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.