A banking reboot would create necessary condition for economic growth

In his Telegraph column, Liam Halligan lays out the argument for rebooting the banking sector as this creates the necessary condition for economic growth.

Mr. Halligan effectively calls for the end of the Japanese Model for handling a bank solvency led financial crisis under which bank book capital levels and banker bonuses are protected at all costs.  Instead, he calls for adoption of the Swedish Model where banks are required to recognize upfront their losses on the excess debt in the financial system.

Where Mr. Halligan refers to the UK, please feel free to substitute EU, Japan or US.

Five years on from this sub-prime collapse, though, and ... 

The debate about how the UK escapes from this economic torpor remains deeply entrenched, largely along party lines. Our politicians are locked in a "growth versus austerity" soap opera, trading ideological jibes as they argue over tax and spending plans that are, anyway, largely fiction. 

The truth is that, if the UK economy is to fire on all cylinders again, our banks badly need to raise fresh private sector capital, then extend finance to the creditworthy businesses that will generate sustainable recovery. 

A little bit of extra government spending here, a new "scheme" there, while driving endless political spats, will have zero impact on growth compared with forcing a banking sector reboot. 

Debates over tiny dabs of unaffordable state largesse amount to posturing and political parlour games. Such energy-sapping policy tweaks don't affect our growth trajectory in the slightest, but are mere exercises in temporary media management. 

Sorting out the opaque, wealth-destroying mess that is the UK banking system, by contrast, requires courage and a sustained determination to face down powerful vested interests. 

I wonder, after decades of relative prosperity and the complacency that breeds, if the UK and much of the Western world has leaders who are willing and able to do this. I see much evidence to the contrary....

Please re-read the highlighted text as Mr. Halligan has nicely summarized the current situation under the Japanese Model and just how difficult it will be to adopt the Swedish Model.

The British economy is suffering not from a lack of government spending, as the Keynesian spend-a-holics would have it, but from a chronic lack of private sector investment.... 

An even more significant explanation, though, of why our capital stock is stagnating – it grew by just 1.1pc in 2012, a 20-year low – is that our banks are failing to extend commercial credit to SMEs, or are often doing so only on terms so harsh as to kill stone dead what would otherwise be feasible business plans. 

If the UK economy is to recover, our banks need to raise capital and then extend the finance needed to kick-start investment and commerce. 

One reason this isn't happening is that banks are doing nicely lending out small volumes at high rates. 

More fundamentally, their capital raising is stymied as investors don't trust banks' financial statements, given that risks are often understated and huge, smouldering sub-prime related losses remain buried off-balance sheet. 

Bank of England policymakers recently warned that UK banks need to raise additional capital of £25bn. Market estimates put the figure at nearer £50bn. 

The banks insist that refinancing themselves would make lending even more difficult, but the truth is that no one really knows the state of our banking system. 

Politicians remain deeply reluctant to push the big banks into "full disclosure" for fear of what will be found.

Please re-read the highlighted text as Mr. Halligan has nicely summarized the current global state of the banks.  No one knows whether they are solvent or not.

The only way to know the true condition of a bank is if it provides full disclosure, what I call ultra transparency, and discloses on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the solvency of each bank and its risk.

Please note, as your humble blogger has said repeatedly, banks are designed so they can continue to operate and support the real economy even when they are insolvent.  A bank is insolvent if the market value of its assets is less than the book value of its liabilities.  However, this is not necessarily a permanent condition.

What is important to focus on with a bank is the question of whether the interest income generated by its assets on a fully performing basis (after all losses have been realized) exceeds the interest expense on its liabilities plus operating expenses before banker bonuses.

If the answer is yes, then the bank is capable of generating and retaining earnings so that it can become "solvent" in the future.

If the answer is no, then the bank should be closed.

The UK may avoid a triple-dip recession. But banking sector gridlock is turning our country – once a shining example of industry, ingenuity and enterprise – into a low-investment, low-productivity basket case. Something has to give.