Deutsche Bank's Monte Dei Paschi derivative shows why banks must disclose current exposure details

As Bloomberg reports, Deutsche Bank designed and sold a derivative to Monte dei Paschi so the large Italian bank could hide losses that it had already incurred.

The very fact that a bank could engage in a trade to hide its losses confirms the need for banks to provide ultra transparency.

By requiring banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, it eliminates the ability of banks to hide their losses.

Deutsche Bank AG (DBK) designed a derivative for Banca Monte dei Paschi di Siena SpA at the height of the financial crisis that obscured losses at the world’s oldest lender before it sought a taxpayer bailout. 

Germany’s largest bank loaned Monte Paschi (BMPS) about 1.5 billion euros ($2 billion) in December 2008 through the transaction, dubbed Project Santorini, according to more than 70 pages of documents outlining the deal and obtained by Bloomberg News. 

The trade helped Monte Paschi mitigate a 367 million-euro loss from an older derivative contract with Deutsche Bank. As part of the arrangement, the Italian lender made a losing bet on the value of the country’s government bonds, said six derivatives specialists who reviewed the files. 

“I can’t understand why any financial institution would engage in a trade like this for legitimate objectives,” said Frank Partnoy, a professor of law and finance at the University of San Diego who structured derivatives at Morgan Stanley and has read the files. “They shouldn’t ever be doing that.”...

Which is why banks should not operate behind a veil of opacity, but rather should have their entire business exposed to the best disinfectant of bad behavior: sunlight.

The Santorini transaction shows how investment banks devised opaque products that years later are leaving companies and taxpayers with losses. 

From the Greek government to the Italian town of Cassino, borrowers have lost money on bets that were skewed in banks’ favor. In December, an Italian judge convicted bankers at four firms, including Deutsche Bank, of fraud in arranging an interest-rate swap for the city of Milan....

Under the FDR Framework, government regulators are given responsibility for ensuring transparency.

Had banks been required to disclose the details of these opaque products, they probably wouldn't have sold them and the buyers probably wouldn't have purchased them.

“You have two banks gambling on regulatory action in late 2008, at a time of supposed crisis, and they are using overly complex and opaque derivatives to do it,” said Partnoy, the University of San Diego professor. “Deutsche Bank made a fortune for facilitating the trade. You can’t tell any of this from looking at their financial statements.”...

As your humble blogger has been saying since the beginning of the financial crisis, so long as banks are opaque "black boxes", bankers will engage in gambling.

Current disclosure rules for banks are not up to the task of preventing or exposing this gambling.  A point Professor Partnoy makes.

The only way to expose what is happening so that market participants have the information they need to assess each bank is to require ultra transparency and disclosure of each bank's exposure details.

Santorini “exemplifies the complex structuring, questionable internal decisions and lax external supervision rampant in the lead-up to the crisis and beyond,” Dempster said....

The only way to prevent this from recurring in the future is by restoring transparency to all the opaque corners of the financial system.  This includes bank balance sheets.

Monte Paschi shareholders haven’t been in a position to know about the bank’s derivative bets because its filings didn’t provide sufficient information on Santorini and its liquidation, according to two accountants in Italy who reviewed the documents....

Please re-read the previous paragraph because if shareholders aren't in a position to know about derivative bets, they aren't in a position to exert market discipline to prevent these bets in the first place.

“This transaction shows the complexity of banks’ balance sheets,” said Mark Williams, a former bank examiner for the Federal Reserve and now a lecturer at Boston University’s School of Management, who also reviewed the documents. “It leaves one wondering what other skeletons are in the closet.”

The only way to know what skeletons are in each bank's closet is to have them provide ultra transparency and disclose their current global exposure details.

UK bank demonstrates regulators' capital ratio conundrum

Regular readers know that your humble blogger thinks that bank capital requirements are incredibly dangerous (without transparency, they suggest banks are stronger and less risky than they really are) and bank capital requirements suffer from numerous problems like the fact that they are implemented on a pro-cyclical basis.

The Guardian carried an interesting article on this pro-cyclical implementation of capital requirements featuring Nationwide and the Bank of England.

The Bank of England has denied that its insistence on Nationwide holding a bigger capital cushion had forced the UK's largest building society to slow its launch of small business lending. 

The Bank of England's actions are pro-cyclical if in fact requiring the bank to hold more capital reduces its lending capacity and this reduced lending capacity has a negative impact on borrower access to funds for growth and reinvestment in the economy.

Nationwide admitted plans to expand lending to small- and medium-sized enterprises (SMEs) are unlikely to take effect until 2014 at the earliest. 

It said plans to begin lending to smaller firms were still under development but "moving slowly"; , it denied a report that it had shelved a planned launch date for later this year....

Where there is smoke, ....

The Bank of England refuted any suggestion that Nationwide's decision to hold off from a launch into the SME sector was due to its demands on capital strength. 

A very tough assertion to prove.

A spokesman added: "The plan agreed with Nationwide to meet the 3% leverage ratio in 2015 will not result in them restricting lending to the real economy. Therefore it is wrong to blame their SME decision on the regulator."...

Banks have a limited number of ways to increase their ratio of equity to assets.  They can retain earnings or sell stock to increase the amount of equity.  Alternatively, they can decrease the amount of assets on their balance sheets.

The Bank of England spokesman suggests that Nationwide intends to meet the 3% leverage ratio by retaining earnings and/or selling stock.

However, regulators warned the lender had rapidly expanded its mortgage business while still wrestling with an overhang of bad commercial property loans. 

It was rebuked in July by the regulator, the Prudential Regulatory Authority (PRA), for running an aggressive lending policy without adequate reserves to insure against a possible collapse.

So much for retaining earnings to increase equity.

To build up reserves, banks take a provision for loan loss as an expense through their income statement.  This drives down earnings, so there is a lower level of earnings that can be retained.

Apparently Nationwide is planning a stock offering if meeting the higher capital ratios is not going to reduce its lending capacity.

But can it sell stock?

Analysts at credit ratings firm Standard & Poor's followed with a warning that a doubling in the losses on commercial property loans to £450m weakened the lender's financial position. 

S&P downgraded Nationwide's credit rating this month and signalled that further downgrades could follow without a rapid improvement. 

"These impairment charges have hindered Nationwide's internal capital generation. As a result, we have revised down our assessment of its risk position to 'adequate' from 'strong'," it said.

In the absence of disclosure of Nationwide's current asset, liability and off-balance sheet exposure details, why would anyone buy stock in Nationwide?

Without this information, there is no way of knowing what additional losses might be hidden on and off its balance sheet.

So if Nationwide cannot increase its equity from either retained earnings or stock sale, then the only way to increase its leverage ratio is by decreasing its assets.

Decreasing assets strongly suggests a reduction in Nationwide's lending capacity and that it will be more difficult for borrowers to access credit for growth and reinvestment (i.e., sure as heck looks like regulator's requirement to increase capital levels is pro-cyclical and is making downturn in economy worse).

In banking, too much simplicity is dangerous

In his Financial Times editorial, Standard Chartered's chief executive, Peter Sands, puts forth a robust argument for why relying on too much simplicity in the form of bank capital requirements is dangerous for taxpayer wealth.

Simply, these capital requirements, whether specified as a leverage ratio or a risk-weighted ratio or a combination of the two, don't present a true picture of the risk that each bank is actually taking.

Regular readers know that the only way for market participants to assess the risk of each bank is if each bank discloses on an ongoing basis its current asset, liability and off-balance sheet exposure details.  It is only with this information, that market participants have the data they need to actually assess each bank's risk.

As shown by our current financial crisis, when market participants cannot assess the risk the banks are taking, bad things happen to taxpayer wealth.  Specifically, policymakers and financial regulators find it irresistible to reach into the taxpayers' back pocket to bailout the banks and ensure the uninterrupted flow of bonuses to the bankers.

How can people trust banks using their own models when they are so opaque and produce such different results?

Only requiring banks to provide transparency eliminates this problem.

When market participants have access to the exposure detail data, market participants can use their own models to assess each of the banks.

This concern underpins the enthusiasm for the leverage ratio, and why some advocate a return to the so-called “standardised approach”. 

Under this approach, there are no sophisticated models – simply standard risk-weightings for different categories of asset that all banks have to apply. This gives the appearance of comparability, but it is entirely illusory. 

Massive differences in risk profile are simply smoothed out by very crude assumptions. 

Like the leverage ratio, it assumes lending to a start-up and an established multinational are equivalent risks, and takes no account of collateral. Indeed, imposing the standardised approach amounts to imposing a very poor model we know is wrong.

With transparency, the massive differences in risk profile are not smoothed out by very crude assumptions.

In fact. the massive differences in risk profile are exposed for all to see.

The standardised approach and leverage ratio share two characteristics. 

First, they simplify a complex reality. But the allure of simplicity should be resisted if the simplification so dangerously distorts and obscures the real picture. 

Your humble blogger agrees with Mr. Sands that the allure of the simplicity of capital ratios as a measure of bank solvency is a simplification that dangerously distorts and obscures the real picture.

Capital ratios are a form of regulatory opacity.

It is only with transparency into the underlying exposure details that a real picture of the risk each bank is taking can be seen.

Second, they narrow the difference in regulatory approach between risky and safe assets, creating perverse and powerful incentives for banks to run higher risk portfolios....

Your humble blogger agrees with Mr. Sands that capital ratios allow bankers to operate behind a veil of opacity and take on far more risk in their portfolios.

It is only with transparency into the underlying exposure details that market discipline can be exerted on the banks to restrain their risk taking.

The fact that different institutions give apparently similar assets different risk weightings is a real problem, and it has created a serious credibility gap. 

Some of the differences between model results are good, reflecting real variations in intrinsic risks and in the effectiveness of different banks’ risk-management approaches.

When each bank is required to disclose its current exposure details, the market gets to see which banks are being overly aggressive and which banks are being conservative in the management of their risks.

Why should ECB's bank asset quality review be believed?

Given Mario Draghi's commitment to do whatever it takes, why should the ECB's review of the asset quality at the EU banks be remotely believable?

Please recall, this is not the first time a governmental entity has overseen an asset quality review.  Previously, these reviews were done in Ireland, Greece, Cyprus, Portugal and Spain.

The result of these reviews was predictable.  The banks took additional reserves for potential losses and the governments declared their balance sheets had been cleaned up.

Of course, the banks were not required to disclose their current asset, liability and off-balance sheet exposure details so that market participants could confirm that all their losses had been recognized.

A few savvy market participants recognized that this lack of transparency was the equivalent of waving a giant red flag and announcing that the banks were still hiding losses on and off their balance sheet.

These market participants' insight have always been confirmed as shortly after the asset reviews it would be shown that there were in fact many more losses hiding on and off the bank balance sheets.

This pattern has held true whether the asset review was carried out by the government itself or using an "independent" third party (accounting firm or BlackRock).

This pattern has also held true when the asset quality review has been combined with stress tests.

So your humble blogger's question stands: why in the absence of transparency would anyone believe the results of the ECB's asset quality review?

One of the downsides of the ECB running an asset quality review without requiring the banks to provide transparency is that ECB puts itself in the position of now having to accept as collateral any of the assets it reviewed and didn't require loss recognition on.

From a Financial Times article on the ECB's asset quality review,

Within a matter of weeks, assuming legislative go-ahead, the ECB is expected to establish its new “single supervisory mechanism”, hiring the 1,000 staff it will need to police the banks, and making its mark with a tough root-and-branch Asset Quality Review (AQR) to determine how truthful banks are being about the loans on their balance sheets....

Properly done, the exercise could quickly establish the ECB as a tough regulator and help restore investor faith in Europe’s lenders. A succession of botched stress tests over recent years and laggardly recapitalisation of troubled lenders have deterred investors from backing the sector. 

A credible AQR, followed immediately by a stress test to show how balance sheets would stand up to further trouble, would, it is hoped, convince the world that Europe’s lenders are as resilient as US banks okayed by the Federal Reserve’s annual Comprehensive Capital Analysis and Review (CCAR).

No one thinks the US banks are okay.  Everyone knows that as a result of the stress tests the US on an annual basis renews the vow made by then US Treasury Secretary Tim Geithner when he pledged the full faith and credit of the US to keep the banks solvent.

All of which explains the flurry of preparations. 

Italy’s Intesa SanPaolo has been the most upfront about its desire to be ready for the ECB process. This month the bank revealed a “conservative” 30 per cent increase in the amount it has set aside to cover bad loans, undertaken explicitly “in the light of the [ECB’s] asset quality review”....

In the absence of exposure detail transparency, how would anyone know if a 30 percent increase in the amount set aside to cover bad loans is "conservative" or not?

Based on the history of Ireland, Greece,.... it is a fairly safe bet that this additional 30% will not be shown to be conservative and that much more in the way of losses will materialize.

The ECB exercise is set to implement new pan-European definitions of non-performing loans, standardising an NPL as anything that is 90 days past due, and also forcing banks to categorise all exposures to a single borrower as non-performing, even if only one of a number of loans is actually in default....

In the presence of regulatory forbearance which allows banks to engage in 'extend and pretend' and turn non-performing loans into 'zombie' loans, it is nice to have a standard, but the regulators have already undercut it.

Autonomous, an independent research house, predicts the changed definitions could increase problem loans by an average of 40 per cent – forcing weaker banks to raise fresh capital. Lenders in Germany, Austria and France could face the biggest shocks in the AQR....

I guess Autonomous doesn't see the 30% increase in loan loss reserves as conservative.

But a litany of ifs and buts still hangs over the whole process. Most immediately, it is still uncertain whether the EU will deliver the legal go-ahead to empower the ECB next month.  

More fundamentally, there is still disagreement about how to deal with a bank if it fails to plug a capital shortfall under its own steam. 

Here, too, Europe must learn from the US, where the government’s Tarp scheme injected capital as necessary back in 2009. For the ECB exercise to work, the sovereign-focused European Stability Mechanism must become a bank bail-out vehicle of last resort.

The issue for a bank fixing its book capital shortfall is can it generate earnings after all the losses have been realized.

If a bank can generate earnings after taking the losses on its dud exposures, it can recapitalize itself over time by simply retaining earnings.

If a bank cannot generate earnings after taking the losses on its dud exposures, it should be resolved.

ECB discovers why transparency into bank current exposure details needed

Reuters reports that the ECB has discovered why transparency into bank current exposure details is needed.

Policymakers at the European Central Bank had initially hoped that the asset review would feed into the stress tests in part because it is difficult to measure the sturdiness of a bank without knowing precisely the contents of its balance sheet.

Please re-read the highlighted text as your humble blogger has been saying this since the beginning of the financial crisis.

Without ultra transparency, there is simply no way of knowing if a bank is sturdy, as in solvent, or unstable, as in insolvent.

Without ultra transparency, stress tests are meaningless.

EU trying to harmonize definition of non-performing loan

Reuters reports that for the ECB's bank asset quality review test the EU is attempting to come up with one definition of what is a non-performing loan.

It is not surprising that there are several definitions of non-performing loans.

Since the beginning of the financial crisis bank, regulators have engaged in regulatory forbearance.  Under regulatory forbearance, banks are allowed to engage in 'extend and pretend' to turn non-performing loans into 'zombie' loans.

Naturally, each bank is going to engage in extend and pretend in a way that minimizes the non-performing loans on and off their balance sheets.

The current attempt to harmonize the definition of non-performing loans confirms what your humble blogger has said about the results of the bank regulator run stress tests as being meaningless.

The current attempt to harmonize the definition of non-performing loans also confirms what your humble blogger has been saying about the importance of requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, regulatory forbearance and extend and pretend is ended.  Markets will exert discipline by rewarding banks that clean up their bad debt exposures.

Banks across the European Union will be asked to use a single definition for bad loans in the upcoming review of their loan books, a senior EU regulatory source told Reuters, making it harder for banks to conceal the state of their businesses behind local conventions.... 

A senior EBA source told Reuters a key feature of the asset quality review will be harmonizing the way banks categorize loans. EU supervisors use a host of different ways to classify troubled or non performing loans, making it difficult to compare across jurisdictions.... 

The 2011 version of the stress tests, which relied entirely on national supervisors' submissions and definitions, was widely criticized for finding that Europe's 70 largest banks collectively needed just 106 billion euros ($140.62 billion). 

The EBA is keen to ensure this round of stress tests has more credibility, and sees consistency of definitions and transparency of information as a key way of ensuring this.

Italy's banks may be forced to seek capital from government

Reuters reports that Italy's banks may be forced to seek capital from the government if they recognize some (all?) of the losses currently hiding on and off their balance sheets.

Italy is following the same failed strategy as Ireland, Portugal, Greece, Cyprus and Spain.

Step 1:  Have the banks announce modest losses
Step 2:  Hope market participants will be dumb enough to belief the banks when they claim to have cleaned up their balance sheets.
Step 3:  Failing to find enough dumb investors, the government will stand ready to buy any equity that market participants don't want.

There is no reason for investors to buy equity in any Italian bank in the absence of transparency that discloses that bank's current global asset, liability and off-balance sheet exposure details.  It is only with this information that the investor can confirm that all losses have been realized and an assessment of the remaining risk made.

Under pressure from the Bank of Italy, banks are cleaning up their balance sheets before a health check-up on asset quality by the European Central Bank (ECB) expected in early 2014, before it takes over supervision of euro zone lenders mid-year. 

That may force them to turn to the market or the state for cash. 

"If done properly, the asset quality review should result in loan losses spiking in the second half, dividend cuts and potential capital increases," analysts at Berenberg said in a note to clients. 

Monte dei Paschi, the country's scandal-hit No. 3 lender, and a string of mid-sized banks look particularly vulnerable. 

"Italian mid-tier lenders are among the weakest in Europe," Royal Bank of Scotland chief credit strategist Alberto Gallo said. 

He estimates that Monte dei Paschi, which posted its fifth straight quarterly loss on Wednesday, may need up to 5 billion euros over the next three years, on top of a 4.1-billion-euro state bailout it received in February. 

The bank will find it difficult to lure private investors for such a sizeable amount - more than twice its market capitalisation, potentially requiring more support from Italy's cash-strapped government, Gallo said.

ECB says Europe faces Japanese style lost decade if banks not fixed

Reuters reports that according to the ECB, Europe faces a Japanese style lost decade if banks not fixed.

Regular readers know that your humble blogger said this almost six years ago when the EU, UK and US adopted the Japanese Model for handling a bank solvency led financial crisis.

It is nice to see with four years left to go in the decade, the ECB agrees and has produced a study the confirms all of observations about the failings of the Japanese Model that I have made.

Decision makers should move quickly to repair the euro zone's ailing banking system to avert a Japanese-style lost decade of minimal growth and inflation, a European Central Bank study said on Thursday. 

"The risk is the emergence of a situation of the type experienced in Japan during its 'lost decade'," the study said. 

"Fragile banks have an incentive to continue financing troubled and inefficient firms, so as to avoid recognising further losses." 

The unwinding process can become a long-lasting drag on the economy, the research paper said. 

"In this constant balancing act, policy interventions should, therefore, avoid delaying the necessary adjustment process." 

Once banks' balance sheets have been cleaned, corporate defaults might have a much smaller impact on the economy, it said.

Swiss banking regulator adopts bail-ins, but in time of crisis will this work

Reuters reports that the Swiss banking regulators have adopted the following structure for absorbing bank losses before a taxpayer funded bailout: shareholders, contingent convertible holders, unsecured debt holders and then senior debt holders.

While this sounds like a good plan, there is one small detail that hasn't been addressed: implementation during a time of financial crisis.

One of the primary lessons learned from our current global financial crisis is that bank regulators will not require banks to recognize their losses if the result would be to reduce the level of bank book capital.

Why?

For fear of sending a message about the safety and soundness of the banking system.

The result is that bank regulators have an irresistible urge to use taxpayer funds instead.

Regular readers know that the way to end this irresistible urge is to require the banks to provide transparency into their current global asset, liability and off-balance sheet exposure details.

With this level of transparency, market participants can assess and know the current condition of each bank.

Should a bank need to be recapitalized through bail-in, market participants know this and the size of the bail-in.  As a result, actually implementing the bail-in doesn't send a message that threatens the safety and soundness of the banking system.

Switzerland shouldn't bail out its largest banks again before asking creditors and shareholders to stump up, the local financial regulator said on Wednesday. 

Authorities have been grappling since the collapse of U.S. investment bank Lehman Brothers five years ago with the question of how banks regarded as systemically important - or too big to fail (TBTF) - can be recapitalised without causing panic or needing taxpayer cash.... 

The regulator recommended spreading bank losses across a range of creditors, including shareholders, holders of contingent convertible (CoCo) instruments (which may convert into equity under certain conditions) and owners of debt including senior debt. 

"This recapitalisation must be sufficient to meet the needs of all group companies in Switzerland and abroad," FINMA said in its position paper. "This buys time with regard to restructuring the affected banks so that they can return to viable operation."

Why have banks been exempt from recognizing losses since beginning of financial crisis?

On the sixth anniversary of the beginning of the global financial crisis, it is time to end the myth surrounding why banks have been exempt from recognizing losses from the crisis that they created.

I have chosen to write on this topic because recently I have been involved in a series of twitter exchanges where the justification given for a whole range of monetary and fiscal policies is based entirely on the assumption forcing the banks to recognize their losses would lead to a "disaster".

But is this disaster just a convenient myth spread by bankers or is it true?  And if it is true, who is it a disaster for?  Let's look at the question of who it is a disaster for first.

Is it a disaster for public and private borrowers?  No. They have their debt written down to a level that they can afford.

Is it a disaster for homeowners when neighbors have their debt written down and house prices decline? No.  Just like stocks, it is nice to sell at the top, but this is not guaranteed.  In the meantime, the neighborhood is better off as each of the owners can afford to maintain their property.

Is it a disaster for loan origination?  No.  Banks are senior secured lenders and having the debt written down means that the value of the assets pledged as security are not artificially inflated.  Lenders have to take into account this artificial inflation in price because it is likely to not be there when the collateral for the new loan is needed as a source of repayment.

Is it a disaster for the capacity to hold loans in the financial system?  No.  Selling loans out right to private investors (insurance companies, pension funds, hedge funds) or through syndication to other banks or securitization is commonplace in the US.  In Europe, the equivalent is the covered bond.

Is it a disaster for bank book capital levels?  Yes.  Bank book capital is the accounting construct through which losses on loans flow.  When losses are realized, bank book capital declines.

Is it a disaster for bank regulators?  Yes.  Bank regulators, through the bank examiners, attempt to determine if a bank is holding enough capital to absorb any losses that arise.  When their estimation of the probability of default (PD) and the loss given default (LGF) are too low, this is exposed when banks have to recognize their losses and bank book capital becomes a negative value.

Is it a disaster for bankers?  To answer this question, we also answer the question of is the notion of disaster just a convenient myth spread by bankers.

As Economist William White pointed out, if you ask a banker, there is never a good time to recognize their losses.  This is not surprising.  Bankers have an incentive to sell the disaster myth as recognizing losses would eliminate their bonuses.

But is it true that banks recognizing their losses would lead to a disaster?

The starting point for determining if  this is true is to look at the FDR Framework and see if banks are specifically exempted from recognizing losses.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Under the principle of caveat emptor (buyer beware), all market participants are responsible for all losses incurred on their investments.

The FDR Framework and its related legislation in the 1930s does not exempt banks from taking losses.

But what about any bank specific legislation like Glass-Steagall that was passed in the aftermath of the Great Depression or subsequently?

Again, legislation does not exempt banks from the consequences of their actions.  Legislation does however through deposit insurance exempt depositors from the consequences of the bank's actions.

But what happens if the losses at the banks are so big that disaster occurs?  Disaster for banks having large losses can only be that the taxpayers through the deposit guarantee would lose money should the losses be recognized.

Interestingly, this very scenario was planned for by the legislation that came out of the Great Depression.  By design, the legislation made banks special.  Unlike every other company, banks cannot go out of business unless the government steps in and puts them out of business.

Why can banks operate even when they have negative book capital levels or are insolvent (where the market value of the bank's assets is less than the book value of its liabilities)?

Because the combination of deposit insurance and access to central bank funding allows a bank to continue to operate.  Deposit insurance effectively makes the taxpayers the bank's silent equity partner when it has negative book capital or is insolvent.

Over the last 40 years there have been plenty of examples of banks that were insolvent but continued to operate for years.

Over the last 40 years there have been plenty of examples of banks that market participants knew would have had negative book capital levels if regulators had not intervened and prevented the banks from recognizing their losses.

Examples of banks like this include, but are not limited to, the money center banks with their exposure to loans to Less Developed Countries in the mid-1980s, US Savings and Loans with their concentration in low interest mortgages during a high interest rate period throughout the 1980s, and most recently all of the major global banks with their exposures to structured finance securities.

Please note that in each of these examples market participants were aware that the banks were or are hiding significant losses on and off their balance sheets.  Despite the existence of these losses, depositors continued to do business with these banks.

Why do business with an insolvent bank?

Because depositors don't care about solvency because of the deposit guarantee.

Why do bank regulators allow insolvent banks to continue to operate?

Because as long as the bank has the capacity to generate income in excess of its expenses it can use future earnings to rebuild its book capital level and return to solvency.  Plus the burden of paying for the disaster stays with the banks and not the taxpayers as retention of future earnings means the banks pay for their losses.

So if depositors aren't going to run and the banks are capable of generating income in excess of their expenses to pay for the losses incurred by the banks, what is the disaster lurking if banks are required to recognize their losses?

The disaster is it crushes banker bonuses.