E&Y says 'zombie' companies holding back UK economy

The Telegraph reported that 'zombie' companies are holding back the UK economy according to E&Y.

Regular readers know that zombie companies are the direct result of policymakers and financial regulators adopting the Japanese model for handling a bank solvency led financial crisis.  Under the Japanese model, bank book capital levels are protected.

E&Y highlights several negative consequences for the real economy that have occurred as a result of protecting bank book capital levels.

Britain's recovery is being held back by a wave of "zombie" companies that should be allowed to fail but are instead undermining capitalism, according to Ernst & Young. 

The accountant said that the financial crisis had created an environment where it is "too difficult to fail", with businesses being kept afloat to the detriment of the broader economy. 

As a result, so-called "financially undead" companies are clinging on, despite the recession, making markets and the economy inefficient. 

"The expected jump in the number of companies falling into administration has not materialised," a report by E&Y said. ...

E&Y said that although companies are struggling, the number of administrations actually fell last year, despite a 42pc rise in profit warnings among listed companies. It said the mismatch could be explained by a change in attitude among the government and creditors, which have allowed more breathing space for businesses since the onset of the crisis. 

"[Banks] do not want to be seen to be pulling the financial rug from underneath companies that are facing difficult trading conditions," the accountant said.

Actually, this reflects bank capital preservation as not pulling the rug out from underneath financially undead companies saves the banks from recognizes the loss on their exposures.

Bankers are all for this as the resulting "higher" earnings translate into bigger bonuses.

Alan Hudson, E&Y head of restructuring in the UK, said while zombie companies were still operating, they were taking market share from viable companies that should be growing and boosting the economy. 

"The whole thing grinds along very slowly," he said. "It is a very unsatisfactory environment that has become so during the crisis which began in 2007-08."

When the Japanese model was adopted and banks were allowed to hide their losses under regulatory forbearance.

E&Y argues that because lenders continue to fund these businesses, capital is not being recycled and reinvested as it should be. 

Although it said the number of zombie companies was difficult to estimate, R3, the business distress specialists, said around 30pc of companies are regularly reliant on their maximum overdraft facility – a good gauge of whether a company is viable. 

"Insolvency is becoming such a difficult thing to carry off that well-advised borrowers are now in a stronger position than they used to be. They know they can push their banks further," said Alan Bloom, head of global restructuring at R3.

Here is confirmation that zombie companies have better access to loans than do creditworthy companies.

"Everything is becoming complicated and making insolvency a difficult option. 

"It means that businesses which probably should fail, don't fail. In a capitalist economy you get winners and losers," he said.

WSJ's David Reilly: 'Banks don't bank on their Euro peers'

In his Wall Street Journal Heard on the Street column, David Reilly reminds everyone why banks need to be required to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

Simply, without this information, even banks cannot tell which of their peers are currently solvent or insolvent and which can repay a loan and which cannot.

If banks don't trust each other, why should an investor? 

That was a troubling question for U.S. banks back in 2007 and 2008 as the financial crisis got under way and banks reduced exposures to one another. And it is again pertinent as Europe founders.

Please re-read the highlighted text as this is why ultra transparency is needed.

Fourth-quarter 2011 global-banking data from the Bank for International Settlements showed that interbank lending fell $637 billion in the fourth quarter of 2011. Of this, nearly 60% was due to a falloff in cross-border claims on banks in the euro zone. 

"It was the largest contraction in cross-border claims on euro-area banks, in both absolute and relative terms, since the fourth quarter of 2008," the BIS noted. 

What's more, the reduction wasn't just related to troubled European countries like Greece and Portugal or even Spain and Italy. Cross-border claims on banks in Germany fell 8.7% and in France by 4.2%..... 

While a natural form of self-protection, such moves also are implicit votes of no-confidence in counterparties. 

That serves as a reminder for investors to continue doubting claims by European banks that they have sufficient capital. 

With many of Europe's biggest banks trading at less than half their book value—Germany's Deutsche Bank, for example, is about 45%, France's BNP Paribas is at 43% and Italy's UniCredit is at 25%, according to FactSet Research—investors have decided that bank assets are likely overstated or their liabilities understated. 

The BIS figures show that banks themselves may be of a similar mind.

Bank for International Settlements confirms 9% Tier I capital target is driving EU credit crunch

As reported in the Telegraph, the Bank for International Settlements confirms that the EU financial regulators' policy of requiring banks to achieve a 9% Tier I capital ratio has lead to a credit crunch precisely when access to loans is needed to help the real economy rebound from the financial crisis.

Regular readers know that when this capital ratio target and Basel III was first announced your humble blogger predicted they would a) result in a regulator induced credit crunch and b) would not restore confidence in the banking system.

The BIS and the current deposit flight across the EU to Germany confirm I was right on both predictions.

The Bank for International Settlements (BIS) said cross-border loans fell by $799bn (£520bn) in the fourth quarter of 2011, led by a broad retreat from Italy, Spain and the eurozone periphery. 

Lending to banks in the eurozone fell $364bn or 5.9pc, with drastic reductions of 9.8pc in Italy and 8.7pc in Spain. 

The BIS's quarterly report said the decline in lending was "largely driven by banks headquatered in the euro area facing pressures to reduce their leverage". 

Banks must raise their core tier one capital ratios to 9pc by the end of this month or face the risk of partial nationalisation. The global Basel III rules are also pressuring banks to retrench. 

It is not just EU financial regulators who have adopted policies that are creating a credit crunch.

The International Monetary Fund said banks will have to slash their balance sheets by $2 trillion (£1.6 trillion) by the end of next year even in a "best-case scenario". 

This could reach €3.8 trillion if Europe mishandles the debt crisis. 

Tim Congdon from International Monetary Research said regulators were making a grave mistake by forcing banks to cut lending during a slump. 

"What they are doing is frightening. If banks shrink their balance sheets, it destroys money. It causes a credit crunch and intensifies the recession. This is why we are facing a global slowdown," he said. 

Alastair Clark, a member of the Bank of England's interim Financial Policy Committee, said last month that regulatory pressure may have gone too far, "inadvertantly" causing banks to restrict credit.

Actually, regulators could not possibly have adopted a worse response to the financial crisis.

On the one hand, regulators engaged in forbearance and allow banks to hide losses on and off their balance sheet.  On the other hand, regulators require banks to achieve higher capital ratios.

The easily predictable results are that the banks refuse to make new loans (hence, the credit crunch) and sell of the performing loans on their balance sheets (lowering their risk weighted assets and boosting their capital ratios).

This leads to a situation where it is easier for a zombie borrower to access credit than a creditworthy borrower.

It also leads to a situation where the assets in the banking system are becoming increasingly toxic.

The BIS said French banks slashed their cross border assets by $197bn, and German banks cut by $181bn. The figures mostly predate the effects of the European Central Bank's liquidity blitz over the winter, which has had the effect of "Balkanizing" Europe's banking system. Analysts say the pace of withdrawal has since quickened.

Paul Krugman: "I'm sick of being Cassandra. I'd like to win for once."

In an interesting Guardian column, Decca Aitkenhead interviews Nobel-prize winning economist Paul Krugman to discuss his new book, End this Depression Now!.

Since the beginning of the financial crisis, Professor Krugman has been advocating that governments should be adopting aggressive economic stimulus policies.  The idea being that with a big increase in economic growth, the economy can afford to repay the current excess debt in the financial system.

Professor Krugman has made a number of very public statement that support his claim to being a Cassandra with regards to our ongoing financial crisis.  These include his statements that Obama's stimulus was not going to be successful because it was not big enough.

Unfortunately, these statements do not make him a Cassandra.  Like all but a small handful of his peers in the economic profession, Professor Krugman was absent when it came to predicting the financial crisis and offering a solution beforehand to mitigate the impact of the crisis.

Yes, his predictions about the policies failing were accurate.  However, the reasons that he gives as to why the policies failed are limited and do not really explain the totality of why the global economy has failed to revive.

There is an alternative explanation that also predicts these policies, both stimulus and austerity, would fail.  This explanation also suggests policies which if implemented, unlike Professor Krugman's, would end the financial crisis.

Regular readers know that your humble blogger used this alternative explanation to predict the financial crisis.  I also offered a solution, the Swedish model with ultra transparency, to mitigate the impact of the financial crisis.  Equally importantly, I have continued to make predictions about the success or rather the lack of success of the various policy responses, like stimulus, austerity and zero interest rate policies, and these predictions have also come to pass.

For example, I predicted that the economy would  remain in a downward spiral until such time as opacity was eliminated in all the corners of the financial markets (including structured finance securities and bank balance sheets).  Even with Obama's fiscal stimulus, this trend continues (Professor Krugman might choose to argue this, however, the fact that every time fiscal or monetary stimulus is stopped, the economy stalls and heads towards recession confirms the underlying trend).

Professor Krugman has been pounding the table to call attention to his solution.  However, by itself, his solution will not address what is undermining the real economy.  The real economy is in a downward spiral as a result of the excess debt in the financial system and all the related distortions in pricing caused by the regulatory and monetary policy responses to the financial crisis.

Until such time as it is easier for a creditworthy borrower to get a loan than a zombie borrower, no amount of fiscal stimulus is going to end the financial crisis.

The only thing that will end the financial crisis is forcing the banks to recognize the losses hidden on and off their balance sheets and requiring the banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details to confirm this.

Now I happen to believe that combining Professor Krugman's call for fiscal stimulus with the Swedish model and ultra transparency is a good idea.  That is why it is in the blueprint for saving the financial system.

What Professor Krugman has achieved with his table pounding is to make it harder to focus attention on the blueprint and end this financial crisis.

Deregulation of financial services was supposed to have made us all better off, so why did most of us have to live off credit to keep up? Now that it has all gone wrong, and everyone agrees we're in the worst crisis since the Great Depression, why aren't we following the lessons we learned in the 1930s?

Excellent question as the number one lesson from the 1930s was the introduction of transparency into the financial system.  Specifically, the FDR Administration rebuilt the financial system based on the philosophy of disclosure and ensuring that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could make a fully informed investment decision.

President Obama is the only world leader who has attempted a Keynesian stimulus programme. Why has it been only minimally effective?

Doesn't address the losses hidden on and off the banks' balance sheets.

Why do most other western leaders still insist the only way out is to tighten our belts and pay off our debts, when that clearly isn't working either?

Because most western leaders have adopted the Japanese model for handling a bank solvency led financial crisis and are trying to protect the bank's book capital levels.  If we stop paying our debts, the capital levels take a big hit.

And how come the bankers, credit agencies and bond traders are still treated with cowed reverence – don't frighten the markets! – when they got us into this mess?

When you spend as much money as they do on lobbyists, academics and jobs for former regulators and policymakers, you tend to get what you want.

An authority on John Maynard Keynes, Krugman wrote a book in 1999 called The Return of Depression Economics, largely about the Japanese slump, which drew ominous parallels between Japan's economic strategy and the pre-New Deal policies of the early 30s that turned a recession into catastrophic depression. At the time, unsurprisingly, most western economists weren't bowled over; in thrall to the seemingly endless boom, the Great Depression looked to them to be more or less irrelevant. Krugman's latest book will be much harder to ignore.

He is right that the Japanese model should never be adopted as the only beneficiaries are the bankers.

He doesn't expect it will be an easy message to sell, though. "As far as I can make out, the serious opposition to the coalition's policy is basically a half-dozen economists, and it looks as if I'm one of them – which is really weird," he laughs, "since I'm not even here." 

Visiting London last week, he met lots of what he calls Very Serious People: "And there are lots of things these people say that sound very wise and sensible. But it's all upside-down; it's all wrong. Yet the power of their orthodoxy – even when it's failing – is quite awesome." 

These Very Serious People present economics as a morality play, in which debt is a sin, and we have all sinned, so now we must all pay the price by tightening our belts together. They tell us the crisis will take a long time to resolve, and must inevitably be painful. 

All of this, according to Krugman, is the opposite of the truth. Austerity is a self-imposed collective punishment that is not just unnecessary, but won't work. We know what would work – but for complex political and historical reasons that his book explores, we have chosen to forget. "Ending this depression," he writes, "should be, could be, almost incredibly easy. So why aren't we doing it?"...

Because we have economists who didn't predict the crisis (see the Queen's Question) pro-offering their solution without understanding what is really driving the crisis.

Thus far, Krugman has essentially restated the case for Keynesianism. "And these are not hard concepts, actually. It's not hard to get it across to an audience. But it doesn't seem to play in the political sphere." What's fascinating is his historical analysis of why policy-makers, who once understood these principles, collectively decided to forget them. 

In the years following the Great Depression, governments imposed regulatory rules upon the banking system to ensure that we could never again become indebted enough to make us vulnerable to a crisis. "But if it's been a long time since the last major economic crisis, people get careless about debt; they forget the risks. Bankers go to politicians and say: 'We don't need these pesky regulations,' and the politicians say: 'You're right – nothing bad has happened for a while.'" 

That process began in earnest in 1980, under President Reagan. One by one the regulations on banking were lifted, until "we lost the safeguards, and it meant there was an increasingly wild and woolly financial system willing to lend lots of money". Politicians were in part persuaded to deregulate by the argument that it would make us all richer. And to this day, "there's this very widespread belief that there was, in fact, a great acceleration in growth. But this really isn't hard. You sit down for a minute with the national account statistics, and you see it ain't so." 

If we divide the period between the second world war and 2008 into two halves, "the first half is a really dramatic improvement to living standards, and the second half is not."... 

Why would economists claim ordinary people were getting much richer if they weren't? "The answer, I think, has to be that you need to ask: 'Well who are the people who say these things hanging out with? What is their social circle?' And if you're a finance professor at the University of Chicago, the people that you're likely to meet from the alleged real world are going to be people from Wall Street – for whom the past 30 years have, in fact, been wonderful. If you're a mover and shaker in the UK, you're probably hanging out with people from the City. I think that is the story of the disconnect."...

Or perhaps economists were being hired as consultants by Wall Street and as any good consultant knows, you give the client what they ask for.

There were early warning signs, such as the savings and loans crisis of the late 80s, that should have alerted politicians to the dangers of financial deregulation, moral hazard and subsequent spiralling debt. But by then Wall Street's influence over policy-makers had rendered them deaf to alarm bells – in part because bankers were financing so many politicians' campaigns. 

Krugman quotes Upton Sinclair's famous observation: "It's difficult to get a man to understand something, when his salary depends on his not understanding it" – but more than that, he suspects the sheer glamour of wealthy bankers had a powerful influence over politicians. 

"My impression is that old style captains of industry can be rather boring. I'm not sure how much thrill there is in hanging out with someone like that. But Wall Street people are in fact very smart; they're funny, they're not company men who work their way up the chain. They're impressive."

This is why it is virtually impossible to get policy-makers to consider the Swedish model with ultra transparency.

Since the crash Krugman has become the undisputed Cassandra of academia, but he jokes: "I'm kind of sick of being Cassandra. I'd like to actually win for once, instead of being vindicated by the disaster coming – as predicted. I'd like to see my arguments about preventing the disaster taken into account instead."

That makes two of us.  Any time you would like to actually end this financial crisis, I look forward to hearing from you Professor Krugman.

Praying that Spain and the EU work out their banking crisis

Four years after adopting the Japanese model for handling a bank solvency led financial crisis, the point at which denial and covering up no longer works has been reached.

It has become clear to everyone that the EU (and UK, US, China and Japan for that matter) has not come remotely close to dealing with the banking crisis.

As Philip Aldrick observed in his Telegraph column,

[Spain’s] banking crisis is threatening to sink the nation. Around €100bn was pulled out of Spanish banks in the first three months of the year, €66bn in March alone, on concerns about the solvency of the institutions. 

At about 5pc of deposits, the “bank jog” – as some wags have billed it – is in danger of turning into a full-blown “bank run” that would send Rajoy back to Washington – this time cap in hand. 

“We are in a situation of total emergency, the worst crisis we have ever lived through,” Felipe Gonzalez, Spain’s former prime minister, said last week. The following day, Olli Rehn, Europe’s economics commissioner, warned that the eurozone was on the brink of “disintegration”. Greece, Portugal and Ireland might be small enough to contain, but Spain, the currency region’s fourth largest economy, poses a far more dangerous threat.... 

As predicted by your humble blogger, the Japanese model would never solve the banking crisis.  While I firmly believe there are some benefits to prayer, I think policymakers should not make praying for a miracle the foundation of the policy response to the financial crisis.

The result of adopting the Japanese model and praying for a miracle was to turn a financial crisis into the worst crisis we have ever lived through.  The human cost of the economic stupidity of choosing the Japanese model is now apparent to everyone, but the policymakers and financial regulators.

Rather than a bail-out, though, Santamaria was seeking to drum up international support for an alternative proposal – a eurozone-funded bank rescue that would not cripple Spain’s public finances.  

According to some estimates, Spain needs to inject €100bn into its banks to cover the vast volumes of bad real estate debt on their books – €19bn of which has already been earmarked for its giant domestic lender, Bankia. 

But the size of such a recapitalisation would destroy the nation’s finances, piling more on the country’s €850bn borrowings and – if made to pay between 5pc and 6pc for the new money – plunging the economy into an unsustainable debt trap. 

The lessons of Ireland, whose public finances were wrecked by rescuing the banks, loom large.

Please re-read the highlighted text as it shows one of the costs of needlessly bailing out the banks.

Instead, Spain wants to change the terms of the eurozone’s €500bn rescue fund, the European Stability Mechanism (ESM), to allow it to invest directly into banks rather than through governments. 

Santamaria made the purpose of her Washington visit plain after meeting Geithner. “We were talking about the possibility that the banks, not only Spain’s but also in other countries who need it, could access funds directly without intervention from the governments and without conditions,” she said. 

“The Treasury Secretary indicated that we are working in the same direction and that we must find a solution for the banks.”

Having exhausted the capacity of countries like Spain to pay for the bankers' bonuses, the bankers shift their target for funding their bonuses to other potential sources of funds.

Support in Europe is gathering for the proposal. If Greece is not expelled from the eurozone after its June 17 elections, it will also require bank recapitalisations. Even France could potentially use the funds for its weaker lenders. Italy does not want to be the next domino to fall, so wants Spain as a buffer between it and the bond vigilantes. And Portugal’s economy is hugely dependent on the success of Spain. 

In Brussels, too, there is a growing consensus. On Wednesday, the European Commission was the first to raise publicly the idea of direct capital injections by the ESM, instead of routing funds through governments already saddled with huge debts. “To sever the link between banks and the sovereigns, direct recapitalisation by the ESM might be envisaged,” the EU executive said....

Regular readers of this blog know that the link between banks and sovereigns is easily cut by the policymakers requiring the banks to retain future earnings to recapitalize themselves.

There is no need in a modern banking system for sovereigns to inject a single euro into a bank.

With deposit insurance and access to central bank funding, banks with negative book capital levels can operate and support the real economy for years while they retain their earnings to rebuild their book capital levels.

The only individuals who think that banks need capital are a) policymakers and regulators looking to be employed by or receive a significant amount of money from the banks after they 'retire' from their current position, b) economists who by definition know absolutely nothing about how the financial system actually works and c) bankers who need the money to pay themselves a bonus.

Banks have once again shuffled uneasily back into the centre of the crisis, not just because of the potential losses they are carrying but also because, without a functioning banking sector, countries will never be able to grow their way back to financial health.

However, a functioning banking sector does not require banks to have a positive book capital level.

This is a very important point (for anyone who doubts that banks can still take in deposits and make loans while they have negative book capital levels, please look at the US Savings and Loans in the late 1980s; they took in deposits and made loans while their regulator allowed them to use TRAP - terribly rotten accounting principles - to try to disguise their negative book capital).

“Spain needs to clear up its banking system and it needs to be done rapidly,” said Bill Rhodes, a former senior vice-chairman of Citigroup and veteran of bank and sovereign rescues from the Latin American and Asian debt crises. 

The fastest way to clean up the banking system is to require the banks to recognize all the losses hidden on and off their balance sheets.

At the same time, banks should be required to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details so market participants can confirm that all the losses have been realized.

“If you don’t get the banks lending, you won’t get growth. It’s particularly true in parts of the eurozone, which do not have deep capital markets so are highly dependent on the banks. That’s the key element that’s been missing so far.”...

What would get the banks lending again is if the EU financial regulators would drop their misguided policy of having the banks reach a 9% Tier I capital ratio by the end of June 2012.  With the banks not having recognized all their losses yet, everyone knows the ratio is meaningless (the OECD agrees).

The EU banks cut back on lending to reach this meaningless ratio.

Recapitalising Spain’s banks without jeopardising the nation’s finances could potentially restore market confidence and draw institutional funds back, giving the lenders the money to start the crucial business of extending credit once again. 

“If in Spain things are done right, the risk premium comes down and we start seeing capital flows moving normally again, that will be a touchstone for the euro project to continue ahead,” Mr de Guindos said. 

“If not, we will have problems for the euro project itself, as we know it,” he added.

Recapitalizing Ireland's banks did not restore market confidence (they are still experience a 'bank jog') nor did it restart the normal flow of capital.

You cannot restart the normal flow of capital while the banks are still sitting on their losses.  It is easier for a zombie borrower to get credit than it is for a creditworthy borrower.  Until this is reversed, capital will not flow normally.

'We must find a solution to our banks' ... look here

As Spain's deputy prime minister said, 'we must find a solution to our banks'.  This applies not just to the banks in Spain, but to the banks in the EU, UK, US, China and Japan.

The facts are clear.  Pursuing the Japanese model for handling a bank solvency led financial crisis has failed.

Under the Japanese model, bank book capital levels have been protected under the mistaken idea that high capital levels are synonymous with either depositor confidence in the banking system or the ability to make loans.  This protection has included regulatory forbearance which has allowed bad assets to be hidden on and off the banks' balance sheets and bailouts.

It hasn't worked.  Across the EU, they are busily bailing out the banks and the deposits are busily running to Switzerland or to the only perceived safe-haven, Germany.

It hasn't worked.  Across the EU, there is a credit crunch.

We now find ourselves in the interesting situation where there isn't a big enough pot of funds under government control left in the world to tap in order to continue bailing out the banks and supporting the payment of bonuses to bankers.

As Spain's deputy prime minister said 'we must find a solution to our banks'.

Regular readers know that there is a solution to the banking problem.  The solution is to adopt the Swedish model for handling a bank solvency led financial crisis with ultra transparency.

The Swedish model doesn't require governments or more specifically taxpayers to bailout the banks.  Instead, it takes advantage of the features of a modern banking system, specifically deposit insurance and access to central bank funding, to allow the banks to bail themselves out using retention of future earnings.

Ultra transparency enhances the effectiveness of the Swedish model.  By requiring the banks to disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details, market participants can see for themselves that the banks absorb the losses on the excesses in the financial system.

With ultra transparency, market participants can independently assess the riskiness of each bank and adjust both the amount and price of their exposure to reflect this risk.  There are four benefits to the financial system from this.

• It ends contagion as each participant will limit their exposure to what they can afford to lose given the risk of the bank;
• It puts market pressure on the banks to keep risk at a minimum as higher risk will raise the cost of funding across the entire capital structure of the bank;
• It ends reliance on the financial regulators by ending their information monopoly; and
• It shines a bright light into all the opaque corners of the financial system.

Since it was first tried and according to the NY Fed broke the back of the Great Depression, the Swedish model has proven its effectiveness.  

Markets in summer of 2012 face an 'eerie echo of 2008'

In a Daily Mail article, the retiring Head of the World Bank, Robert Zoellick, observed that the financial markets are facing a rerun of 2008.

To regular readers of this blog, this is no surprise.

The choice by the EU, UK and US of the Japanese model over the Swedish model for handling a bank solvency led financial crisis meant that bank solvency would not be addressed and that we would get a sovereign debt crisis too.

For new readers, the Japanese model is built on the flawed idea that preserving bank book capital levels is necessary for both maintaining confidence in the banking system and for banks to extend loans to support the needs of the real economy.  This blog has spent considerable amounts of time debunking this idea including highlighting how the only beneficiaries are the bankers who collect their bonuses.

The Swedish model is built on the proven idea that banks in a modern financial system with deposit guarantees and access to central bank funding can and should absorb all of the losses on the excesses in the financial system today.  Subsequently, the banks can rebuild their book capital levels through retention of future earnings and stock sales.  The Swedish model is also known as Wall Street Rescues Main Street.

This blog has spent considerable amounts of time showing how this idea has worked since it was first implemented by the FDR Administration to, in the words of the NY Fed, 'break the back of the Great Depression'.

The head of the World Bank yesterday warned that financial markets face a rerun of the Great Panic of 2008. 

On the bleakest day for the global economy this year,  Robert Zoellick said crisis-torn Europe was heading for the ‘danger zone’. 

Mr Zoellick, who stands down at the end of the month after five years in charge of the watchdog, said it was ‘far from clear that eurozone leaders have steeled themselves’ for the looming  catastrophe amid fears of a Greek exit from the single currency and meltdown in Spain. 

The flow of money into so-called ‘safe havens’ such as UK, German and US government debt turned into a stampede yesterday.  In Berlin the two-year government bond yield fell below zero for the first time, with the bizarre result that jittery international investors are now  paying – rather than being paid – for lending to Germany. 

There was a raft of dismal economic news from around the world, with manufacturing output falling in Britain and Europe, unemployment jumping in the eurozone and America, and fast-emerging economies such as Brazil and China showing signs of running out of steam.... 

Mr Zoellick warned that the coming months could be as bad as the collapse of US investment bank Lehman Brothers in 2008. 

He said: ‘Events in Greece could trigger financial fright in Spain, Italy and across the eurozone. The summer of 2012 offers an eerie echo of 2008. 

‘If Greece leaves the eurozone, the contagion is impossible to predict, just as Lehman had unexpected consequences.’ 

Fears are mounting that Spain will be crippled by its banking sector and will be the next domino to fall. 

Mr Zoellick said: ‘Eurozone leaders need to be prepared to recapitalise banks. In the eurozone, the guarantees of some national sovereigns are unlikely to be sufficient and only that of the “euro-sovereign” will suffice.  

‘It is far from clear that eurozone leaders have steeled themselves for this step. Eurozone leaders need to be ready.  'There will not be time for meetings of finance ministers to discuss the outlook and debate the politics. 'In panicked markets, investors flee to safe assets, sparking other flames.’  

Yesterday investors scrambling for lifelines piled into German, US and UK government debt.Not only did the German two-year bond yield fall below zero for the first time, but also the yield on ten-year UK gilts – the benchmark borrowing cost for the British Government – hit a record low of 1.44 per cent.  

The yield on the equivalent US treasuries fell to 1.46 per cent – the lowest in over 200 years of records.  

‘People’s objective is the return of their capital, not the return they get on their capital,’ said Sam Hill, a strategist at Royal Bank of Canada.

It is still not too late to adopt the Swedish model with ultra transparency.

My question is when will the German taxpayer recognize that this is the solution that doesn't require them to pay for bailing out the excesses in the EU?

Regulatory failure: banks offered incentive to buy government debt

CNBC carried an interesting article on how financial regulators are offering an incentive banks to buy government securities.  Regulators do this by waiving the need for banks to hold capital against these securities.

Of course, government debt is not risk free.  Not only is there interest rate risk, but as Iceland, Ireland and Greece have shown, there is also default risk.

Requiring banks to hold zero capital against assets with this type of risk profile is a fairly clear example of regulatory failure.

US and European regulators are essentially forcing banks to buy up their own government's debt—a move that could end up making the debt crisis even worse, a Citigroup analysis says. 

Regulators are allowing banks to escape counting their country's debt against capital requirements and loosening other rules to create a steady market for government bonds, the study says. 

While that helps governments issue more and more debt, the strategy could ultimately explode if the governments are unable to make the bond payments, leaving the banks with billions of toxic debt, says Citigroup strategist Hans Lorenzen. 

"Captive bank demand can buy time and can help keep domestic yields low," Lorenzen wrote in an analysis for clients. "However, the distortions that build up over time can sow the seeds of an even bigger crisis, if the time bought isn't used very prudently." 

"Specifically," Lorenzen adds, "having banks loaded up with domestic sovereign debt will only increase the domestic fallout if the sovereign ultimately reneges on its obligations." 

The banks, though, are caught in a "great repression" trap from which they cannot escape.
"When subjected to the mix of carrot and stick by policymakers...then everything else equal, we believe banks will keep buying," Lorenzen said....

"Ask the simple question: Why are banks buying sovereign debt when yields are either near record lows, or perhaps more interestingly, when foreign investors are pulling out?" Lorenzen wrote. 

He thinks he has the answer. 

For one, the European Central Bank's Long-Term Refinance Operations provided guarantees for the debt, which Lorenzen deems a "heavily sweetened form of financial repression given the pressure banks were under" to buy. 

"Banks have ended up buying bonds at yields where they would happily have sold them only a few months prior," he said. 

Moreover, banks are allowed to not count the sovereign debt against their Basel capital requirements. Also, Lorenzen argued, European banks have escaped the onus of stress tests this year, a less-than-subtle hint that authorities are willing to tolerate a bit of looseness in banks so long as they are helping to stave off a full-blown debt crisis. 

"One doesn’t have to be too cynical to hypothesize that all the disclosures on sovereign exposure have become a bit of a political liability at a point in time where the only buyers in size of periphery sovereign debt are periphery banks funded by the ECB," he said. 

"As long as funding for sovereigns in markets remains in jeopardy, and as long as there is no clear move towards proper fiscal solidarity in Europe, we reckon there will be a strong political incentive to make banks captive buyers. That implies a move away from marking sovereign debt to market, away from raising risk weights, away from capital ratios that don't risk weight assets and away from stress tests incorporating government bonds."

Spain's banking rescue should become example for Europe

A Bloomberg editorial correctly points out that Spain's banking rescue should become the example for not just Europe, but globally.

Unfortunately, the editorial recommends injecting capital into the banks.

As regular readers know, injecting capital is not needed in a modern banking system with deposit guarantees and access to central bank funding.  With these in place, a bank can operate and support the real economy for years with negative book capital levels.  As a result, the banks are capable of rebuilding their book level capital through retention of future earnings.

Perhaps no country better illustrates the mutually reinforcing links among the euro area’s banking, sovereign-debt and economic crises than Spain. 

Its banks are largely paralyzed amid concerns about heavy losses on real estate loans that, by various estimates, could require as much as 120 billion euros ($150 billion) in fresh capital to offset. 

Tight bank credit has in turn deepened the country’s economic slump, increasing banks’ potential losses and fueling fears that bailout costs will overwhelm the Spanish government’s already stretched finances. 

The longer the situation lasts, the worse it gets: Nervous investors pushed Spain’s 10-year borrowing rate as high as 6.7 percent Wednesday, up from less than 5 percent in early March.

This analysis is flawed because it omits the critical fact that EU financial regulators have set a 9% Tier I capital requirement for the end of June 2012.

It is this capital requirement that has triggered the credit crunch in Spain and the rest of Europe.  It is not the losses hidden on and off the Spanish banks' balance sheets.

As demonstrated by the US Savings & Loans during their solvency crisis, being insolvent or having negative book capital levels does not stop a bank from making loans.

What stops a bank from making loans is a regulatory requirement that says they must shrink their balance sheet!

Spain’s response has been far from adequate. 

Government- induced bank mergers haven’t reduced the system’s capital needs. Last week, the country’s third-largest bank, Bankia SA, said it would require 19 billion euros in fresh capital to cover losses -- far more than the resources available in the country’s bailout fund. 

A bank run of sorts has already begun: Central- bank data suggest that, in the first four months of this year, more than 100 billion euros in private money has fled Spain for other euro-area countries, an amount roughly equal to a 10th of the country’s annual economic output. A European Central Bank measure of deposits in Spain’s banks declined by 31.5 billion euros in April.

The trigger for the bank run is the growing perception that Spain will not be able to honor its deposit guarantee.

This is very important as depositors don't care about bank book capital levels.

This blog has offered numerous example proving this point including:  a child asking how they can know the bank will give them back their money and a parent answer it is insured by the government; and how many economists/policymakers/financial regulators know what the book equity level was at the end of last quarter for the bank where they have their checking account.

Restoring confidence to prevent bank runs is not a matter of injecting capital into the banks, but rather a matter of backstopping the deposit guarantee.

It’s imperative that Europe step in to break Spain’s fall, lest the country’s problems topple the euro area’s banking system. 

Europe’s banks have about 672 billion euros in claims on Spain’s banks, government and companies, according to the Bank for International Settlements.  Germany’s claims alone add up to about 186 billion euros, or nearly half of German banks’ aggregate capital. 

How, then, can Europe draw the line at Spain? 

Dire as the country’s predicament may seem, it offers an opportunity to create a model for bank recapitalizations throughout the euro area....

The Bloomberg editorial goes on to recommend injecting equity into the banks.  As stated above, in a modern banking system, this is unnecessary.

Spain should be a model for bank recapitalizations in a modern banking system.  It should be a model of letting the banks rebuild their book capital levels through retention of future earnings.

According to an IIF study on the Spanish banking system, it will take less than 4 years for Spanish banks to rebuild their book capital levels.

Let’s say Spain’s banks need 120 billion euros in new equity -- or capital -- to cover losses and restore confidence.

Injecting new equity into the banks does not restore confidence.  Confidence for depositors is a function of confidence in the deposit guarantee.

As discussed in previous posts, one of the unintended consequences of threatening to kick Greece out of the EU is redenomination risk.  Suddenly, depositors are looking at the potential for having their funds forcibly converted into a weaker currency.

This too is also not addressed by injecting new equity into the banks.  In fact, an argument can be made that injecting new equity into the banks increases redenomination risk as it unnecessarily uses up sovereign borrowing capacity.

The first place to look for the money would be the banks’ own subordinated creditors, whose claims aren’t secured against any of the institutions’ assets. These investors, who received a higher return to compensate for their low position in the pecking order of creditors, have often been made whole in bank bailouts....

Until banks are required to provide ultra transparency, governments have a moral obligation to bailout the subordinated creditors.

This moral obligation is the direct result of the governments conducting stress tests and publicly announcing that the banks have passed.  If the government, which has a monopoly on all the useful, relevant information about the banks says they are solvent, then it is up to the government to bailout investors who relied on this representation should the banks not be solvent.

Ultimately, the place to look for capital to rebuild a bank's book equity levels is retained earnings.  Earnings that are subject to ultra transparency so that market participants can see that the bank has recognized all the losses on and off its balance sheet and exert discipline on the level of risk taken by the bank to achieve those earnings.

Bank of England: Contingent convertible bonds won't make banks safer

The Telegraph reports that a study by the Bank of England shows that contingent convertible bonds won't make banks safer, but could make a bad situation even worse.

Regular readers know that your humble blogger doesn't think that much of a market will develop for contingent convertible bonds in the absence of ultra transparency.

If prospective buyers of the bonds do not have access on an on-going basis to a bank's current asset, liability and off-balance sheet exposure details, they have no way to assess the risk of the bank and the likelihood of the bonds converting to equity.  Therefore, they cannot properly value the bonds to buy them in either the primary or secondary market.

Bonds designed to protect banks in the event they get into financial difficulty could cause more problems than they solve, according to the Bank of England. 

So-called "contingent capital", more commonly knowns as CoCos, could create “wider systemic problems”, accordig to a report by the Bank, which warned that buyers of the bonds could deliberately undermine a bank’s share price to force the debt to convert into equity.... 

The Bank of England warned that buyers of the bonds could sell short a bank's shares to push their price down below the “conversion trigger”, or the pre-determined level at which the bond converts from debt into equity. 

To the extent that there is a buyer for these bonds, it is hedge funds.  These funds could engage in any number of trading strategies involving the bonds and the common stock.

Under the terms of a CoCo, an investor is sold a bond by a bank with the condition that should the lender’s core capital fall below a certain level the debt will transform into shares to provide the institution with an increased buffer to take new losses. 

However, the Bank of England said that while this was fine in theory, in practice buyers of the CoCos could “run” as soon as a bank showed any signs of getting into trouble to be replaced by investors who might have a vested interest in forcing the bonds to convert into shares. 

The reason for the buyers running is the lack of ultra transparency.  They have no way of evaluating the risk of the bank.

For their part, the hedge funds see the bonds and the bank's common stock as a trading opportunity.

“Policymakers should also consider the possibility that precautionary contingent capital instruments lead to wider systemic problems because investors have incentives to manipulate the conversion trigger to generate a conversion or bank equity holders or management have incentives to take actions (such as fire-selling assets) to try to avoid a conversion occurring,” said the Bank.