Who should bear the pain?

In his Bloomberg column, Matthew Klein examines the question of "who should bear the pain" when it comes to absorbing losses on the excess debt in the financial system.

For the global financial system, which is based on the FDR Framework, losses are the responsibility of the market participants who have exposure to the investment.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all useful, relevant information is disclosed in an appropriate, timely manner.  Market participants are responsible for all the losses on their exposures under the principle of caveat emptor (buyer beware).

Because market participants know they are responsible for losses, they have an incentive to independently assess the risk of any investment and limit their exposure to any one investment to what they can afford to lose.

The result of market participants assessing risk and limiting their exposure is they charge more and reduce the amount of their exposure as the risk of an investment increases.  This is very important as it is the mechanism by which market discipline is exerted.

Regular readers know that under the FDR Framework, banks are responsible for the losses on their exposures just like any other market participant.

Banks do have one unique feature, since the 1930s banks have been designed so that they can absorb upfront the losses on the excess debt in the financial system and still continue to operate and support the real economy.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers become the banks' silent equity partners when they have low or negative book capital levels.


Please note, under the FDR Framework, taxpayers are not responsible for bailing out market participants including banks for their losses.  This is particularly true of banks because a bailout is simply making explicit what is already the implicit role of taxpayers being the banks' silent equity partners when they have low or negative book capital levels.

So why is Mr. Klein asking the question of who should bear the pain?

Because bailing out the banks has proved irresistible to policy makers and regulators.

If banks are designed to absorb losses upfront to protect the real economy and the social contract, why did bailing out the banks at the beginning of our current financial crisis prove irresistible to Paulson, Geithner, Bernanke et al?

Mr. Klein provided the answer in a tweet when he observed about the banks' ability to recognize losses that it:

Only works if they are sufficiently capitalized to absorb the loss.

Please re-read Mr. Klein's tweet as it highlights an artificial constraint imposed by financial regulators and economists that was not put in place by the designers of our financial system: the myth that banks need positive book capital to operate.

Bank book capital is an accounting construct and by definition can have a positive or negative value.  It is the account through which any losses taken by the bank flows.

Since it is an accounting construct, it is easy to manipulate.

For example, regulators can manipulate it by engaging in regulatory forbearance and letting banks practice extend and pretend to turn non-performing loans into zombie loans.  The result is no losses flowing through the book capital account.

The fact that the losses are not flowing through the bank's book capital account does not mean that the losses do not exist.

The fact that existing losses are not flowing through the bank's book capital account also does not mean that market participants are unaware of these losses.

The losses on loans to Less Developed Countries is a classic example of investors knowing losses exist and regulators working with the banks to keep the losses from flowing through the book capital accounts.

The activity by regulators was unnecessary.

Market participants simply adjusted each bank's reported book capital level for an estimate of the bank's losses on its loans to Less Developed Countries.  This adjustment showed a number of large banks had very low or, in Security Pacific's case, negative book capital levels.

When Citi finally acknowledged and took the loss on the loans to Less Developed Countries through its book capital account, market participants reacted positively because the level of losses was consistent with their estimate.  Market participants didn't care what the level of Citi's book capital was.

Despite its negative adjusted book capital level, there wasn't a run on Security Pacific by either depositors or wholesale investors.

The reason there wasn't a run is that for banks the critical measure of a bank's viability is whether its income (from performing assets plus fees) exceeds its expenses.  If this measure is positive, the bank can continue to operate as it has the ability to generate earnings and rebuild its book capital level.

Why should it make any difference to market participants if a bank absorbs losses and has to rebuild its book capital level from a negative level rather than a slightly positive level?  It doesn't.

What does make a difference is if a bank has to disclose its current global asset, liability and off-balance sheet exposure details.  With these details, market participants are able to assess whether the bank has recognized all of its losses and to exert restraint on its risk taking.

Without ultra transparency, market participants have no idea if a bank has recognized all the losses that regulators have allowed the bank to hide on and off its balance sheet.