BoE's Mervyn King: RBS must "accept losses" currently hiding on and off its balance sheet

At last, the facade bank regulators have constructed since the beginning of the global financial crisis about the solvency of the large global financial institutions has collapsed and with the facade's collapse the Swedish Model for handling a bank solvency led financial crisis has gain acceptance.

In his testimony to the Parliament's commission on banking standards, Sir Mervyn King left no doubt that RBS is hiding so much in the way of bad debt on an off its balance sheet that it is impeding RBS' ability to continue to lend to the real economy.

Quite simply, if after five years of cleaning up its exposures, RBS has not managed to put its bad debt behind it, there is no reason to believe that any other Too Big to Fail bank has done so.

Regular readers know that the question know facing the bank regulators is do they ask for another taxpayer bailout of the banks or do they let the banks operate with low or negative book capital levels as they are designed to do?

Your humble blogger has championed since the beginning of the financial crisis letting the banks continue to operate as designed.  With the combination of deposit insurance and access to central bank funding, there is no need to make the implicit role of the taxpayer as the banks' silent equity partner explicit through a bailout.

What is needed is that the banks be required to 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 independently assess whether the banks have recognized all the losses on their bad debt.

More importantly, with this information, market participants can exert discipline on the banks so that they restrain their future risk taking and do not gamble on redemption while they are rebuilding their book capital levels through retention of 100% of pre-banker bonus earnings.

With ultra transparency in place and banks recognizing upfront all the losses on the excess public and private debt in the financial system, the real economy is poised to resume growing and the banks are positioned to provide the necessary lending to support this growth.

Sir Mervyn King has blown open the debate about the future of Royal Bank of Scotland by calling for the bailed out bank to be broken up into a good and bad bank, describing the current situation as a "nonsense". 

Less than a week after the Edinburgh-based bank insisted it could be ready for partial privatisation ahead of the election, the Bank of England governor laid bare his disagreement with the chancellor, George Osborne, over the future of RBS. 

In evidence before the banking standards commission, King said it was a "nonsense" that RBS, 82%-owned by the taxpayer, was run at "arm's length". 

"The whole idea of a bank being 82% owned by the taxpayer, run at arm's length from the government, is a nonsense. It cannot make any sense," King said. 

Labour created the current structure of UK Financial Investments to oversee the £45bn pumped into RBS and £20bn into Lloyds Banking Group during the 2008 banking crisis. It has been adopted by the coalition too. 

"I know it was put there for a good reason. People didn't want politicians running banks. But I think it would be a much better idea to accept that it should have been a temporary period of ownership only – to restructure the bank and put it back. The longer this has gone on the more difficult that's become," King said. He said nothing had been achieved at RBS, other than removing risk from its balance sheet....

Please re-read the highlighted text as Sir Mervyn King has summarized how little has been accomplished over the last 5 years with what is effectively a nationalized bank in terms of cleaning it up.  He refers to the risk removed from its balance sheet as positive, but leaves the distinct impression that there is plenty more risk still there.

The chancellor moved determinedly to stamp out any idea that he would use up to "£8bn or £9bn" of taxpayer funds to take control of the rest of RBS. He told Lawson there were "very considerable obstacles" to nationalising RBS in a move that cleared the way for the bailed out banks, including Lloyds Banking Group, to last week insist they were on course for privatisation....

And this is why banks need to be required to provide ultra transparency.

On the one hand, we have Sir Mervyn King saying the banks are still hiding significant quantities losses and risks on and off their balance sheets.  On the other hand, we have the banks saying they have addressed the losses, reduced their risks and are almost ready to return to the private market.

Who is right?

The only way to know is if the banks provide ultra transparency and market participants can independently assess the exposure details.

Without ultra transparency, the banks are happy to push for a return to the private market.  They know that returning to the market allows them to capture in their pay the subsidies their Too Big to Fail size confers on them.

King made clear he is concerned about the level of bad debts on the RBS books that could be impeding its ability to lend to small businesses. 

The idea being put forward by politicians such as Lawson is that with the creation of a bad bank, a cleaned up RBS might be more willing to lend and be easier to privatise, even at the potential cost of bad loans falling on the state. 

"I would certainly be prepared to lend my support to those who would argue that it is better to recognise it and we shouldn't worry about the consequential impact on the apparent scale of public debt," said King.

There is no consequential impact on the apparent scale of public debt if the banks are required to recapitalize themselves through retention of future earnings.

"The lessons of history is that we should face up to it – it's worth less than we thought and we should accept that and get back to finding a way to create a new RBS that could be a major lender to the UK economy," he said....

"The economic reality is that we must accept the losses. We should accept the reality that the state-owned banks are worth less than we thought." 

Please re-read the highlighted text as Sir Mervyn King has succinctly summarized why the Swedish Model for handling a bank solvency led financial crisis should be adopted.  Under this model, banks are required to recognize upfront the losses on the excess debt in the financial system.