European banks need to be recapitalized when?

In his Financial Times column, Jean Pisani-Ferry asserts that European banks need to be recapitalized now.

Why recapitalize now?

Europe also made two mistakes in responding to the crisis. First, it failed to recognise the true extent of its banking problem. It believed – or pretended to believe – that the guarantees and recapitalisations of 2008-2009 had addressed the issue whereas weaknesses were in fact much more widespread. Second, it failed to appreciate that excessive private-sector debt was not just an American problem. In Europe too many households and companies needed to deleverage....

The first priority is financial repair. Banks with weak balance sheets lend on too expensive terms or lend to insolvent borrowers to keep them afloat and do not grant credit to new firms. This prevents profitable investment and the growth of new, more efficient firms.

A comprehensive bank balance sheet assessment is needed....

The first priority should be a comprehensive bank balance sheet assessment and this can only by accomplished by requiring the banks to provide ultra transparency.  With on-going disclosure of their current asset, liability and off-balance sheet exposure details, market participants can assess each of the exposures.

Market participants can then exert discipline so that banks recognize their losses on the excess debt in the financial system.  This market discipline ends the practice of lending to insolvent borrowers to keep them afloat.

This market discipline also rewards banks for making new loans to borrowers who can afford to repay the loans.

The ECB should not and will not accept undercapitalised – let alone insolvent – banks to fall under the common supervision. 

With this statement, Mr. Pisani-Ferry moves into the world of theory.  He assumes there are solvent banks in Europe.

In the real world, there is no such thing as a European bank that is not insolvent under the traditional definition of insolvency (the market value of its assets is less than the book value of its liabilities).  Supporting evidence for my statement comes from the need to nationalize several European banks that had passed the stress tests (for example, Dexia).

Mr. Pisani-Ferry also asserts that the ECB should not accept undercapitalized or insolvent banks.

As I discussed in a previous blog, were Walter Bagehot, who wrote the book on modern central banking, alive today he would recognize the existence of deposit insurance. This recognition would change his definition of bank solvency and result in the central bank acting as lender of last resort to banks with substantial negative book capital levels.

Mr. Bagehot would recognize that a bank that does not qualify for access to central bank funds is a bank where its interest income is not greater than its interest expense plus pre-banker bonus operating costs.

National authorities therefore have to initiate a recapitalisation of undercapitalised banks and a resolution of the insolvent ones. The moment is now. 

I agree that the moment for cleaning up the banking system is now.

Using the income driven approach to bank solvency, clearly those banks that are insolvent need to be resolved.

Using the income driven approach to bank solvency, those banks that are solvent should be required to retain 100% of their pre-banker bonus earnings until such time as they have rebuilt their book capital levels to regulatory standards.

While this may take years, it is not a problem as banks can continue to make loans to support the real economy.