Unlike transparency, debate rages over benefit of derivative reforms

The International Financing Review ran a terrific article on the question of does the benefit of the proposed reforms of the derivative market exceed their costs.

Unlike transparency, where the benefit is measured in trillions of dollars and the cost measured in single billions of dollars, the case for the proposed reforms of the derivative markets is not so clear cut.

This is not surprising.

The complex rules and regulatory oversight being brought to the derivatives market is a belt and suspender imperfect substitute for transparency and market discipline.

As an imperfect substitute, complex rules and regulatory oversight is much, much longer on costs with far more ambiguous benefits.

This is a very important point as Wall Street has turned to the court system to have complex rules and regulatory oversight thrown out when it cannot be shown that its benefits outweigh its costs.

The Macroeconomic Assessment Group on Derivatives – a body of prudential and securities regulators chaired by the Bank for International Settlements – calculated OTC derivatives reforms would boost annual GDP growth by as much as 0.13% by avoiding future derivatives-fuelled crises. 

Some derivatives experts have questioned the findings, though, which could even be cynically interpreted as an exercise in self-validation... 

Craig Pirrong, professor of finance at the University of Houston, argues the group’s analysis is fundamentally flawed, as it evaluates derivatives regulations in isolation of the rest of the financial system and fails to account for spillover effects to other market participants.... 

The MAGD report reckons the regulations stemming from the G20 mandate of increased capital requirements, central clearing and initial margin for uncleared trades should be enough to prevent derivatives exposures from sparking future crises “absent the remote possibility of a CCP failure”. 

Using CDS default data, the group calculates the annual probability of derivatives fuelling a financial crisis at 0.26%. The Basel Committee has previously estimated the median cost of financial crises is 60% of annual GDP, meaning the implementation of the reforms should boost annual GDP by 0.16%. 

Meanwhile, the costs to the economy of higher collateralisation and forcing banks to hold more capital will reduce annual GDP by 0.03% to 0.07% depending on the amount of netting that can be achieved through central clearing, the group calculates. 

But Pirrong argues this is an overly-simplified analysis of the impact of derivatives market regulations, which only examines part of the picture. Overall, the concern is derivatives reforms merely redistribute losses elsewhere in the financial system in a way that may still undermine market stability. 

“The reforms do dramatically reduce systemic risk in derivatives markets. But they also have the effect of promoting derivatives counterparties to the head of the bankruptcy queue, which inevitably means somebody else will get less money,” said Pirrong.

BoE's Carney would like bank reform that ends TBTF and fragmented regulation

Reuters reported that the Bank of England's governor, Mark Carney, is worried about the risk to economic growth from Too Big to Fail banks and fragmented banking regulation.

Regular readers know requiring banks to provide ultra transparency ends both the problem of Too Big to Fail and fragmented banking regulation.

If banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, they become subject to market discipline.

Market discipline occurs because market participants link a bank's cost of funds to their independent assessment of its risk level.  Market participants make this linkage because they limit their exposure to each bank based on what they can afford to lose given the risk of the bank.

When market participants limit their exposure to what they can afford to lose, then no bank is Too Big to Fail as there are no contagion effects from its failure.

Market discipline also addresses the issue of fragmented banking regulation.  Market participants will exert discipline on banks to restrain their risk taking while at the same time improving their liquidity and ability to absorb losses.

Bankers say privately that solving too-big-to-fail will be hard but that success would make other post-crisis reforms almost irrelevant as lenders would not act recklessly again in the knowledge there will be no more public rescues. 

Solving Too Big to Fail is easy: require banks to provide ultra transparency and disclose their current global exposure details.

The banks realize that all of the complex regulation and regulatory oversight proposed and implemented since the beginning of the financial crisis is simply a reckless substitute for transparency.

It is reckless because complex rules and regulatory oversight failed in the run up to the current financial crisis and there is no reason to believe they won't fail again.

The slow progress has prompted some countries to take unilateral measures as trust among supervisors over banks is still not strong enough. 

The European Union is annoyed with U.S. plans to impose heavier capital requirements on foreign banks as a safeguard to keep its taxpayers off the hook if they get into trouble. 

Britain has also been criticised for putting pressure on foreign banks to become fully fledged subsidiaries and thus required to hold a pot of capital and cash locally. 

Carney said nationally focused policies could reduce global growth by hindering efficient allocation of capital and liquidity. 

"Reforms that strengthen the resilience of the national and global system can also prevent regulatory arbitrage, reduce contagion and reduce incentives to ring-fence national systems," Carney said.

Transparency is the ultimate reform in that it strengthens the resilience of the national and global financial system, prevents regulatory arbitrage, eliminates contagion and eliminates the need to ring-fence national systems.

China not immune to zombie borrowers and insolvent banking system

While I have been traveling over the last two weeks, there have been several articles on China that discuss how it has not been immune to zombie borrowers and that like the EU, Japan, UK and US it too has an insolvent banking system. [Examples of articles include excellent Reuters article and Economist article.]

This raises the interesting question of how will China or any other country transition from policies designed to mask an insolvent banking system to policies designed to restore growth to their economy.

Regular readers know China, like the other countries, is pursuing the Japanese Model for handling a bank solvency led financial crisis.

Under this model, bank book capital levels and banker bonuses are protected at all costs.  This shifts the burden of the excess debt in the financial system onto the real economy.  As a result, growth in the real economy slows substantially as capital needed for reinvestment and growth is instead consumed by the excess debt.

Regular readers also know the way for China and the other countries to escape the negative consequences of pursuing the Japanese Model is to adopt the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront their losses on the excess debt in the financial system.  This protects the real economy and insures that capital needed for growth and reinvestment is used for growth and reinvestment.

But what happens to the banks when they recognize these losses.

Those banks that have a franchise that is able to generate earnings after recognition of their losses will continue to operate and will rebuild their book capital levels through retained earnings.

Those banks which don't have the ability to generate earnings after recognition of their losses will be closed down.

But what happens to depositors if there is not enough capital or unsecured bank debt to absorb the losses?

Depositors can and should be protected.  One way to protect them is to transfer their deposits to a bank that is capable of generating earnings.  [For accounting purposes, the "loss" that these depositors would have suffered is also transferred.  This simply increases the amount of retained earnings needed to rebuild book capital levels.]

Don't outsource bank risk management to global financial regulators

In an interesting ABA Banking Journal article, Dan Borge explains why he feels we should not outsource bank risk management to the global financial regulators.

Your humble blogger would offer a different reason for not outsourcing risk management to the bank regulators based on my experience working at the Federal Reserve and at a Too Big to Fail bank.

As demonstrated by our current global financial crisis, the global financial regulators are not very good at risk management and when they fail they have an irresistible urge to have the taxpayers pay for their failure.

By outsourcing bank risk management to the regulators, we interfere with how the financial markets are suppose to work.

For financial markets to work properly and risk to be restrained, banks must provide transparency into their current global exposure details.

With this information, market participants can independently assess the risk of and value each bank and adjust their exposures based on this assessment.  Then, bank management responds to market discipline as revealed through higher cost debt or lower equity share price that results from the adjustment in market participants' exposures and lower its risks.

Instead, we have a situation where financial markets don't work because risk management has been outsourced to regulators.

Leading up to the financial crisis and still to this day, banks have been allowed to remain opaque "black boxes".  As a result, they are not subject to market discipline.

Instead, banks are subject to regulatory discipline which they respond to by applying political pressure to get the regulators to back off or by gaming the financial regulations.

Regulators have besieged bankers with new and complex risk regulations in the aftermath of the financial crisis: Basel III; stress tests; risk-based compensation ... the list goes on. 

Whether all this regulation is making the financial system safer and healthier is debatable. 

But what is not debatable is that the regulators are taking a much more active role in asserting and enforcing their own notions of what constitutes excessive risk in banking.

Who is holding the risk?

The Economist magazine raised an interesting question in 2003 when it reported on the lack of an answer to the question: who is holding lending risk?

Today, 6 years after the beginning of the global financial crisis, we still cannot answer the question of who is holding lending risk.

Regular readers know that the only way to answer the question of who is holding lending risk is to bring transparency into all the opaque corners of the financial system.

THE world's leading banks decided some years ago that lending is a mugs' game. 

They began to get rid of their loans, repackaging them and selling them off as securities, or getting others to re-insure their risk....

Alan Greenspan, chairman of America's Federal Reserve, said in a speech in May that this spreading of the banks' risks has made the financial sector more resilient, and individual institutions within it less vulnerable to shocks. 

It can indeed be argued that the world's financial system is safer if banks carry less of the overall credit risk. 

Their previous mismanagement of credit has caused so many damaging banking crises in the past; and banks, with their unique role in the payment system and the distribution of liquidity, are prone to systemic risk in a way that is not true of other financial institutions. Better, in that case, that they are strong, and that risks and losses are borne by a wider investment pool. 

Others, though, are less sanguine. They fear that credit losses, buried today, will show up in new places later, causing unpredictable damage deep in the world economy....

But analysts and central bankers do not have a complete picture of where the banks' risks have ended up. 

One thing is certain. Such risk does not neatly disappear into thin air. 

In a weak economy, bad debts increase and banks traditionally take a big hit. If they are not taking the hit in this economic slowdown, then somebody else is. 

Credit risk is like air in a squishy balloon. You can squeeze the balloon into any shape you like, but the air does not disappear.

BoA showed why asset level transparency needed for RMBS deals

Bloomberg reported on how Bank of America included questionable mortgages in its RMBS deals in the run-up to the financial crisis.

BofA was able to do this because RMBS deals were and still are opaque.

Investing requires transparency.

Regular readers know that the investment process has three steps:

1. Independent analysis of the data disclose to assess the risk of and value a security;
2. Soliciting prices from Wall Street that it would be willing to buy/sell the security at; and
3. Comparing Wall Street's prices with the result of the independent assessment to make buy/hold/sell investment decisions.

Without transparency, Step 1 of the investment process cannot be completed.

If the investment process cannot be completed, then the only thing that buyers or sellers of an opaque security are doing is gambling on the contents of a brown paper bag.

It is this simple fact that buyers were willing to blindly gamble on the contents of a brown paper bag that let BofA offload its questionable mortgages into a security.

Regular readers also know that the only way to encourage investors to come to the RMBS market is by providing observable event based reporting.  With observable event based reporting, any activity like a payment or delinquency involving the underlying collateral is reported before the beginning of the next business day.

Observable event based reporting is necessary so investors can know what they own or what they are buying.

Absent observable event based reporting, buyers and sellers of RMBS securities are simply gamblers.

Bank of America Corp.’s traders fought off efforts by the firm in 2007 to include risky Alt-A mortgages in a securitization. That wasn’t enough to spare investors from being cheated, according to the U.S. 

The Department of Justice accused the company in a lawsuit yesterday of misleading investors about the quality of loans tied to $850 million in mortgage-backed securities. 

The complaint chronicles friction among bank staff in 2007 and 2008 as they excluded risky Alt-A loans while leaving in wholesale debts once scorned as “toxic waste” by the firm’s then-chief. 

“None of these loans are suitable for a prime jumbo A-credit securitization,” one trader wrote in an e-mail, expressing discomfort with adding the low-documentation Alt-A debts to the pool. 

“Like a fat kid in dodgeball, these need to stay on the sidelines,” another trader wrote, according to the Justice Department’s complaint.

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.