disclosure in its annual report....

Based on the correspondence, the reason that the SEC is allowing banks to be black boxes is the SEC does not know what is the information that investors actually want from a bank.  What investors really want to know is what each bank's exposure details are (ultra transparency).

Banks are black boxes because they hide their exposure details behind the veil of opacity provided by current SEC mandated disclosure requirements.

Why are investors interested in each bank's exposure details?

Because in order to make a good investment decision, an investor needs to be able to assess the risk of the investment.  It is the risk of these exposures that drives the riskiness of the bank.

Can investors actually use bank exposure details to assess risk?

Investors either have the expertise to use the exposure details to model the bank's risk themselves or they can engage a third party expert to model the bank's risk for them.  As a result, they do not need to know how the bank models its risk.

Dean Baker: in reality, it's the failure of financial reform

In his Guardian column, Dean Baker observes in his usual understated tones that financial regulators are simply not up to the task of overseeing the large, global financial institutions and that financial reform since the beginning of the financial crisis is inadequate.

He suggests that what is needed to fix this situation is for citizens to pressure their policy makers so that the policy makers adopt legislation that breaks up these Too Big to Fail institutions.

Regular readers know that your humble blogger prefers a much simpler solution that doesn't require policy makers to adopt new legislation over the objections of the banking industry.  I would like to see our policy makers pressure financial regulators to simply use the laws on the books.

During the 1930s, Congress adopted the securities laws that require that market participants be provided with access to all the useful, relevant information in an appropriate, timely manner so they could independently assess this information and make a fully informed investment decision [note: similar laws have been adopted in Europe and Japan].

For banks, all the useful, relevant information in an appropriate, timely manner is defined by ultra transparency under which the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This definition of what constitutes all the useful, relevant information is an appropriate, timely manner is not just mine.  At the time the securities laws were passed, it was also the definition used by the banking industry.  

The banking industry use to see a bank disclosing all its exposure details as a bank that could stand on its own two feet as it had nothing to hide.  I realize that the current banking industry doesn't believe this and will push back against the regulators because they prefer to hide their true risk.

So let me offer a compromise:  only banks that have government insured deposits need to provide ultra transparency.

There is no legitimate business reason why a bank that benefits from having the taxpayers guarantee their deposits should be allowed to hide the risks that it is taking.

My compromise gives all banks a choice:  keep their insured deposits and provide ultra transparency or get rid of their insured deposits and continue to hide behind the veil of opacity of current disclosure requirements.

JP Morgan is a huge bank and can swallow $6bn in losses, but the incident showed as clearly as possible that the Dodd-Frank reforms are not working. The London Whale's losing trades were all done in the Dodd-Frank era. The bill's provisions did not prevent JP Morgan from making massive bets and misleading regulators about their nature and the risks involved. 

If the regulators were not able to catch the London Whale's huge gambles before they went bad, why would we think that they will catch the next crapshoot from the Wall Street gang? 

It's time that we looked at this seriously: the regulators lack either the will or the competence to rein in the big banks. 

The big banks are going to get away with everything they want, regardless of the provisions of Dodd-Frank. 

If the big banks are too big to regulate and, according to Attorney General Holder, too big to prosecute, then the only sensible course is to break them up.... 

Or simply require them to provide ultra transparency if they are to have access to deposit insurance.

At the top of the list is Elizabeth Warren's election to the senate. Senator Warren has already made it clear that she will use her seat on the Senate banking committee to try to hold the banks and bank regulators accountable. The other important development is that Warren seems to have an ally in Louisiana Senator David Vitter. 

At first glance, this might seem an unlikely alliance. Warren is clearly on the left side of the Democratic party and Vitter is to the right of center of a very conservative Republican party. But Vitter, apparently, takes his belief in the market seriously enough ...

Disclosure is not a Democrat or Republican issue.  Disclosure is the necessary condition for the invisible hand of the market to operate properly.

The point is straightforward: if a bank's creditors know that the government will cover its losses, the bank is gambling with the taxpayers' money, not its own.... 

Hence my compromise: if the government will cover a bank's losses, then the bank must provide ultra transparency.  Transparency ends the bank's gambling with the taxpayer's money.

As it stands, the leadership of both parties is too closely tied to the financial sector to take any steps that fundamentally threaten their interests. 

This has nothing to do with political philosophy: the leadership of both parties is owned by the financial industry. 

However, if the outsiders in both parties can build up enough popular outrage over Wall Street's shenanigans, the party leadership will follow.

All that is required is that enough pressure be applied so that regulators use the laws on the books.

Germany belief in its reliance on Deutsche Bank outweighs scandals

Reuters ran an interesting article in which it looked at how Germany's belief in its reliance on Deutsche Bank gave the bankers at Deutsche Bank immunity from scandals.

Germany has become so dependent on Deutsche Bank to grease the wheels of its export driven economy that it looks willing to gloss over scandals involving its largest bank.

Germany is not alone as similar observations could be made in the rest of the EU, Japan, the UK and the US when it comes to giving bankers immunity from scandals.

Deutsche is one of several European banks under investigation by regulators in Europe and the United States for its suspected role in rigging benchmark interest rates. It is cooperating with German authorities in a separate inquiry into alleged tax fraud. Deutsche has denied allegations it misvalued derivatives and mis-sold mortgage-backed securities. 

Such an array of inquiries could be expected to damage any bank's reputation.

Such an array of inquiries would be unnecessary if Deutsche Bank and the other banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is well known that sunlight is the best disinfectant and this level of ongoing disclosure would encourage a culture where every action the bank takes is an action the bank would be willing to see on the front page of Der Spiegel.

But back-up from business leaders and key members of the bank's supervisory board appear to be helping Deutsche's new co-chief executives Anshu Jain and Juergen Fitschen put the scandals behind them. The two men, with more than 40 years experience at Deutsche between them, took over as co-CEOs on June 1. 

This bedrock of support is crucial for Deutsche, especially in a German election year when banks' perceived excesses and misdemeanours could become a campaign issue.

The bank's behavior risks becoming a campaign issue because there is no distinction being made between the bank as an institution and the individuals who worked for the bank who engaged in or oversaw the areas that engaged in misbehavior.

This distinction is important as it highlights the simple fact that individuals from the top of Deutsche Bank down can be punished without destroying the franchise or hurting its ability to support the German economy.

The newest revelations for Deutsche will come in the next few days when the German regulator issues a report on the bank's alleged involvement in the manipulation of Libor, a global interest rate benchmark.

If the bank was engaged in manipulating Libor, anything less than dismissal of everyone who engaged in or oversaw the areas, and oversight of the areas goes all the way to the bank's supervisory board, that engaged in manipulating Libor is an insufficient response.

After all, does Germany and Deutsche Bank really want to have individuals who were responsible for overseeing an area and failed to prevent it from engaging in manipulating a global benchmark interest rate around?

The report will test Germany's commitment to keeping Deutsche strong for the sake of its export led economy. That commitment is a common theme to surface in interviews Reuters has conducted with current and former Deutsche staff, business leaders, sources at the regulator and bank directors. 

Several sources familiar with the regulator's report have said it will focus on "organisational flaws" rather than placing blame on Jain or Fitschen, making it less likely the Berlin political establishment will call for them to go....

Regulatory capture at its finest.  But then again, the regulators didn't catch Deutsche manipulating Libor either and this suggests that a number of regulators should also lose their jobs.

Crucially for Jain and Fitschen, Deutsche's supervisory board chairman, Paul Achleitner, supports their strategy. 

A former Goldman Sachs executive who helped Deutsche make one of its biggest expansions into investment banking in 1998, when he advised it on a deal to buy Bankers Trust, Achleitner is a firm believer in a strong German investment bank. 

"What we need as a society is to come to an agreement over what we want. Do we want Germany to be home to a major bank of global importance? There aren't that many companies left in the financial sector capable of competing with U.S. firms," Achleitner said in a written statement in response to questions....

There is no reason that Germany cannot be home to a major bank of global importance.

After all, who would global clients rather deal with:  a bank that provides ultra transparency and prides itself on a culture of honesty or a bank that hides behind the veil of opacity provided by current disclosure rules and has a culture that actively supports manipulating benchmark interest rates for profit?

When the question is asked this way, ultra transparency is seen as a competitive advantage over US firms.

To ensure they retain the support of corporate Germany, Jain and Fitschen need to prove that 'Project Pharos,' a plan to become a more client focused lender really means a change in style. 

The restructuring efforts, set to be completed by 2015, has already seen about 1,400 jobs axed out of the investment bank, which had 9,094 staff at the end of 2012. 

The proprietary trading division, which used the bank's own money to make bets with a notional value of up to $128 billion on mortgage-backed securities, has been shut. 

Deutsche has pared back risk taking, reducing the value at risk at its main trading units to 57.1 at the end December, from 95.6 at the end of 2010. A lower number for value-at-risk indicates a reduced likelihood of potential losses....

Voluntarily adopting ultra transparency is a logical extension of Project Pharos.  After all, management wants to show that Deutsche has been cleaned up and to change its culture.

The bank has beefed up a 'risk and reputation' committee, which now includes four members of the Group Executive Committee, the bank's 18-member senior management panel. Potentially controversial business is discussed by the head of compliance, the chief risk officer and legal counsel.... 

Deutsche's problem is that the changes, underway since 2009, take time to filter through to the outside world, insiders say. 

"There is a lag between perception and practice," a senior Deutsche Bank executive said....

There is nothing that says you have changed as a bank like the adoption of ultra transparency.  It dramatically cuts down on the lag between perception and practice.

In the absence of ultra transparency, like Barclays recent announcements, Project Pharos can be seen as simply happy talk with no real substance behind it.

Senior Deutsche Bank staff say the reform process is credible. 

"Anybody who was involved in anything illegal is no longer with the bank, so it's unfair to keep drawing parallels between now and then," a second senior bank executive said. 

But critics says the investment bank's DNA still bears the legacy of Edson Mitchell, the American banker who helped lay the foundations of its global investment banking franchise by introducing a more Anglo-Saxon management style and Wall Street sized paychecks. 

"The vast majority at the bank doesn't need a cultural change. It's just the traders," said a Deutsche investment banker specialising in merger and acquisitions. "They have shown over and over again that they care more about themselves than about the bank's reputation."... 

Ultra transparency would provide an instant culture change to the trading floor.  Gone would be proprietary trading.  Only market making would survive.

The UK's bank capital fudge

The Bank of England's Financial Policy Committee highlighted why bank capital regulations without banks being required to provide ultra transparency are completely meaningless.  Without disclosure by the banks of their current global asset, liability and off-balance sheet exposure details, it is impossible to measure a bank's capital adequacy.

I give the FPC a tremendous amount of credit for simply stating that UK banks don't have enough capital.

Now the question is given the losses and risks that are hidden on and off the banks' balance sheets is $75 billion of new capital enough and which banks need to raise the capital?  Without the banks being required to provide ultra transparency, market participants don't know the answer.

Given its mandate to protect the financial system from systemic risks, I wish the FPC had also called for the banks to provide ultra transparency.  Not only would the FPC have solved the measurement problem with bank capital, but it would also have addressed a systemic risk.  Specifically, our current financial crisis shows that opacity in the banking system is a systemic risk.

From a Simon Nixon Wall Street Journal Heard on the Street column,

So that's clear then. The U.K. banking system has a capital hole of around £50 billion ($75.8 billion), according to the Bank of England's Financial Policy Committee. Well, actually, that hole shrinks to around £25 billion relative to a new BOE benchmark of a 7% minimum core Tier 1 capital ratio on a Basel III basis after making various regulatory adjustments. 

OK, the true capital hole may be only half this size once one takes account of anticipated retained earnings and other capital-enhancing actions under way at U.K. banks. 

But the final size of the capital hole and the identity of the guilty banks must remain a state secret, only the regulators and the banks themselves to know. 

This is, of course, nonsense.

Actually, it is worse than nonsense that the size of the capital hole is a state secret known only to the regulators and banks.

It puts the financial system at risk.  Effectively, the regulators are gambling with taxpayer money.  I say this because experience shows that banks that need to raise capital would rather try to "earn" the capital by taking on risk than sell shares.

A classic example of this were the US Savings and Loans.  Everyone knew they needed more capital, but rather than try to sell stock at low prices, bank management preferred to gamble on redemption on risky exposures.  The end result was bigger losses for the taxpayers.

This state secret also distorts the financial system as those banks that need additional capital benefit from investors providing them with funds at too low a rate of return.  Recall that investors don't know how big each bank's capital shortfall is as it is a state secret.

With its latest pronouncement on the capital adequacy of the banking sector, the FPC has effectively introduced a new regulatory capital standard for U.K. banks. Yet it has failed to spell out key details of how this regime works in practice. 

At best, this creates an opportunity for fudge, with key decisions relating to the safety and soundness of the financial sector taken behind closed doors on the basis of a negotiation between regulators and banks.

Excuse me, but how much capital a bank should hold should not be limited to a negotiation between regulators and bankers.

Ideally, unsecured bank creditors should have a say as they should be exposed to the risk of loss on their investment.  The only way these investors can have a say is if there is ultra transparency and they can assess the risk of loss for themselves.

At worst, it risks creating a false market, with investors in U.K. bank shares—particularly Royal Bank of Scotland RBS.LN -2.83%and Lloyds Banking Group, LLOY.LN +2.42% believed to be the FPC's primary target—denied information vital to making informed decisions.

Please re-read Mr. Nixon's comments about the false market because investors are denied information vital to making informed decisions.

Your humble blogger has been making this point since the beginning of the financial crisis.

Basel Committee seeks to limit bank-to-bank exposure

In another classic example of the substitution of complex rules and regulatory oversight for the combination of transparency and market discipline, the Basel Committee is looking at how to limit bank-to-bank exposures so as to eliminate the risk of financial contagion.

The Basel Committee is effectively trying to do through regulation what market discipline would do more efficiently if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Regular readers know that our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  It is the principle of caveat emptor that makes each bank responsible for all losses on their exposures, including to other banks.

With the responsibility for losses comes the incentive to limit exposures to what the bank can afford to lose.

With transparency, banks look at their exposures to other banks not just as an exposure to another bank, but as an exposure to that bank's exposures.  It is these exposures that drive losses at both banks and therefore banks set their exposures to each other based on the risk of the other bank.

When the level of inter-bank exposure is based on transparency of each bank's risks, the global financial system both minimizes financial contagion and maximizes inter-bank exposures needed for supporting the real economy.

As reported by Reuters,

Global regulators have proposed tougher rules from 2019 to stop big banks from building a level of risk on their books that would make them vulnerable if a major customer goes bust. 

In an attempt to gain transparency on bank assets and facilitate speedy action from regulators in the event of a crisis, the global Basel Committee on Banking Supervision is proposing much tougher rules on banks' exposure to other banks. 

The aim is also to reassure markets that when a bank is in trouble, other banks' exposure to it would be relatively limited to avoid the type of contagion seen during the 2008/09 financial crisis.

Why attempt to gain transparency on bank assets and reassure markets through complex regulation when simply requiring banks to provide ultra transparency permanently solves the problem?

Big losses at some banks on asset-backed securities in 2008 prompted investors to withdraw funds from a wide range of lenders, exacerbating the market turmoil....

Investors withdrew funds because banks are 'black boxes' and there was and still is no way to assess each individual bank's solvency or risk.

Again, a problem solved by having the banks provide ultra transparency.

Basel is now proposing to impose a stricter exposure limit on big banks and a requirement for more detailed reporting on exposures. 

"This is to ensure that the large-exposures standard is effective and consistent for internationally active banks," a committee statement said. 

"On this basis, breaches of the limit should be exceptional events, should be communicated immediately to the supervisor and should, normally, be rapidly rectified."

Basel said that the very biggest banks would only be allowed to conduct business with another bank of similar size up to the equivalent of 10-15 percent of its core capital, well below the 25 percent limit recommended at present....

The Basel Committee is proposing substituting regulations and regulatory oversight for transparency and market discipline.

Exposure limits by their very nature are fundamentally flawed.  For example, is the 10-15% of core capital exposure limit based on gross or net exposures?  I ask because it is often the case that a net exposure becomes a gross exposure when the bank on the other side of the transaction fails.

"The knock-on effect is another dampener on the flow of capital around the system. It's a bit more grit in the machine," said Richard Barfield, of accountant and consultancy PwC. 

"What is coming into focus is the whole balance between the supervisory appetite for risk and the need to have a financial system that can support international business activity and commerce efficiently."

It is not a supervisory appetite for risk, but for additional regulation.  When the system fails next (and it already has in Greece, Cyprus,...), the regulators want to be in a position to say it was not their fault, just look at all the regulations.

The financial crisis highlighted the simple fact that a financial system that is dependent on the combination of complex regulations and regulatory supervision is prone to failure.  This is not surprising as the system has a single point of failure: the regulators.

Fortunately, our financial system is designed not to have a single point of failure and to be much more robust and resistant to failure.  Our financial system achieves this through transparency and caveat emptor.  When everyone is responsible for their losses, our financial system is much more robust and resistant to failure.

Where our financial system failed was in the areas it was dependent on the regulators.

Guardian's Seamus Milne calls for change in policy to save real economy

In his Guardian column, Seamus Milne channels what your humble blogger has been saying since the beginning of the financial crisis and makes the case for adopting the Swedish Model for handling a bank solvency crisis to save the EU and UK economies.

Europe's flesheaters are back. The claim that the worst of the eurozone crisis is behind us now looks foolish.

Please recall that your humble blogger predicted at the beginning of the financial crisis that until transparency was brought to all the opaque corners of the financial system that the global economy would spiral downwards (despite the best efforts at economic stimulus by central banks and governments).

The deal forced on Cyprus by the German-led Troika at the weekend isn't a bailout: it will effectively destroy the island's economy. Instead of getting a grip on its grossly inflated banks, it will impose a brutal credit contraction, combined with sweeping cuts and privatisations, wiping out perhaps a quarter of Cyprus's national income. Ordinary Cypriots, not Russian oligarchs, will pay the price. 

Of course Cypriot politicians are to blame for having allowed the country to be turned into an adjunct of a bloated financial sector and a refuge for hot Russian money. 

But what tipped the divided island over wasn't foreign investors' sharp practices, but the impact of Europe's wider crisis on its banks: in particular, their exposure to devastated Greece, currently also in the Troika's tender care. 

Some have hailed the fact the raid was carried out on Cypriot bank deposits over €100,000, rather than the public purse. 

At last the rich and those responsible for private banking failures are being made to cough up, it's been said. Which would have been a good thing. But it's savers, not bankers or shareholders, who are taking the 40% hit.  

And many of the targeted depositors, such as pensioners, are scarcely rich – or are small businesses which will now go bust. 

The Cypriot government should instead have learned from Iceland: taken over the banks, isolated the bad loans, protected deposits, imposed losses on the wealthy, and used a publicly owned banking sector to rebuild the domestic economy. That would have offered its citizens a better future, almost certainly outside the eurozone. 

But it would have also encroached on private capital's privileges and clearly couldn't be tolerated. ...

Please re-read the highlighted text as Mr. Milne has nicely summarized the benefits of the Swedish Model and why bankers are vehemently opposed to its adoption.

As the Greek economist Costas Lapavitsas argues, Cyprus has "reactivated" the European banking crisis. 

Not that it had been resolved. Only last month the Dutch government was forced to nationalise the Netherlands' fourth biggest bank, SNS Reaal, partly because of its over-exposure to losses in Spain.... 

Now the Troika's decision to help itself to Cypriot savings has paved the way for a new contagion. In the short term that may be contained because of the island's minuscule proportion of eurozone output. 

But the move has demolished confidence in bank deposits – a point rammed home by the Dutch finance minister's blundering signal that the deal had set a precedent. That could easily turn into bank runs in states likely to need new bailouts, as investors move cash to safer locations.

Safer locations like German government debt and not Deutsche Bank deposits.  Safer locations like money market mutual funds invested in UK or US government debt and not EU or UK banks.

Given the spectacular failure of austerity across the continent to overcome the crisis, rather than deepen it as output shrinks and debts mount, more such breakdowns are clearly on the cards.

The choice of austerity or stimulus didn't matter for ending the financial crisis.  If stimulus, all that was going to happen is the stimulus would ultimately be swallowed by the burden of debt service on the excess debt in the financial system.

Stimulus could buy a short-term reprieve from the downward spiral, but once the stimulus ended, the real economy would resume its contraction as money needed for growth and reinvestment was diverted to debt service on the excess debt.

The eurozone has now become a zombie zone.... 

Whatever the focus of the meltdown in each country – banking in Cyprus, property in Spain – all flow from the same crisis that erupted in 2007-8 out of a deregulated profit-hunting credit boom across the western world and has delivered a prolonged depression....

In Britain, the power and weight of the City of London are a particular block on sustainable recovery. 

But across Europe, people are being held to ransom by banks, bondholders and corporations determined to ensure that it's not they who bear the costs of the crisis they created – and politicians who regard it as their job to oblige them. 

Please re-read the highlighted text as Mr. Milne nicely summarizes why we have made no progress to addressing the underlying issues that caused the financial crisis and why the financial crisis continues.

Paul Krugman: do central banks purchases of government debt influence level of interest rates

In his NY Times blog, Nobel prize winning economic Professor Paul Krugman examines the conventional wisdom that the Fed's buying US debt is keeping interest rates artificially low and concludes that this is simply not true.

Given this conclusion is also supported by Fed Chairman Ben Bernanke, your humble blogger is left to ask the question of why then is the Fed engaging in zero interest rate and quantitative easing policies?

If the Fed has no impact on the level of interest rates, these policies are completely ineffective.  So why pursue policies with no benefit?

If the Fed has no impact on the level of interest rates, then why is it trying to claim credit for the pickup in activity in the housing market?

Cyprus fallout: over half of Germans doubt deposit guarantee

Reuters reports that according to a survey by Stern magazine over half of Germans doubt that their government will honor its deposit guarantee.

At a minimum, this suggests how big the blow was to trust and confidence in the EU financial system caused by the decision to bail-in depositors to pay for the losses hidden on bank balance sheets.

Regular readers know that ultimately there is only one way to restore trust and confidence in the financial system: bring transparency to all the opaque corners of the financial system.

For banks, this means that they will have to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  It is only with this disclosure that market participants can see the true condition of these banks.

As predicted at the beginning of the financial crisis by your humble blogger, until transparency is brought to all the opaque corners of the financial system, the global economy will continue in a downward spiral (even with central banks and governments pursuing stimulative policies).

According to a recent survey commissioned by the magazine "Stern" 54 percent of Germans believe the promise of the Chancellor no longer that savings are safe in Germany.  

Conversely, only 41 percent trust their warranty.  

67 percent of Germans are great or at least a little worried about their savings. 

Because of the initially planned compulsory levy on Cypriot bank deposits under € 100,000 Merkel reaffirmed their guarantee for German savers last week over government spokesman Steffen Seibert. "It is the mark of a guarantee that it is," he said. Cyprus is a special case.  

Savers will be raided to pay for hidden bank losses

As reported by the Telegraph, the EU has decided that the way to break the bank-sovereign link is to have savers pay for the losses still hidden on the EU bank balance sheets.

This is a very important change in policy because savers have no way to assess the risk of the banks and therefore how much of their money will be seized to pay for the hidden losses.  A point that the Bank of England's Andrew Haldane made abundantly clear when he referred to banks as 'black boxes'.

EU policy makers would like savers to trust some combination of high capital ratios and the stress tests run by financial regulators.  However, there is absolutely no reason for savers to trust either the book capital reported by the banks or the results of the stress tests.

The history of book capital is that it is easily manipulated by both the financial regulators and the bankers.  As the OECD pointed out, regulators manipulate it by suspending mark-to-market accounting.  They also manipulate it by engaging in regulatory forbearance which allows the bankers to engage in 'extend and pretend' with their non-performing loans and turn them into 'zombie' loans.

The history of the stress tests is that passing the test with high capital ratios is not a good predictor that the bank will not subsequently be nationalize/closed due to insolvency.  This was shown first with the Irish banks, subsequently with Dexia and most recently with the Cyprus banks (July 2011 Cyprus banks pass stress tests).

What made the US stress tests "successful" was former Treasury Secretary Tim Geithner pledging the full faith and credit of the US to provide all the capital necessary to support the insolvent banks.  Previously, the EU made the same representation about its stress tests.

Regular readers know since the beginning of the financial crisis your humble blogger has been saying that if the policy makers and financial regulators want the unsecured creditors of the banks to be responsible for absorbing losses, the banks must first provide ultra transparency.

It is only when the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details that market participants have the information they need to assess the risk of the banks.

Under the FDR Framework, it is only when market participants have access to all the useful, relevant information in an appropriate, timely manner, which is what ultra transparency is, that market participants become bound by the principle of caveat emptor (buyer beware) and responsible for losses.

Without ultra transparency, savers, including large depositors and other unsecured creditors, are being asked by EU policy makers to blindly gamble on the contents of a black box.  Why should they?

I understand the reluctance of the EU policy makers and financial regulators to require the banks to provide ultra transparency before they seize the savers' money.  Ultra transparency will show just have negative the book capital level is for each bank.

Fortunately, it is not a problem if market participants know how negative the book capital level is for banks as banks are designed to operate with low or negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

Deposit insurance effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.  As a result, banks can continue to lend and support the real economy.

Your humble blogger has proposed on numerous occasions how to transition so that investors are responsible for losses:

1. Require banks provide ultra transparency.
2. Continue to protect large depositors and unsecured debt holders on all investment made at each bank until 6 months after the bank has begun providing ultra transparency.  This gives market participants a chance to assess the risk of the bank.
3. All new large deposits or unsecured debt purchased after the 6 month period has elapsed is subject to being bailed-in.

At the same time that investors become responsible for losses, the banks become subject to market discipline.

Has the spirit of light-touch regulation ended with the UK regulator that embodied it?

The Guardian's Jill Treanor wrote an interesting column in which she talks about how it was not just the light-touch regulation practiced by the UK's Financial Services Authority, but also the interventionist policies practices by other western financial regulators that failed in the run-up to the financial crisis.

It is a very important point that regulatory oversight failed across the entire spectrum from light-touch to active interventionist.

The question is why?  Why did the combination of complex rules and regulatory oversight not prevent a financial crisis?

Regular readers know the answer is the combination of complex rules and regulatory oversight was used as a substitute for the combination of transparency and market discipline.  Not only was it used as a substitute, but the combination of complex rules and regulatory oversight created additional opacity in the financial system.  Opacity that eventually undermined financial stability.

Western financial systems are based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

This combination produces financial stability because it puts on each market participant the responsibility for losses on their investment exposures.  This responsibility creates stability because each market participant has an incentive to limit their exposure to what they can afford to lose.

Opacity interferes with the mechanism that makes the financial system stable.  It makes it impossible for investors to assess the risk of their exposures and therefore limit them to what they can afford to lose.

This is particularly true when it comes to the banking system and the role of the financial regulators.  As the BoE's Andrew Haldane says, banks are 'black boxes'.  They do not disclose the information needed by investors to assess their risk.

This lack of transparency is made even worse by the action of regulators.  Regulators who engage in activities like stress tests and proclaim the banks to be solvent.

How exactly is an investor suppose to determine the true risk of the banks and properly limit their exposures when the regulators are saying that insolvent institutions are solvent?

Which brings us back to light-touch regulation.  Whether it is light-touch or activist interventionist regulation, it is the focus on "regulation" that distracts from the primary responsibility of the regulators under the FDR Framework:  ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess and make a fully informed investment decision.

It was the watchdog that didn't bark. When the Financial Services Authority (FSA) was created in its current form by Gordon Brown, it was modelled on the all-powerful US regulators, but it is likely that it will be remembered for only thing: presiding over the near-meltdown of the UK's banking system. 

In its short life, the FSA failed to rein in the banks, and even encouraged the City to explode in the mid-2000s with a "light touch" approach to regulation. 

It did not notice that Northern Rock was built on such shaky foundations that it could easily run out of money, and failed to prevent the takeover of ABN Amro by RBS just as the credit crunch was biting in late 2007....

Please note that it is not the responsibility of the regulators to be the watchdog.  It is the responsibility of all the market participants to continue to monitor their investment exposures and make sure that their exposures do not exceed their ability to absorb losses.

Tearing up the FSA – which united the nine regulators that had existed before Labour was swept to power in 1997 – was one of the first key policy announcements by Osborne after the May 2010 election. 

But it has taken almost three years – much longer than expected – after he first pledged to disband Brown's regulator to fulfil the vision to create two new ones – the PRA (a subsidiary of the Bank of England to ensure banks have enough capital and liquidity) and the FCA (essentially charged with putting consumers at the heart of the matter when dealing with financial regulation)....

Do you notice how there isn't a regulator focusing on making sure that the banks provide transparency so that market participants can independently assess their risks?

Our current financial crisis showed that capital standards in the absence of transparency is hazardous for financial stability.  The reason it is hazardous is that risk is the important issue.  Without transparency, there is no way to measure risk.

While the FSA's legacy seems likely to be the banking crash, Kevin Burrowes, UK head of financial services at PricewaterhouseCoopers, acknowledges that the watchdog was not alone in missing the warning signs. "It's not apparent that any regulator from around the world can stand up and say they did a great job over this period," he says....

In the fallout from the crisis, they set about changing what Sants's predecessor, John Tiner, had described as principles-based approach to regulation. In 2006, reflecting the mood of the time, Tiner said: "Firms' managements – not their regulators – are responsible for identifying and controlling risks. A more principles-based approach allows them increased scope to choose how they go about this. In short, the use of principles is a more grown-up approach to regulation than one that relies on rules." 

But by 2009, Sants was saying, damningly: "A principles-based approach does not work with individuals who have no principles." 

Meanwhile, Turner was outlining to MPs what he saw as a major problem, telling the Treasury select committee: "It was not the function of the regulator to cast questions over overall business strategy of the institutions … You may find that surprising."

Thankfully, the new regulators are now being encouraged to be more curious and ask more questions....