Opacity in financial system is boon to study of financial contagion

Bloomberg ran an interesting article on Kristin Forbes and her pursuit of the study of contagion in the financial system even though her MIT economic department colleagues thought it was a dead-end.

Regular readers know that in financial systems that adhere to the FDR Framework, the study of financial contagion is in fact the study of the empty set.

Why?

Because under the FDR Framework, all market participants are held responsible for the losses on their exposures.  As a result, market participants set their exposures at a level where they don't have more exposure than they can afford to lose.

Hence, the idea of contagion doesn't apply.

How can market participants set their exposure at what they can afford to lose?

They are given access to the information they need to independently assess the risk of any exposure.  Based on the results of this assessment and the market participant's capacity to absorb any losses from the exposure, the market participant sets their exposure.

Isn't the global financial system based on the FDR Framework?

Yes.

Then why is there concern over financial contagion?

Because financial regulators failed to ensure that the financial system adhered to the FDR Framework.

Specifically, the financial regulators let large swathes of the financial system become opaque.  Examples of the opaque corners of the financial system include the "black box" banks and the "brown paper bag" structured finance securities.

A financial product or corner of the financial system is opaque if market participants do not have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Beginning in 2007 and continuing to this day, where there is opacity the financial system has effectively frozen.  An example is the inter-bank lending market where banks with deposits to lend cannot assess the risk and solvency of banks looking to borrow and therefore are unwilling to lend.

Bottom line:  bringing transparency to all the opaque corners of the financial system would in fact prove her MIT colleagues right that studying financial contagion is a dead-end.

BoE's Robert Jenkins: Stable banks need a stable financial system

In a Financial News column, Bank of England Financial Policy Committee member Robert Jenkins makes the argument that since the beginning of the financial crisis senior bankers have had a 'refresher course in basic banking' and are finally stumbling upon the simple fact that a new risk has emerged:  contagion.

Regular readers know that under the FDR Framework contagion is not a risk as market participants limit their interconnectedness to what they can afford to lose.

Why?

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  As a result, market participants set the size of each of their exposures based on what they can afford to lose given the risk of each exposure.

Market participants do this because the combination provides them with access to all the useful, relevant information they need to independently assess the risk of each exposure and makes each market participant responsible for all losses on their exposures.

However, contagion is a risk in our current financial system as opacity across wide swathes of the financial system has led market participants to underestimate risk and therefore become too interconnected.

Contagion will remain a risk until such time as transparency is brought to all the opaque corners of the financial system including bank balance sheets and structured finance securities.

• For banks, transparency takes the form of disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
• For structured finance securities, transparency takes the form of disclosing on an observable event basis all activities like a payment or delinquency that involve the underlying collateral before the beginning of the next business day.

With transparency, market participants can go through the process of assessing the risk of each of heir exposures and, where appropriate, reducing their interconnectedness so that it properly reflects the risk of the exposure.

It took four years plus a string of scandals but in 2012 bankers began to acknowledge publicly their past failures and failings. 

Perhaps (some admitted), reputation was critical after all. Perhaps customers should not come last. Maybe, irreplaceable executives were more easily replaced than thought. Maybe some businesses really were too complex to manage. Maybe bonuses tied to risk-taking should not be paid until the risks taken had matured. And yes, in retrospect the industry could not be trusted to regulate itself. 

That these lessons had to be relearned by many highly paid professionals is disgraceful. That they are being learned at last is progress. 

May the momentum continue – for there are three banking basics yet to be grasped or if grasped, then embraced by many senior bankers. The first is that the financial institutions for which they are responsible require a more stable financial system. ... 

Since the advent of the crisis, the financial world has received a refresher course in the basics of banking. In 2007 we rediscovered credit risk; 2008 – liquidity risk; 2009 – market price risk; 2010/11 – sovereign risk. (And coming soon to a theatre near you: geopolitical risk.) 

These risks are not new but what has dawned is the degree to which the interconnectedness of the financial system now amplifies such threats. 

Thus balance sheet values for an otherwise sound institution may plunge because of the forced sale of assets by less sound members of the fraternity. Wholesale funding flees those suspected of weakness. Exposures to “risk-free” sovereign debt can tie vulnerable banks to vulnerable countries. And it does not stop there. Even those financial firms free from direct sovereign exposure remain at risk if their financial counter-parties are so exposed. 

Interconnectedness and the domino effects it can trigger are now a fact of financial life.

A fact of life that is created by opacity across wide swathes of the financial system.  And therefore, a fact of life that can be eliminated by restoring transparency to all the opaque corners of the financial system.

As we have witnessed, the loss of confidence in large financial institutions can cause a loss of confidence in the system as a whole. Had AIG been allowed to fail, the impact would have been felt on both sides of the Atlantic. 

But here’s the rub: should (when) such threats return, the public may be in no mood to bail out the behemoths – and the public purse may be insufficient to do so.

Fortunately, there is no reason that the public should be called on to bail out the behemoths again.  By simply restoring transparency, all market participants can and will reduce their exposures to what they can afford to lose (recall market participants know that in return for access to all the useful, relevant information they are held responsible for all losses on their exposures).

Banks will also reduce their interconnectedness and exposures as market participants will exert restraint on their risk taking behavior.  This restraint will take the form of less access to and a higher cost of funding if the bank is seen as too risky because of its interconnectedness.

If banks need a sound and stable system in which to pursue success, it is equally true that a stable system depends on the perception that the most interconnected banks are sound and stable. This becomes all the more urgent with the prospective removal of government guarantees. 

Markets must believe that when faced with financial loss, banks will either: 1) be able to stand on their own two feet; or 2) be able to be closed down without sparking systemic contagion. Such confidence can come only from a system in which banks’ risk-taking is kept within their loss-absorbing ability. 

This in turn requires sharply less leverage than in the past and more loss-absorbing capital in the future.

What is required is the banks provide ultra transparency.

With ultra transparency, market participants can confirm that a bank is able to stand on its own two feet (in the 1930s, ultra transparency was in fact the sign that a bank could stand on its own two feet).

Requiring ultra transparency has several beneficial results besides increasing the stability of the financial system by reducing the interconnectedness of the market participants.  These benefits include lower leverage and higher loss-absorbing capital.

Did either interconnectedness or contagion cause the financial crisis

Harvard professor Hal Scott and the Committee on Capital Markets Regulation issued a discussion paper in which they looked at the role played by interconnectedness and contagion in the financial crisis.

They found that contagion was the primary cause of the financial crisis and they offered seven solutions to address the problem.

The study engages in a detailed analysis of interconnectedness (i.e., the linkage between financial institutions) in the context of the failure of Lehman Brothers in October 2008 and concludes that interconnectedness was not a major cause of the recent financial crisis. 

The study continues with a discussion of financial contagion (i.e., run-like behavior that spreads from the perceived failure of a financial institution to other financial institutions) and an analysis of possible solutions to contagion. 

The study highlights that a distinguishing feature of contagion is its ability to spread indiscriminately among firms in the financial sector and notes that contagious runs can occur even if there are no direct linkages to the original institution (i.e., even in the absence of interconnectedness).

This finding is in direct contrast to the finding of the Financial Crisis Inquiry Commission (FCIC).  FCIC found that all financial institutions shared a common interconnectedness and source of contagion.

Specifically, due to a lack of transparency, no financial institution (or investor) could determine if any other financial institution was solvent or not.

Without the ability to determine if a financial institution is solvent, banks with deposits to lend or investors with money to invest refused to lend to banks looking to borrow.  The result was the interbank lending market and unsecured bank debt market froze.

The study comes to the conclusion that contagion was the primary cause of the financial crisis and that short-term funding in particular is the primary source of systemic instability. 

In the context of these conclusions, the study engages in a comprehensive and detailed analysis of the possible solutions to financial contagion. The solutions include: (i) capital requirements, (ii) liquidity requirements, (iii) resolution procedures, (iv) money market mutual fund reform, (v) lender of last resort, (vi) liability insurance and guarantees, and (vii) public bailouts. ....

Please note that requiring the financial institutions to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is not included in the list of possible solutions.

If the financial institutions had been required to provide ultra transparency, then the issues of interconnectedness and contagion would have been moot.

With ultra transparency, each market participant can independently assess the risk of each financial institution and adjust their exposure to what they can afford to lose given this risk.  Included in the market participants who would adjust their exposure are a bank's competitors and investors.

References to transparency showed up 9 times in the study including the following

One example widely discussed during the financial crisis is the Swedish banking bailout in the early 1990s. 

The Swedish bailout adopted a typical “good bank-bad bank” approach and was not noteworthy in terms of techniques. 

However, the Congressional Oversight Panel has noted two aspects of the Swedish bailout: maximum transparency and independence. 

The Swedish government created an entity separate from its existing financial regulators to oversee the bailout efforts and granted it both political and financial independence. The bailout authority then required the banks in trouble to open their books and conducted audits to assess their potential capital needs. 

Gee, ultra transparency!

Bank of England's Andrew Haldane calls for 'curbing King Kong banks'

The Bank of England's Andrew Haldane in his speech 'on being the right size'  became the latest regulator to call for cutting the Too Big to Fail banks down to size.

Besides Mr. Haldane's typical insightful analysis, his speech reiterated many of the observations made by Paul Volcker on why the regulations proposed since the beginning of the current financial crisis are not going to be effective at dealing with the Too Big to Fail banks.

Regular readers know that there is only one way to right size these banks:  require the banks to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency harnesses the market in shrinking these global financial institutions.

For example, the market shrinks these banks by charging the banks more for their complexity.  It is one thing to say these big banks have 14,000+ subsidiaries, it is another to make these banks disclose the intimate details of each subsidiary so the market participants can assess their risk.

In addition, the market shrinks these banks by restraining proprietary trading.  Management and traders know that disclosing their positions limits how much can be earned from proprietary trading.  At a minimum, market participants can use programs similar to IBM's Watson to identify trades that appear to violate the Volcker Rule and call these trades to the regulators' attention.

More importantly, ultra transparency ends contagion in the financial system.  With ultra transparency, market participants have the information they need to independently assess the risk of each of these banks and adjust the amount of their exposure to what they can afford to lose given the risk assessment.

As reported by the Telegraph,

Andrew Haldane, the Bank’s executive director for financial stability, claimed that current bank reforms – including the Government’s plans to ringfence retail banks – do not go far enough and further measures should be considered. 

To address properly the “too-big-to-fail” problem, he said regulators should consider doubling banks’ loss-absorbing capital buffers to around 20pc, “placing limits on bank size”, or imposing a “full separation of investment and commercial banking” rather than a ring-fence.

Each of these alternatives has problems.

The OECD observed and your humble blogger has fully documented why the accounting construct known as bank capital is meaningless.  It bears repeating that bank capital is meaningless because it is easily manipulated by both banks and their regulators.

Limiting the size of banks sounds nice in theory, however, the question is whether it is size that makes the Too Big to Fail problematic or the risk that if they fail it will cause damage to the rest of the financial system.  The way to mitigate this risk is to require the banks to provide ultra transparency.

Ring-fencing or full separation of investment and commercial banking sounds nice in theory, but the reason that Glass-Steagall fell was banks and their regulators had discovered that banks were bad holders of credit, interest and liquidity risk.  It was far more sensible for banks to originate and service loans and distribute these loans to investors who were better able to hold the loans.

The freezing of the structured finance market is a reflection of the failure to require that each deal provide observable event based reporting so that investors could know what they own.  The fact that the market froze does not say that it is a bad idea to have banks reducing their credit, interest and liquidity risk.

He added that the evidence pointed to the optimal size for a bank to be as small as $100bn (£62bn). ... 

Although banks claim to be more efficient the larger they are, Mr Haldane said the analysis ignored the cost of the implicit taxpayer guarantee that he calculated was worth $70bn a year for the world’s largest banks between 2002 and 2007, and $300bn a year now. 

Without the subsidy, “there is no longer evidence of economies of scale at bank sizes above $100bn. If anything, there is now evidence of dis-economies which rise with bank size, consistent with big banks becoming ‘too big to manage’,” he said. 

“Subtracting this subsidy, removing the state crutch, would suggest a dramatically lower socially-optimal banking scale. Like King Kong and Godzilla, these giants would arguably then be physiological impossibilities ... the weight transfer associated with a single step would have shattered their thigh bones.”

Mr. Haldane does have a wonderful way with words.

I know what his analysis suggests, but it is not clear to me that a bank that provides ultra transparency and operates as a utility doesn't have economies of scale when it gets larger than $100 billion.

Mr Haldane was warning that, despite regulators efforts to build regimes that allow banks to fail without taxpayer support, the risk is that – in the practical event of a giant lender’s imminent collapse – the government would discard the theory and step in. 

“Consider that trade-off when a big, complex bank hits the rocks,” Mr Haldane said. “On the one side is a simple, but certain, option – state bail-out. On the other is a complex, and less certain, option – resolution. If governments are risk-averse ... then bail-out may look attractive on the day. 

“The history of big bank failure is a history of the state blinking before private creditors.”

Please re-read the highlighted text as the point that Mr. Haldane makes is extremely important.

Our modern banking system is designed not to require government bailouts of the banks, however, there is a long tradition of bank regulators urging governments to bailout failing institutions (think Savings & Loans for example).

In his speech at the Institute of Directors, he argued that “one way of lessening that dilemma, and at the same making resolution more credible, is to act on the scale and structure of banking directly”....

The most direct way to act on scale and structure of banking is to require the banks to provide ultra transparency.  It would be amazing how much the banks would change by simply shining the bright light of transparency on them and letting it act as the best disinfectant.

Mr Haldane warned of potential loopholes in the structure. “Today’s ring-fence [can become] tomorrow’s string vest,” he said. He also questioned whether banks would properly separate “cultures and capital” as long as the two operations remained under one roof.

Both of these loopholes were identified by Paul Volcker in his testimony before Parliament prior to Mr. Haldane's speech.

As I learned when working for Mr. Volcker, what he says might not be the word of god when it comes to banking, but it does come from closer to god given his 6'7" height.

Although he welcomed the progress made on bank reforms so far, he added: “Claims that they have solved the too-big-to-fail problem appear to me, however, premature, probably over-optimistic. Worse, they risk sending a false sense of crisis comfort.”

His comments were released shortly after Christine Lagarde, managing director of the International Monetary Fund, spoke out against the “vested interests” in banking and said that unfinished reforms were hampering economic recovery. 

“There are many vested interests working against change and push-back is intensifying,” she said. “It is interesting how some banks say the new regulations will be too burdensome, but then spend hundreds of millions of dollars lobbying to kill them.”

The leading unfinished reform that is hampering economic recovery and that is being strongly resisted by the banks is requiring them to provide ultra transparency.

The banks know if they provide ultra transparency the market will force them to recognize upfront the losses on the excess debt in the financial system.  This will take the burden of supporting this debt off of the real economy and, as shown by Iceland, result in the economy growing again as capital that was used for debt service is now used to buy goods and services.

The banks know if they provide ultra transparency they will be forced to shrink dramatically.  Gone will be the subsidiaries to arbitrage rules and regulations.  Gone will be proprietary trading.  Gone will be behavior like manipulating Libor.

She added that progress was needed on resolution regimes to allow banks to fail and for regulators to coordinate and align their rules, particularly over new rules on bank structures such as ring-fencing or proprietary trading bans. “We need a global level discussion of the pros and cons of direct restrictions on business models,” she said.

Actually, we need to stop talking and simply implement ultra transparency.

Germany pushing for Greece to default raises question of who is holding losses

In a Telegraph article by Bruno Waterfield, he discusses how Germany is pushing for Greece to default.  This of course raises the interesting question of who is holding onto the losses on the Greek debt and related CDS (credit default swaps).

The answer to who is holding the losses is that nobody knows.

By pushing for Greece to default, Germany is betting on market participants having adjusted their exposure to Greece bonds and CDS over the last two years to what they can afford to lose.

The fact that nobody knows if market participants did adjust their exposure means that pushing for Greece to default is gambling with financial stability.  There is some chance that some unexpected market participant is over exposed and this could trigger systemic problems.

Regular readers know that if there were ultra transparency, all market participants would know who was holding the losses.  As a result, there would be less chance of an unexpected surprise from a Greek default.

The German finance ministry is actively pushing for Greece to declare itself bankrupt and to agree a "haircut" on the bulk of its debts held by banks, a move that would be classed as a default by financial markets. 

Eurozone finance ministers meet on Monday to approve the next tranche of loans from the EU and the International Monetary Fund, designed to stave off national bankruptcy while the new Greek government puts the country's finances in order. 

But the severe austerity measures being demanded have caused such fury in Greece, and the cuts required are so deep, that Wolfgang Schäuble, the German finance minister, does not believe that any government would be able to implement them.... 

"He just thinks the Greeks cannot do what needs to be done. And even if by some miracle they did what has been promised, he - and a growing group - are convinced it will not pull Greece out the hole," said a eurozone official. 

"The idea instead is that the Greek government should officially declare itself bankrupt and begin negotiating an even bigger cut with its creditors. For Schäuble, it is more a question of when, not if." ...

With Greek morale at rock bottom, the national mood darkened yet further after armed thieves looted a museum on Friday in Olympia, birthplace of the Olympic Games, and stole bronze and pottery artefacts - just weeks after the country's National Gallery was burgled. 

One Greek newspaper suggested the state could no longer properly look after the nation's immense cultural heritage. "The Greek state has gone bankrupt, let's face it," the conservative daily Kathimerini said in an editorial. 

"If the state cannot guard the country's great cultural heritage for financial or other reasons it must find other ways to do it."...

Mr Schäuble's pessimism .... is not yet fully shared by Angela Merkel, who is said still to be determined to prevent Greece's financial collapse. "She thinks Greece going bust could cause a shock wave that buries other countries - with Spain and Italy among them. It could break apart the entire monetary union," said an official. 

But it has support from Austria and Finland - holding the prospect that a eurozone meeting tomorrow will fail to agree the next set of EU-IMF payments for Greece.... 

Rumours are already circulating in Wall Street that banks are preparing for a "credit event" - a technical term used by credit agencies to mean a default - in the days immediately following March 20, as Greece looks likely to be unable to meet its debts....

Mr Schäuble maintains that since Greece is already regarded by the financial world as bankrupt, a formal bankruptcy would have no negative consequences for other euro members.

The Euro crisis deepens

In his Guardian column, Aditya Chakrabortty lays out all the facts that support his observation that the Euro crisis is getting worse.

He then asks the question of why have the Eurozone policymakers and financial regulators been unable to end the crisis.

The answer is that the Eurozone and the rest of the global financial system are facing a solvency crisis that they have been treating as a liquidity crisis since 2008.  Treating the symptom is kicking the can down the road and not curing the cause.

Europe's leaders have spent most of the euro crisis denying there's a euro crisis....

The denialism ended this summer, as the financial bushfire moved to Italy and even began to menace Belgium and France.... If the rhetoric and the not-so-faint snobbery have vanished, to be replaced by panic about "a last wakeup call" and "a crucial crossroads", the actual policy-making is as clueless as ever.... 

The eurocrats can impose austerity, and bring in Goldman Sachs employees such as Mario Monti to run newly impoverished economies; but anything that might actually break the fire still eludes them. 

In the meantime, the crisis has just kept growing. 

Which is exactly what you would expect given that they are focused on treating the liquidity symptoms and not the underlying solvency cause of the crisis.

In February 2010, Greece needed to raise just €53bn for the entire year; now euro leaders are looking for a trillion euros and counting. Compare and contrast: in his memoirs, Alistair Darling recounts that it took ministers and officials 10 days and one curry-fuelled all-nighter in autumn 2008 to hammer out the complex and costly combination of ready cash, loans and guarantees that saved the British banking system....

Actually, they did not save the British banking system.  They kicked the can of solvency down the road.

Incidentally, these same policies were adopted by both the US and the Eurozone.

Does anyone really believe that the large British banks are solvent given the fact that their exposure to Eurozone governments and banks vastly exceeds their equity?

A good rule of thumb in this crisis is that when a European state pays more to borrow than an ordinary taxpayer shells out for a bank loan, the government eventually has to call in the rescue brigade. 

For much of November, Italy was borrowing at a rate of 7% – and probably the only thing that has kept interest rates from going higher still is that the European Central Bank (ECB) has been buying Rome's IOUs. 

In other words, the markets trust the Italian state – with its own tax-raising powers – less than it does a couple in Kettering who'd quite like a new kitchen. Which, given that Italy plans to roll over more than €360bn (£310bn) of debt next year, is hardly sustainable for the new prime minister Mario Monti. Indeed, on 1 February, Rome will have to either repay or renew €28bn of loans. Even now, no one has the faintest idea how it will do that.  

Over the next couple of months, Italy's crisis can go one of three ways: either the ECB keeps on buying its bonds, with the blessing of northern-European voters and markets; or ECB head Mario Draghi pledges to fund financially distressed eurozone governments; or Rome gives in and calls for a bail-out. If the last even looks likely, financiers will almost certainly panic that Italy is about to default on its debt. With about a third of the country's bonds held abroad, this could wreak chaos in world markets – including in Britain, which is by far the biggest foreign owner of BTPs. That's the sort of event Barack Obama has in mind when he remarks that Europe's crisis is "scaring the world". 

The idea that owners of Italy's debt might have to take a haircut is not what scares the world.  What scares the world is no-one knows who is holding onto the losses.  It is the possibility of contagion pulling down the global financial system that scares the world.

Regular readers know that the way to eliminate the fear of contagion pulling down the global financial system is not more expensive bailouts, but disclosure.  Specifically, every bank must be required to provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this data, everyone knows who is holding the losses.  More importantly, market participants can take steps to adjust the amount and price of their exposure so that they do not lose more than they can afford to lose.

As for the banks in any country that sees its sovereign default, what is needed is a backstop to the sovereign's guarantee of the banks' deposits.  In Europe, this backstop could be provided by the EFSF or the ESM.  The backstop is needed to prevent a run on the banks.

It must be remembered that history has shown that banks with negative book equity can continue to operate and provide loans and payment services.

Rome's not the only government whose finances are in jeopardy; Madrid is in the same boat, while Brussels and Paris have also seen a surge in loan rates. 

Less often talked about is that many of Europe's banks, even well-known French names, are unable to borrow unless from the ECB. "You have European banks nowadays claiming they're not European at all because they're worried the very word will scare away investors," says Grant Lewis, head of research at Daiwa Europe. That credit crunch cannot carry on for much longer without causing either a full-scale banking crisis or throttling economic growth. 

Not that there's much growth to be had, because the prescription of austerity for sick economies simply makes them sicker. By the IMF's own projections, 2012 will be Greece's fifth straight year in recession, which by now should really be termed a depression...

Central banks respond to solvency crisis with more liquidity

Just like 2008, the global central banks have once again responded to a solvency crisis with massive quantities of liquidity.

In 2008, their response was to the interbank lending market freezing over because banks would not lend to each other because they could not determine if the borrower was solvent or not.

Today, their response was to the interbank lending market freezing over because once again banks are refusing to lend to each other because they cannot tell if the borrower is solvent or not.

I wonder if this time the central bankers will put pressure on the policymakers to require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details so that solvency can be assessed.

Why not pull the trigger on Greek credit default swaps? Authorities fear contagion.

A NY Times Dealbook article asks the question of why not pull the trigger on Greek credit default swaps.  The simple answer is fear of the unknown in the form of contagion.

Since financial regulators have not required that banks disclose their current asset, liability and off-balance sheet exposure details on an on-going basis, they have no idea who would win or who would lose if the credit default swaps payout.

This lack of disclosure creates the potential for surprises and the financial regulators are trying to avoid this.

Far better that the financial regulators should have required ultra transparency so everyone could see what the impact would be.

The really important issue here centers on why the European Union cares so much about not setting off credit-default swap triggers in this exchange offer. The absurd lengths European leaders are going to in order to make this “voluntary” does raise a few eyebrows. And I have no really compelling explanations. 

Still, would it be so hard to imagine that the Eurpean Union wants to avoid setting off the swaps because of aggregate exposure among European banks to Greek and other European sovereign debt? For example, what if European banks have all been hedging their sovereign credit-default swaps with each other. If that proves to be the case, a German bank with seemingly modest net exposure to sovereign debts, for example, could really be heavily exposed because the hedge is with a French bank? 

And let us stop with the “Greek C.D.S. market is small” argument. Yes, the publicly acknowledged market is small. What about the bespoke market? 

Moreover, what would the collateral posting requirements be for European banks if non-Greek sovereign debt was downgraded after the triggering of Greek credit-default swaps? What if we also add collateral posting requirements that result from European banks being downgraded?

US banks face contagion risk from Europe

A Bloomberg article reports on Fitch's observation that US banks face contagion risk if the European debt crisis widens.

It is hard to argue with this observation as the implosion of the European financial system as we know it  undoubtedly wouldn't be a positive for the US financial system.

It is also true that market participants do not have access to the current detailed exposure data for the US banks to assess exactly how bad the damage might be.

U.S. banks face a “serious risk” that their creditworthiness will deteriorate if Europe’s debt crisis deepens and spreads beyond the five most-troubled nations, Fitch Ratings said. 

“Unless the euro zone debt crisis is resolved in a timely and orderly manner, the broad credit outlook for the U.S. banking industry could worsen,” the New York-based rating company said yesterday in a statement. 

Even as U.S. banks have “manageable” exposure to stressed European markets, “further contagion poses a serious risk,” Fitch said, without explaining what it meant by contagion. 

The “exposures” of U.S. lenders to major European banks and the stressed nations of Greece, Ireland, Italy, Portugal and Spain, known as the GIIPS, are smaller than those to some of the continent’s larger countries, Fitch said. 

The six biggest U.S. banks -- JPMorgan Chase & Co. (JPM),Bank of America Corp. (BAC), Citigroup Inc. (C), Wells Fargo & Co. (WFC), Goldman Sachs Group Inc. and Morgan Stanley (MS)-- had $50 billion in risk tied to the GIIPS on Sept. 30, Fitch said. So-called cross-border outstandings to France for all except Wells Fargo were $188 billion, including $114 billion to French banks. Risk to Britain and its banks was $225 billion and $51 billion, respectively.

Opacity has a high price: EU response to sovereign debt and bank solvency crisis shows it

Opacity has a very high price.

First, there were the losses on the opaque securities sold before the solvency crisis began on August 9, 2007.  This includes the opaque toxic structured finance securities loaded with fraudulently underwritten sub-prime mortgages as well as CDOs like Abacus that were designed so that Wall Street could profit from the collapse in the sub-prime market.

The Bank of England's Andy Haldane estimated the losses from the opaque securities exceeded $4 trillion globally.

Second, there is the on-going cost of bailing out the banking system.  The banks themselves hid risk both on and off their opaque balance sheets.

Based on a chart showing actual US Debt versus its pre-crisis trend line by Diapason's Sean Corrigan, Zero Hedge suggests that this cost is $3.5 trillion.

Third, we have the EU's sovereign debt crisis which to a significant extent is the result of attempting to bail out the banks in 2008/2009.

Based on the tentative agreement reached by EU policy makers, it appears that the cost is at least 440 million euros - the "equity" that the EU is putting into the European Financial Stability Fund.

This tally of costs only looks at the direct costs of opacity.

Hidden are the indirect costs like zero interest rate policies that transfer wealth from savers to bankers (banks pay nothing for the deposits and can park them at central banks and earn a risk free spread).

In short, opacity has a very high price.

Unfortunately, so long as we have pockets of the financial system that remain opaque, the cost of opacity will keep increasing.

For example, in the Eurozone, bank balance sheets are opaque.  What this means is that no one, including the regulators, knows how much exposure any bank has to any other bank, to any sovereign or how the bank might be trying to hedge the risk of this exposure.

As a result, the options available to Eurozone policy makers and financial regulators in how to respond to the sovereign debt and bank solvency crisis are limited.

For example, how many times did the policy makers express fear of causing contagion.  This "fear" clearly influenced the negotiations over the size of the haircut on Greek debt.  The banks knew that the policy makers would not be willing to risk a blow-up of the Eurozone banking system.  Hence, banks could negotiate to minimize the haircut and receive a 30 billion euro credit enhancement.

Imagine how differently the negotiations would have gone if all market participants knew the intimate details of each bank's assets, liabilities and off-balance sheet exposures.  With this information, policy makers could have seen if it fact a 100% write down of the Greek debt would have triggered contagion.

[This blog has suggested on several occasions that disclosure is the cure for contagion.  I have argued that   as soon as the data is made available to the market, it is in each bank's best interest to adjust their exposures to the other banks so that their exposures are not more than they can afford to lose.]

However, the EU policy makers and financial regulators did not have disclosure.

• This is despite the fact that all of the assets, liabilities and off-balance sheet exposures are knowable facts since they are in each bank's information systems.  

• This is despite the fact that the EU policy makers and financial regulators had gone through the first stage of the financial crisis in 2008/2009 and seen that the the financial markets broke down everywhere that there was opacity and that the policies that they adopted then had failed to provide disclosure - actually, they bought time in which disclosure could have been implemented and the current round of the financial crisis avoided.

Instead, the EU policy makers and financial regulators were faced with opacity and the fear of the unknown.

The results were predictable.  Once again opacity extracted its high price.

Now the question is will the Eurozone policy makers end opacity by setting up a data warehouse to collect the current asset, liability and off-balance sheet exposures from each bank and providing this data for free to market participants.

Investors fear worst for banks

The Financial Times ran an article highlighting how opacity is unhelpful at a time of intense investor skepticism about Eurozone banks.

As Barry Ritholtz observed on the Big Picture blog,

Investors have decided they cannot take the risk of a holding an opaque, possibly under-capitalized probably over-leveraged financial firm blindly. They are telling the banks no thanks, we are not interested, we are going to be prudent and we have to assume the worst. Hence, for the second half of 2011, they have been selling off their holdings in these opaque, potentially insolvent too big to succeed entities.

Regular readers know that the solution is to end opacity and for banks to disclose their current asset and liability-level data.

A global bank’s share price drops more than 10 per cent in a single day over concerns about its exposure to the eurozone’s spiralling sovereign debt crisis. Sounds familiar? ... However, when that bank is Morgan Stanley ... it raises broader questions about shareholders’ confidence in the fundamental integrity of some of the world’s largest financial institutions, and whether the worst of the bear market for banks is yet to come.... 

So it is somewhat surprising that French bank executives continue to insist that their priority is deleveraging, rather than recapitalisation. “In this kind of market, I wouldn’t even know how much capital I had to raise,” one top French banker said last week, while insisting that investors in the US, in particular, are peddling doomsday scenarios. 

It is true that the hit from a Greek default, while painful, would be manageable. BNP, which holds the largest amount of Greek debt among French lenders, is expected to take an additional €1.7bn hit in its third-quarter accounts. The impact of a writedown of its Greek exposure would shave just 15 basis points off BNP’s core tier one capital ratio, the key measure of financial strength, according to the bank’s estimates. 

Markets, however, are pricing in the impact not only of a Greek default, but of a substantial haircut on Italian and Spanish debt. Investors simply do not believe that French banks hold enough loss-absorbing capital to withstand contagion across Europe.

To address the fact that investors do not believe they are adequately capitalized, French banks, led by BNP Paribas and Societe Generale have started down the path towards 'utter transparency' by providing more disclosure about their exposures to sovereign debt.

The sooner they actually offer 'utter transparency' in the form of current asset and liability-level data, the sooner they will be able to address investors' worst fears.

Which brings us back to Morgan Stanley, where its sharp sell-offs have been traced in part to a widely circulated report that claimed the bank held $39bn worth of exposure to France. 

People familiar with the situation at Morgan Stanley say the figures reported were from the end of last year and were gross, rather than net, numbers. The bank’s net exposure to France, those people say, is actually near zero.... 

Turbulent markets and a drop-off in dealmaking in recent months are expected to take a heavy toll on Morgan Stanley’s earnings, but executives insist its fundamentals remain sound. 

Like the rest of the banks, Morgan Stanley has reached put up or shut up time.  Either disclose your current asset and liability-level data to show that investors should not be worried or understand that the lack of disclosure is confirmation of the problem.

Like their European rivals, however, they may be shouting into the wind.

Actually, investors who lack the ability to Trust, but Verify bank management's claims are acting prudently by reducing their exposure.

IMF's Lagarde calls for urgent recapitalization of Europe's banks

A Bloomberg article reports that in her speech at the Jackson Hole conference, IMF chief Christine Lagarde called for the urgent recapitalization of Europe's banks.

With this speech, she acknowledges that Europe's banks are still facing the solvency crisis that Mervyn King identified four years ago.

Regular readers know that the key to ending a solvency crisis and the risk of contagion is to address the issue of who is solvent and who is insolvent by using disclosure of each financial institution's current asset and liability-level data.

• It is only with this data that market participants can determine if the market value of a financial institution's assets exceeds the book value of its liabilities (the definition of solvency). 

• It is only with this data that market participants know just how insolvent an insolvent bank might be.

• It is only with this data that the "chains of contagion" are permanently severed as market participants use this data to assess the risk of each financial institution and adjust the price and amount of their exposure.  Market participant will limit the size of their exposure based on their analysis of the risk of losing their investment and their capacity to absorb this loss.

Simply adding capital without disclosure does not mean that a financial institution is solvent.

In 2008 and 2009, policymakers injected capital into the banks without also providing current asset and liability-level disclosure.  Now, in 2011, the solvency of these same banks is once again being questioned.

Bank of America illustrates this point.  Despite raising all the equity required under the 2009 stress tests and $5 billion from Warren Buffett, some analysts believe that BofA still needs to raise an additional $100 - $200 billion to cover the difference between the market value of its assets and the book value of its liabilities.

The time has come to address the solvency crisis and fix the contagion problem once and for all.  First, policymakers must require disclosure of each financial institution's current asset and liability-level data.  Second, only after this data has been made available to market participants should a decision be made as to how to recapitalize or close the insolvent institutions.

... European banks should be forced to build up their capital to prevent the continent’s debt crisis from infecting more countries. 

Bolstering banks’ balance sheets “is key to cutting the chains of contagion,” Lagarde said today in remarks at the Federal Reserve’s annual forum in Jackson Hole, Wyoming. 

Without an “urgent” recapitalization, “we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis.” 

Lagarde, a former French finance minister who took the helm at the Washington-based IMF in July, said recapitalization should be “substantial” and called a mandatory move “the most efficient solution.” Banks should look for funds in the markets first and seek public money if necessary, including from the European bailout fund, she said.

Disclosure of current asset and liability-level data is the most efficient solution because it answers the question of who is solvent and who is insolvent.  Private investors are not going to invest without knowing if a financial institution is solvent or not.

The stress tests on 90 European banks published on July 15 showed eight lenders had a combined 2.5 billion-euro ($3.6 billion) capital shortfall, failing to ease concern that many of them remain vulnerable to a potential sovereign default. European lenders are dependent on aid from the European Central Bank, including unlimited loans that are keeping many banks in Greece, Portugal, Italy and Spain solvent. 

ECB President Jean-Claude Trichet today dismissed any idea that Europe could face a liquidity shortage, saying efforts to combat the financial crisis will prevent such an outcome.

“The idea that we could have a liquidity problem in Europe” is “plain wrong because of these non-standard measures we have taken,” Trichet said in Jackson Hole. 

The ECB, which is also buying sovereign debt from some euro countries including Portugal, is acting in part because governments have yet to ratify a plan to extend the scope of the 440-billion euro rescue facility to allow it to buy bonds and inject capital into banks. 

The fact of the matter is that the ECB, the BoE and the Fed still have the programs in place to provide the financial markets with liquidity during the time it takes to implement disclosure of each financial institution's current asset and liability-level data.

There is plenty of time to implement a solution to the solvency crisis and contagion problem that the market will find credible.

What there is no more time for are more of the same policies that governments can no longer afford and that have not ended the solvency crisis and contagion problem.

Buy-side confirms that disclosure is solution to alleviate solvency fears

In a Bloomberg article, the buy-side confirmed that disclosure of current asset and liability-level data is the solution to alleviate their solvency fears.

“There is a great cloud of uncertainty that’s hanging over the U.S. banks about the full extent of the exposures they have to French and other European banks,” said Andrew Karolyi, a finance professor at Cornell University in Ithaca, New York. “The market is clearly not reacting well to what they’re seeing.” 

Citigroup and Goldman Sachs, both based in New York, were the only large U.S. banks to quantify their exposures to French banks in their quarterly filings, known as 10-Q reports. Cross- border outstandings include cash deposits, receivables, loans and securities. They also include short-term collateralized loans of securities or cash known as repurchase agreements or reverse repurchase agreements. 

The disclosures, which didn’t identify the French companies involved in the two banks’ dealings, don’t provide a full picture of the risks because investors can’t see any offsetting collateral or hedges, said David Hilder, an analyst at Susquehanna Financial Group in New York. 

“Unfortunately, I think the numbers in the 10-Qs are really not economically meaningful,” said Hilder, who has a “positive” recommendation on Goldman Sachs and “neutral” on Citigroup. “The gross amount is very likely to be misleading in terms of true economic exposure.” ...

The 2008 financial crisis showed how the interconnections between financial institutions worldwide can cause risks in one company to spread around the globe. Three years later, investors remain unaware of U.S. banks’ Europe-linked risks, Karolyi said. 

“As investors in these banks, we crave greater clarity about the full extent to which they’re laying off their exposures and how and in what form,” Karolyi said. “A little bit more transparency would go a long way to alleviating a lot of investors’ concerns about the extent of these exposures.” 

...“The French are particularly exposed to funding concerns because of their funding structure,” the RBS analysts wrote. “It is quite likely in our view that funding will not become a serious issue for the large French banks, that anxieties subside and that the shares rebound. But there is a non-trivial risk that confidence deteriorates further.”

British banks ordered to disclose foreign government debt exposure

An Independent article reports that the Financial Services Authority is requiring that British banks disclose their foreign government debt exposure in a bid to head off contagion fears.  Not only does the FSA want this disclosure, but it wants it updated on a daily basis.

Without explicitly endorsing the FDR Framework, the FSA has championed it.

The FSA is saying in no uncertain terms that providing the financial market participants with disclosure produces financial stability.

The Financial Services Authority (FSA) has stepped up scrutiny of UK banks' exposures to foreign government debt as fears of European sovereign debt contagion sent markets into a renewed frenzy yesterday. 

The City watchdog is in talks with Britain's banks and their auditors to ensure consistent disclosure of their sovereign holdings according to the standards of the recent European stress tests in their year-end results. 

As fears over which banks could be hit by downgrades of sovereign bonds continue to rattle markets, the FSA has also upped its day-to-day monitoring of UK lenders' exposures. 

An FSA spokeswoman said: "We have been holding discussions with the banks and their auditors in relation to their sovereign exposures. What we are looking for is greater consistency and disclosures across firms to give the market clear information." 

Yesterday marked another round of turmoil for Europe's banks as fears about exposures to debt-stretched economies made investors question their ability to fund in the market. 

Shares in Société Générale gyrated as the French lender sought to stamp out doubts about its financial strength. The bank was the focal point of Wednesday's rout of bank shares. 

SocGen's chief executive, Frederic Oudea, staged a fightback overnight, dismissing negative speculation as "absolute rubbish". He called for the French market regulator to investigate the source of market rumours. 

"People are scared so the tiniest information touches off irrational fears," he said. "[Our clients] should not listen to this stuff, which is totally baseless." 

Did Dick Fuld at Lehman say something similar?  The reason disclosure is needed is so that market participants can Trust, but Verify!

His comments rallied the shares but they then fell more than 9 per cent in a day of frenzied trading before closing up 3.7 per cent. Speculation about a European ban on short selling helped boost shares. BNP Paribas, France's biggest bank, closed up slightly after falling up to 7.5 per cent earlier. 

However, average short interest across the Euro Stoxx banks sector was 2.85 per cent, only marginally above the average for European companies in general, according to Data Explorers figures. Short interest in SocGen was 1.23 per cent and was 1.95 per cent for BNP Paribas. 

The figures suggest short selling was not a major factor in the banks' declines, though rumours planted by a few short sellers can wreak havoc. 

The cost of insuring SocGen's senior bonds hit a fresh record, according to data provider CMA. Speculation about a downgrade of France's sovereign debt, a bigger bailout for Greece and the bank's ability to raise funds put SocGen shares under pressure. 

Banks' overnight borrowing from the European Central Bank hit a three-month high as prices for inter-bank lending showed Europe's banks increasingly unwilling to lend for longer than overnight. 

Analysts at Royal Bank of Scotland said SocGen was among European banks that rely most heavily on short-term wholesale funding. 

"The mix of euro doubts and rating fears in recent days and weeks may have dented the confidence of funding counterparties, which has then fed back into equity markets," they said. 

How can France's banks restore confidence?

A Telegraph article asked the question of how can Soc Gen [and all of France's banks] restore confidence. Regular readers know the answer is not to ban short selling, but rather for the banks to disclose to all market participants their current asset and liability-level data.

By announcing that they are going to disclose this information, the French banks are sending a message to the market that they have nothing to hide and any problems that they have are manageable.

By actually providing the information, the French banks would be providing market participants with the ability to confirm or deny this message (trust, but verify).  Confirmation of the message would fully restore confidence.

In addition, the French banks would be setting the global standard for disclosure.

"I mean, why would I as a corporate treasurer want to take the risk?" asked one investor of analysts at Nomura on a conference call yesterday to discuss fears over the funding of European banks. 

John Peace, head of banks research at Nomura, took up the question and gave a lengthy explanation of why he thought the bank was safe, but it was his colleague Alison Miller, head of European credit strategy, who gave a more pithy response. 

"I think the answer is simple, it's about confidence. If something doesn't transpire, that could restore some confidence." 

Confidence in Société Générale, one of France's largest banks, has been lacking this week. 

The bank's shares lost more than 20pc of their value at times and at yesterday's close the lender had seen its market value reduced by about a quarter as rumours swirled the market that it could be in trouble. 

Even a statement from the bank written in bold capitals saying that rumours over its financial health were "COMPLETELY UNFOUNDED" did little to ease fears that something might not be quite right at the bank. 

What is striking is that the suspicions come despite investors having access to far more information on the exposures of European Union banks than they have had before. 

Stress test data published last month by the European Banking Authority provided the market with a detailed breakdown of the exposures of the region's 90 largest banks. 

Analysts at independent research firm CreditSights have even created their own "Stressometer" allowing clients to play around with the numbers and work out the writedowns and losses they think banks could face. 

This is exactly as predicted under the FDR Framework.  Market participants who know how to turn the disclosed data into information do so in a way that makes it easy for other market participants to benefit.

For example, take the fear of the French banking sector's exposure to French government debt, a major source of the collateral used by the banks to fund their day-to-day operations. 

Using CreditSights' database, in just two minutes you can work out that this amounted to €118.73bn (£105bn) at the end of last year. 

Break the figure down and you discover that Société Générale's net exposure to the French government is €16.1bn, about €10bn less than the larger BNP Paribas and about half that of Crédit Agricole. 

Notes sent to clients by Credit Suisse, Goldman Sachs and Nomura, all expressed themselves comfortable with the exposures of France's banks and their funding. 

The question, then, is why are the share prices of European banks being hit so hard? 

Current sector valuations show European banks trade at just 0.8 times their tangible book value and a price earnings multiple of less than six times 2012 forecast earnings. 

"I think there is a really worrying trend here," said one senior London-based credit analyst. 

"What you could be seeing is counter-parties to the French banks asking them to replace French government debt with other assets. What this means is that the market does not want any more exposure to France because of its own worries over its economic outlook." 

Since the eurozone crisis began, there has been the constant fear of contagion to the currency union's larger members and the concurrent worry that it could also lead to a new bank crisis.... 

Unlike in 2008, the banks have a lot more capital and larger liquidity reserves. Dollar funding, one of the main issues in the last crisis, is less of an issue and the banks have about $900bn (£554bn) of funds on deposit with the Federal Reserve, against $50bn in 2008. 

Their funding is also more diversified and banks have made efforts to tap every available investor base, from the Australian bond market to exchange traded funds. 

This is not to say there are not serious problems. European Central Bank lending figures for May showed that more than half of eurozone deposits were being lent out to the region's weaker banks to keep them afloat, a higher proportion than in the previous crisis. 

For all the unknowns made known by the July stress tests, investors still think their are more unknown unknowns out there. 

Actually, the investors know that there are more unknown unknowns out there.  What investors have been clearly communicating since the beginning of the credit crisis is that they do not want facts that are readily knowable included in the unknown unknown category because of a lack of disclosure.

Debt Crisis 2.0: The solvency crisis re-emerges with a vengeance

As a column in the Guardian observed,

The conventional wisdom is that August is a sleepy month for markets, with politicians, policymakers and investors all at the beach rather than at their desks. The conventional wisdom is wrong.  

The credit crunch really kicked off on 9 August 2007, when the French bank BNP Paribas suspended three of its investment funds that had been dabbling in US sub-prime mortgages. 

Within a week, the Bank of England's Mervyn King was getting warnings that Northern Rock was in grave danger if the squeeze in money markets dragged on (not that it had any effect on Threadneedle Street's policies). Over the course of that month, the interest rate that banks charged each other for loans – the London inter-bank offered rate (Libor) – surged. 

Investors and commentators began talking about a credit crunch.... These were the first steps that led to the collapse of Northern Rock in September, and ultimately to a near-death experience for the world financial system. And yesterday you could have been forgiven for thinking that it was happening all over again.... 

What investors are demanding right now is not urgent American spending cuts, but a port in a storm – which means IOUs from DC, Swiss francs and gold. What they don't want is assets associated with the eurozone periphery: whether that be government bonds from Italy and Spain, or British banks (which took a pounding yesterday). 

This is a reflection of the return of the question:  who is solvent and who is insolvent.

The alarming thing, as the European commission president, José Manuel Barroso, pointed out yesterday, is that the eurozone periphery keeps expanding. Italy and Spain are now in the firing line. But Belgium is in the distance, too: the gap between the interest on Belgian government loans and their German equivalents has now widened out to over 2.2 percentage points.... Incredibly, a gap has even opened up between French government bonds and those issued by Germany. 

As this blog has repeatedly pointed out, without current asset and liability-level disclosure, market participants have no way of evaluating the solvency of any financial institution or its host country.  This sets up the necessary conditions for contagion.  This is reflected in the expansion of the eurozone periphery.

... At the height of the banking crisis of 2008, policymakers had two priorities: first, prop up the banks; second, protect the real economies as far as possible from the impact of the crash. This time, the task is again twofold, only much bigger: first, prop up the European banks, and ensure emergency low-cost loans for Spain and Italy; second, another round of reflation. Yet this requires money and moreover statecraft of a kind that has gone awol from European politics.

A column by Andrew Lilico in the Telegraph independently addresses the idea of propping up the European banks.

I’ll sketch this in five parts. First, the banks. Then the euro. Then monetary policy. Then fiscal policy. Then growth. 

But before we begin, accept this: the denial, delay-and-hope, no-creditor-shall-lose bailout strategy pursued since early 2008, as well as being immoral and destructive, has failed. Until policy-makers really embrace that point, at least to themselves, no progress can be made. 

The banks- Introduce Special Administration Regimes for banks. Now. Not tomorrow.
- Make depositors preferred creditors, overturning current bond contracts.
- If banks are insolvent but essentially going concerns, impose debt-equity swaps in special administration and provide unlimited liquidity to see off bank runs.
- If banks are insolvent, restructure or liquidate.
- Withdraw all government guarantees.
- Do not provide any further government recapitalisation funds. Especially resist the temptation to throw yet more good money after bad in the banks previously bailed out.
- Enact longer-term structural reforms– quickly. 

Regular readers know that the first step in re-establishing a solvent banking system and confidence in this fact is disclosure of all the current asset and liability-level data.  Without taking this step, market participants will not trust that the financial system is solvent no matter how it is reconfigured.

UK's Financial Services Authority turns to disclosure

An article by David Enrich in the Wall Street Journal showed how British regulators are turning to disclosure as the solution for retaining investor confidence in the UK banks.

Even more important than regulators adopting disclosure is that bank's perceive there is an advantage to being at the forefront of disclosure.

British regulators are pushing U.K. banks to publicly reveal more information about their exposures to troubled European countries such as Belgium, a sign of how concerns about the euro zone are spreading beyond southern Europe. 

Lloyds Banking Group PLC on Thursday disclosed its holdings of debt tied to the Belgian government and local financial institutions as part of the bank's second-quarter results. 

Executives said they made the disclosure at the behest of the Financial Services Authority. 

"It was the FSA's suggestion that Belgium be added to the list," said Tim Tookey, Lloyds's chief financial officer. "That is the sole reason" the bank started making the disclosures. 

Sarah Bailey, an FSA spokeswoman, said the regulatory agency has been talking with Lloyds and other British banks about ways for them to improve their disclosures about their holdings of debt tied to cash-strapped countries—a major source of angst among many investors and regulators. The FSA "is looking for greater consistency so the market has clearer information" about banks' holdings, she said. 

One possibility, Ms. Bailey said, is for banks to start reporting detailed information about their exposures to countries whose government bond yields have climbed a certain amount above the yields on U.K. government bonds. 

"This is just a suggestion," Ms. Bailey said. "It's not an instruction." She said the talks with banks are continuing and that details haven't been ironed out yet. 

Those discussions prompted Lloyds to reveal its Belgium exposures. Belgium is coming under investor pressure because of its high debt levels and concerns about political dysfunction. In one indication of investors' growing anxiety, the cost of buying insurance against the Belgian government defaulting on its debts has soared 61% since the beginning of July, according to data provider Markit. 

... Mr. Tookey said Lloyds moved faster than other U.K. banks to report its Belgian holdings in order "to make sure we were right at the forefront of disclosures."

Does the EU have the capacity to solve its debt crisis? Update

Since the EU announced its latest strategy for addressing its debt crisis through the European Financial Stability Fund, the capital markets have been questioning does the EU have the capacity to solve its debt crisis.

The debt crisis has two components.  The first component is the banks.  The question here is which banks are solvent and which are not.  The second component is the sovereign.  The question here is can the host country pay its debts.

The two components become intertwined when the sovereign is no longer a potential source of capital for the banks it hosts, but is instead a contributor to their insolvency.

The EFSF is acquiring the authority that it needs to address this interconnection.  Once approved by the EU members, the EFSF will be able to a) help insolvent sovereigns and b) lend money through the sovereign to recapitalized insolvent banks.

The question the market is asking is how much money will the EFSF require to fulfill this mission.

Regular readers know that the only way to answer this question is by providing the market participants with the current asset and liability-level data from the banks.  With this data market participants can determine who is solvent and who is insolvent.  This also allows the market participants to figure out how much capital is required to restore solvency to the EU financial system.

More importantly, once this analysis has been done and the financial system recapitalized, the debt crisis is ended.

As predicted under the FDR Framework, without disclosure, the EU will not be able to put the debt crisis behind it.

Update


A Telegraph article on EC president Barroso in which he describes the problems the EU faces and highlights the fact that the only way to "convince" the markets is to provide the data and let the markets confirm the facts for themselves.

The head of the European Commission urged the 27 European Union leaders to begin a "rapid reassessment" of the bloc's rescue mechanisms. 

He said governments should rapidly review "all elements" including the size of the €440bn European Financial Stability Fund (EFSF) and the €500bn European Stability Mechanism to "address the current contagion" in the eurozone. 

"It is clear that we are no longer managing a crisis just in the euro-area periphery," he said, adding that markets remain to be convinced that the EU is taking the appropriate steps to resolve the crisis. 

He said the July 21 agreements - which has yet to be ratified the individual member states - giving the EFSF the possibility of "precautionary use, recapitalisation of banks and intervention in secondary bond markets, are not having their intended effect on the markets." 

Investors have pushed yields on benchmark Italian and Spanish government bond to 14-year highs, reflecting "a growing scepticism among investors about the systemic capacity of the euro area to respond to the evolving crisis", he said. 

Mr Barroso attributed market pressure on euro states to slow global growth and US debt problems as well as to "first and foremost, the undisciplined communication and the complexity and incompleteness of the July 21 package".

Greece, Portugal and the Irish Republic - known as the eurozone's periphery countries - have needed bailouts. The fear is that the current rescue fund is not big enough to cover bailouts of Italy and Spain.

In short, by not providing the data, market participants could not use the facts to convince themselves that the EFSF would work and had adequate access to capital

Complexity, concentration and contagion solved by the FDR Framework

Since before the credit crisis, your humble blogger has said and demonstrated that the issues of complexity, concentration and contagion in the financial system are most effectively and efficiently addressed and solved with the simple mechanism of disclosure.

Regular readers are familiar with how disclosure works in the context of the FDR Framework.  Under this framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Market participants, since they are responsible for absorbing losses on investments under the principle of caveat emptor, have an incentive to use this data to analyze the risk of any investment and adjust both the price and amount of their exposure based on the results of this analysis.

Recently, the Bank of England's Andrew Haldane delivered a speech on haircuts in the repurchase agreement markets.  This speech was a prelude to the forthcoming publication of an article he co-authored titled "Complexity, Concentration and Contagion".

Like Gary Gorton and Andrew Metrick before them, Haldane and his co-authors develop a theory of how secured funding markets work and a model.  As with Gorton and Metrick, Haldane and his co-authors' theory and model are inferior in every respect to the parsimonious FDR Framework.

Gorton and Metrick observed what they called a run on the repo.  Haldane and his co-authors observe that the amount of collateral required for a repurchase agreement jumped significantly from before the credit crisis to the peak of the credit crisis.

Table 1 demonstrates this pattern [for prime counter-parties]. It compares haircuts on a range of financial instruments used to back borrowing – so-called securities financing. They are shown on two dates, before (June 2007) and after (June 2009) the financial crisis. Haircuts rose by up to 90 percentage points in the space of these two years, as the scorching pre-crisis summer gave way to a frozen crisis winter. In other words, haircuts exhibited a rather dramatic pro-cyclicality over the course of the crisis.

Table 1: Typical haircut on term securities financing transactions (per cent)
                                                                             June 2007      June 2009
Medium-term G7 government bonds                         0                     1
Medium-term US agencies                                        1                     2
AAA-rated prime MBS                                            4                    10
Asset-backed securities                                           10                    25
AAA-rated structured products                               10                  100
AAA- and AA-rated investment grade bonds           1                     8
High-yield bonds                                                      8                    15
G7 countries equity                                                10                    15
Source: Committee on the Global Financial System (2010).

This haircut cycle played an important causal role in the crisis. Secured financing became an increasingly important source of credit in both bank and non-bank markets over the past decade. In the US, the repo market financed roughly half of the growth in investment banks’ balance sheets between 2002 and 2007. In the UK, the securitisation market trebled in size over the same period. Those were the heady days of summer. Since then the US repo market has shrunk by 40%, while the UK securitisation market remains frozen.

Why did this increase occur?  Was it predictable? (hint:  the increase was predictable and it is a matter of record that using the FDR Framework your humble blogger predicted it along with the credit crisis)

As discussed in a previous post, Gorton and Metrick acknowledge that they and their theory of how secured funding markets work using informationally insensitive debt are unable to answer these basic questions.  They wrote [link in previous post]

The reason that this shock occurred in August 2007 – as opposed to any other month of 2007 – is perhaps unknowable. We hypothesize that the market slowly became aware of the risks associated with the subprime market, which then led to doubts about repo collateral and bank solvency. At some point – August 2007 in this telling – a critical mass of such fears led to the first run on repo, with lenders no longer willing to provide short-term finance at historical spreads and haircuts.

According to an article by Larry Elliott, the Economics Editor for The Guardian,

On the face of it, there was nothing especially memorable about August 9 2007.  

... It was, however, the day the world changed. As far as the financial markets are concerned, August 9 2007 has all the resonance of August 4 1914. It marks the cut-off point between "an Edwardian summer" of prosperity and tranquillity and the trench warfare of the credit crunch - the failed banks, the petrified markets, the property markets blown to pieces by a shortage of credit. 

On that day, the European Central Bank and the US Federal Reserve injected $90bn (£45bn) into jittery financial markets.

What happened on August 9, 2007?

According to a report by BBC News,

Investment bank BNP Paribas tells investors they will not be able to take money out of two of its funds because it cannot value the assets in them.

Specifically, it could not value the subprime mortgage backed securities in these funds.

Why could it not value these securities?

As was disclosed by the rating agencies in their testimony before the US Congress a month later, these securities could not be valued because there was no access to the data needed to monitor them and to make timely rating changes.

As all market participants know, ratings are just a form of valuing a security.

Under the FDR Framework, what happened in August 2007 is not the unknowable event Gorton and Metrick claim, but rather an easily predicted one.  It was the month in which BNP Paribas announced that all the useful, relevant information about the subprime mortgage backed securities was not available in an appropriate, timely manner and therefore the securities could not be valued.

Please refer back to table 1.  In particular, look at what happened to the haircut on structured finance products (highlighted).  Under the FDR Framework, it is not surprising that the haircut on structured finance products increased significantly.  If you cannot value them, it is irresponsible to lend aggressively against them even to prime counter-parties.


But this only tells part of the reason why haircuts would increase.  The other issue is the notion of a prime counter-party.  At the beginning of the credit crisis, market participants did not have all the useful, relevant information they needed in an appropriate, timely manner to tell if any prime counter-party was solvent or not.  This dramatically increased the probability of ending up with the collateral. 


This too is predicted and easily explained under the FDR Framework.


In his speech, Mr. Haldane does not attempt to address the questions of what caused the increase in the haircuts and was it predictable, but instead introduces a model and how the model can be used to test different policies options.

The model's predictions do not measure up to the accuracy and predictive value of those predictions generated under the FDR Framework [and stated in this blog].

Take for example the prediction that if there was a 20% haircut on secured financings there would be a very low probability of a liquidity crisis.  Had the model been used prior to the credit crisis in 2007, with a 100% probability there would still have been a liquidity crisis in the secured funding market.

What needs to be better appreciated is that market participants could not value the collateral (structured finance securities) or evaluate the solvency of the borrower and therefore elected not to make a "secured" loan.  This froze the market.

As regular readers know, I have been using the FDR Framework since the beginning of the credit crisis to make predictions about the success or failure of different policy options (see the posts on Ireland for example).  As regular readers know, the accuracy of these predictions has been extraordinarily high.

Once again, I am offering my services to Mr. Haldane and the Financial Policy Committee when it comes to evaluating different policy options.