ECB pushes ahead with plan to find out what is hidden on and off EU bank balance sheets

As reported by Zeit (hat tip Zero Hedge), prior to taking on responsibility for monitoring the EU's banks, the ECB is planning on finding out what losses are hidden on and off the balance sheets of the top 140 EU banks.

Not only does the ECB want to have the losses discovered realized, but it also wants the banks to be recapitalized either by taxpayers or by bailing in equity holders and unsecured creditors including depositors.

The ECB's plan is positive in that the banks will finally be forced to recognize upfront their losses on the excess public and private debt in the financial system.

The ECB's plan is negative in that it insists on an immediate recapitalization of the banks.  The plan would be much better if it allowed the banks to recapitalize themselves over several years through the retention of 100% of pre-banker bonus earnings.

The timing is already set. From the autumn of the monetary authorities will illuminate along with the national supervisory authorities, the balance sheets of major financial institutions in the euro zone. There is a total of around 140 banks, which together cover about 80 percent of the market.  

The ECB teams are already formed to examine the books as required directly into the banks. Thus, at the end come out reliable figures, is the intention of the central bank also independent consultants - to be on board - Wirtschaftsprüer or investment companies....

Regular readers know that your humble blogger dislikes regulators going into banks with teams of consultants to find bad debts.  As shown by Ireland, Greece and Spain, the combination of regulators and consultants never find and have the banks disclose all of their bad debt.

Your humble blogger prefers requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this disclosure, all market participants can see just how much bad debt a bank is exposed to and that the bank recognizes the losses on this debt.

If the combination of regulators and consultants is really going to force banks to disclose and write-off all their bad debt, then regulators should be happy to have banks provide ultra transparency to confirm this fact.

A failure to require the banks to provide ultra transparency is the equivalent of waving a large red flag and saying the banks are still hiding losses.  The experiences of Ireland, Greece and Spain show that this is true.

Financial institutions that can not even fill possible gaps capital should be recapitalized by the Member States. If they are not able to lift the renovation alone, they can access loans from the ESM bailout fund to fall back. 

The risk should not alone bear the taxpayers: Even shareholders, creditors and customers of the affected banks will be first used to cover the losses.

Once the banks have been forced to recognize their losses on the excess private and public debt, they should be separated into two groups.

Those banks whose interest income is greater than the sum of its interest expense plus operating expense should be allowed to remain in business.  These banks have the capability of generating earnings that can be retained and used to rebuild their book capital levels.

Those banks whose interest income is less than the sum of its interest expense plus operating expense should be resolved.  Simply, they do not have a franchise that allows them to generate earnings to rebuild their book capital levels.

Before taking on responsibility for supervising EU banks, ECB wants to know if there are losses being hidden by banks

The Telegraph reports that before it takes on responsibility for supervising the EU's banks, the ECB wants to do a review of their on and off-balance sheet exposures to be sure that there are no losses being hidden by the banks.

The frozen interbank unsecured lending market has been the canary in the coal mine signaling that banks are hiding losses and the issue of solvency has not been addressed.  The interbank unsecured lending market acts as the canary because banks with deposits to lend won't lend to banks looking to borrow unless the bank looking to lend can figure out the borrowing bank will repay the loan.

It is astonishing that we could be 5+ years into a bank solvency led financial crisis and the answer to the question of which banks are solvent (market value of assets greater than book value of liabilities) and which are insolvent is still not known.

So why hasn't bank solvency been addressed given that banks are designed to continue operating even when they are insolvent?

The primary reason why is banker cash bonuses.  If each bank had to disclose the losses hidden on and off their balance sheets, there would be no banker cash bonuses for the foreseeable future as all earnings would be retained to rebuild bank book capital levels.

It is also astonishing that by saying that it wants to review each bank's exposures for hidden losses, the ECB is effectively saying the financial regulator run bank solvency stress tests are a total sham.

“The first thing that the ECB will have to do when they take on their supervisory task is to have an asset-quality review of the main banks that will be under their supervision and I think very soon after that all the other banks in Europe as well because there is still the risk of contamination between banks,” Mr Dijsselbloem said. 

“The outcome of that asset quality review we don't know yet, but it might be worrying. It might be worrying for some banks in some countries. We don’t exactly know. What I do know is that when we do have an outcome that is worrying, we need to have the instruments to deal with the problems.”...

Yves Mersch, an ECB executive board member, confirmed that the new supervisor would check bank balance sheets to reveal any concealed dangers in the quality of assets before taking charge. 

“Before we start working, we need to know what is on the balance sheet of these banks,” he said.

Not only the ECB, but every market participants needs to know what is on and off the balance sheet of the EU banks.

Why the hurry to "fix" Slovenia's banking system when doing it right takes time?

A Reuters article on eurozone leaders pushing Slovenia to fix its banking raises an interesting question: why does it have to be done quickly when doing it right takes time?

Common sense says that there are three steps to fixing the banking system the right way:

1. Require the banks to provide on-going transparency so that market participants can assess their global asset, liability and off-balance sheet exposure details.
2. Based on this assessment, the true extent of the problem can be determined and the losses can be realized.
3. Determine how to rebuild the banks' book capital levels over the next several years.

It is common sense that transparency is needed so that there is no doubt that all of the bad debt hidden on and off the banks' balance sheets is recognized.

As Ireland, Greece, Portugal and Spain have shown, so long as the banks remain "black boxes", market participants will never believe that all the hidden bad debt hidden been recognized.

So long as there is this doubt about what is lurking on or off bank balance sheets, the banking system has not been truly fixed.

Putting ultra transparency in place takes time.

It is common sense that before fixing the banks, the true extent of their bad debt needs to be known.  It is only when the size of the problem is known that the solution for fixing the banks that corresponds to the size of the problem can be chosen.

It will take time for market participants to assess the value of each of the banks' exposures.

Finally, it is common sense that the banks do not need to be recapitalized immediately.  Savers and SMEs, who represent the banks' core depositors, are using the banks today even though they know the banks probably have low or negative book capital levels when adjusted for all the hidden losses on and off their balance sheets.

Recognizing the hidden losses and putting the banks on a path towards recapitalization is not going to make the savers and SMEs stop using the banks.  If anything, it should make them more comfortable using the banks.

Recapitalizing the banks through retention of future bank earnings takes time.

So, why the hurry?

How quickly do banks need to be recapitalized after recognizing losses?

How policymakers respond to a bank solvency led financial crisis is driven by how they answer the question: how quickly do banks need to be recapitalized after they recognize their losses on the excess debt in the financial system.

Your humble blogger's response is that banks do not need to be immediately recapitalized.  Instead, banks can rebuild their book capital levels over several years by retaining 100% of their pre-banker bonus earnings.

This is not the response that the global policymakers or financial regulators would give.  Nor is it the response that almost every economists would give, particularly those who are calling for banks to hold more capital.

The fact that I am in the minority in how I responded to this question puts the onus on me to show why I am right.

To show this, we need to start with a solvent, opaque bank.  The traditional definition of a solvent bank, which comes from the Financial Crisis Inquiry Commission, is the market value of its assets is greater than the book value of its liabilities.

           Assets
                 Cash                           5
                 Bonds
                    Government          10
                    AAA-rated            15
                 Loans                    
                    Performing            70
                   Non-performing       0
           Total Assets                 100

            Liabilities & Equity
                Core Deposits           70
                Hot Money deposits  20
                Equity                       10
            Total Liab. & Equity   100

Not only is this bank solvent, but it has terrific capital ratios.  It shows a simple equity to asset ratio of 10%.  Its Basel I, II or III capital ratios are even better.

Unfortunately, it turns out that this opaque, solvent bank was heavily exposed to subprime mortgages, commercial real estate and other areas of the financial system that collapsed at the beginning of our financial crisis.  The effects on this bank of marking all of its assets to market are shown below [AAA-rated bonds suffer loss of 10; loans suffer loss of 10; equity absorbs loss on bonds and loans and declines by 20].


            Assets
                 Cash                           5
                 Bonds
                    Government          10
                    AAA-rated             5
                 Loans                    
                    Performing            45
                   Non-performing     15
           Total Assets                   80

            Liabilities & Equity
                Core Deposits           70
                Hot Money deposits  20
                Equity                      (10)
            Total Liab. & Equity     80


Clearly, this banks is insolvent as the market value of its assets (80) is less than the book value of its liabilities (90).

Please recall that this bank is also opaque.  It provides the required disclosures that the Bank of England's Andrew Haldane would say results in its being like all the other banks, a 'black box'.

Naturally, this opacity is very important as it gives policymakers and financial regulators a choice:  make the bank publicly acknowledge and absorb its losses upfront or allow the bank to hide the true extent of its losses and slowly absorb them into earnings over the course of time.

Please note that regardless of which choice is made the bank is still insolvent under the traditional definition.

What the choice comes down to is when do the bank's financial statements reflect its true condition.  Now or at some point in time in the distant future.

If the financial regulators want to hide the true extent of the bank's losses, they can suspend mark to market and adopt mark to model accounting for its securities.  The financial regulators can also engage in regulatory forbearance and let banks practice 'extend and pretend' to turn non-performing loans into 'zombie' loans.

Both of these were done by global policymakers and financial regulators in response to our current financial crisis.

The impact of these actions is shown below for our now insolvent, opaque bank.


           Assets
                 Cash                           5
                 Bonds
                    Government          10
                    AAA-rated            14
                 Loans                    
                    Performing            65
                   Non-performing       4
           Total Assets                   98

            Liabilities & Equity
                Core Deposits           70
                Hot Money deposits  20
                Equity                         8
            Total Liab. & Equity     98

Please note that the bank's book capital, which is an accounting construct, no longer reflects the true condition of the bank (it is a positive 8 when the bank's true condition shows minus 10).

As Sheila Bair would say: as a result of measurement errors, this bank's capital is deceptive.  It doesn't present an accurate picture of the bank's risk or solvency.

Before going on, let me summarize three key points.

• First, the bank is insolvent under the traditional definition of solvency regardless of what its financial statements show.  

• Second, by fiddling with the accounting, policymakers and financial regulators are explicitly agreeing with me that a bank can operate and support the real economy even when it is insolvent under the traditional definition.

• Third, by fiddling with the accounting, policymakers and financial regulators are explicitly agreeing with me that a bank that is currently insolvent under the traditional definition can generate and retain enough earnings so that it becomes solvent again.

So, why do global policymakers and financial regulators engage in hiding bank insolvency?

The answer to this question is driven by their answer to how quickly banks need to be recapitalized after recognizing losses.  They assert that banks need to be recapitalized as soon as possible after recognizing losses.

Why?

Because a bank that shows low or negative book capital levels is prone to bank runs or it is hampered in its ability to support the real economy.

Let me address bank runs first.

Why should this bank be any more susceptible to bank runs after it reveals the true extent of its losses than it is when the losses are being hidden?  Do global policymakers and financial regulators think that market participants missed the implosion of subprime securities, commercial real estate and other areas of the financial system?

What market participants don't know is the exact extent of the losses suffered by each bank.  Market participants are keenly aware of the fact that each bank suffered extensive losses.  Losses that if fully recognized upfront may in fact leave the bank with substantial negative book capital levels.

So why aren't depositors fleeing the banks?  Deposit guarantees and access to central bank funding.

I break depositors into two groups: core and hot money.

Core depositors like individuals and SMEs have a long-term relationship with their bank.  They trust that even highly indebted governments will honor their deposit guarantees and protect them from any losses due to bank insolvency.  As Cyprus shows, hurting the SMEs devastates the economy so policymakers and financial regulators have a strong incentive not to do this.

As a result, core depositors don't care and probably couldn't tell you what the book capital level for their bank was at the end of last quarter.  They are with their bank for the long haul.

This is a key point because it is these depositors that are the key to the viability of the banking franchise.  It is their business that allows a bank to generate and retain the earnings that rebuild its book capital level and restore it to solvency over many years.

Hot money depositors are, as their name implies, only dealing with the bank as an investor.  At the first sign of problems and clearly this bank has problems, they are gone as soon as they can get their money out.

This group is in fact already engaged in a bank run.  A run that is slowed down to a jog by having their money tied up in time deposits.

So what does the bank look like after all of its hot money depositors have left?

            Assets
                 Cash                                   5
                 Bonds
                    Government                  10
                    AAA-rated                      5
                 Loans                    
                    Performing                    45
                   Non-performing             15
           Total Assets                           80

            Liabilities & Equity
                Funds from central banks  20
                Core Deposits                   70
                Hot Money deposits           0
                Equity                             (10)
            Total Liab. & Equity           80

Please note that under Walter Bagehot's principle for central banks acting as lender of last resort, central banks are suppose to lend freely against good collateral.  In this example, good collateral at 60 is 3 times greater than the size of the loan from the central bank.  So a bank run by hot money depositors is not a problem.

This example is all well and good, however, in the EU, the ECB is restricted to only lending to solvent banks.

Let's not kid ourselves.  The fact is that all the large banks in the EU, UK and US are insolvent whether their financial statements show it or not.

First, a bank that was not insolvent would provide ultra transparency to show it.  By disclosing its current global asset, liability and off-balance sheet exposure details, the bank is saying it has nothing to hide.  This would give it an enormous competitive advantage in both access to and lower cost of funds over other large banks that don't make a similar level of disclosure.

Banks that don't provide ultra transparency are announcing they have something to hide and are far riskier.

Second, the existence of deposit guarantees would change Walter Bagehot's definition of solvency.  It would no longer be solvency as defined by the Financial Crisis Inquiry Commission.  It would be adjusted for the existence of the deposit guarantee standing behind the core depositors.

The deposit guarantee implies a far higher level of "capital".  One way to reflect this is to subtract the guaranteed deposits from the solvency equation.  A bank is solvent if the market value of its assets exceeds the book value of its liabilities less guaranteed deposits.

In our example, our insolvent bank under the traditional definition of solvency is solvent after adjusting for the deposit guarantee [80 - (90 - 70) = 60].

This is very important.  As regular readers know, the time to resolve a bank is when the interest income from its performing assets does not exceed the combination of its interest expense and its pre-banker bonus cost of operations.

Please note, the ECB is already effectively using my modified definition of bank solvency and lending to banks that would be insolvent under the Financial Crisis Inquiry Commission's solvency definition under its promise to do whatever it takes.  There is no reason to believe that the ECB is fooled by EU policymakers and financial regulators playing games with the banks' financial statements.

Let me now address the issue of recognizing the losses would hurt the banks' ability to support the real economy.

Why?

As shown in the example, there is no reduction in the bank's ability to fund new loans after it absorbs its losses.  Cash didn't change.

Recognizing the losses actually improves a bank's ability to make loans.  As shown by Iceland, when the banks recognize upfront the losses on all the excess debt in the financial system, collateral values adjust to a sustainable level.  This is important as banks are senior secured lenders.

What limits the ability of banks to make new loans is an artificial construct:  regulators and their obsession with easily manipulated book capital.

Quite simply, it is not access to funding that hurts a bank's ability to fund new loans and support the real economy as it is the constraint on making new loans that the regulators force on the banks in the form of capital ratios.

It is the bank regulators who insist on a positive capital ratio even when the bank should be showing a negative book capital level.

Greek PM: Deposits are safe

Reuters reports that the Greek PM is saying that uninsured deposits in Greek banks are safe due to the planned recapitalization of the Greek banking system.

The PM made the statement because of concerns raised by a merger of two Greek banks being called off due to the lack of new equity from private investors. [Regular readers know that the lack of new equity from private investors reflected the lack of transparency into the banks and the inability of the private investors to assess the risk and or solvency of the banks.]

Of course, the Greek PM has to say this.

The question is where is the proof that this is true.

If the Greek banks have been successfully recapitalized and all their losses recognized, then the banks disclosing their current global asset, liability and off-balance sheet exposure details should simply confirm this fact.

The absence of the banks providing ultra transparency so that the safety of uninsured deposits can be confirmed is a big red flag.  Uninsured depositors should see this red flag waving and recognize that their deposits are at risk of a Cypriot style haircut.

Greek bank deposits are safe and the country's lenders are protected due to a recapitalization scheme which will be completed by the end of April, Prime Minister Antonis Samaras said on Saturday. 

In an interview with Imerisia, Samaras ruled out a tax on deposits over 100,000 euros ($131,000) allaying fears of austerity-hit Greeks that their savings may be at risk after a raid on Cyprus depositors as part of the island's bailout. 

"No, I'm categorical. There is no such issue. We have no reason to think about it," he said. "The Greek banking system is shielded due to the recapitalization."...

The banking sector was shaken this week by the unexpected suspension of National Bank's plans to integrate its newly acquired rival Eurobank after the lenders said they were unlikely to raise enough capital to stay private. 

Samaras said the deal depends on the recapitalization. Under the terms of the plan, a minimum amount of new equity must be raised from the market for the banks to remain privately run. 

"If the two banks raise the funds to recapitalize alone, then they will decide if they still want to merge. If they don't raise the demanded funds they will fall under the control of the Hellenic Financial Stability Fund which will decide if their merger is beneficial," he said.

EU seeks plan to handle failing banks without costing taxpayers money

Bloomberg reports that lead by German Chancellor Angela Merkel, the EU is looking for how to handle failing banks without costing the taxpayers any money.

Regular readers know that a modern banking system is designed to handle failing banks without costing taxpayers any money.

A bank "fails" when it becomes insolvent and the market value of its assets is less than the book value of its liabilities.

However, just because a bank is insolvent doesn't mean that the bank has to stop operating and supporting the real economy.  Modern banks are designed to operate and support the real economy even when they are insolvent.

How can banks that fail stay in business?

The combination of deposit insurance and access to central bank funding let banks stay in business even when they have failed and are insolvent.  When banks are insolvent or have either low or negative book capital levels, deposit insurance effectively makes the taxpayers the banks' silent equity partner.

As a result, the only market participant who can close a failed bank is its regulator.

Under what condition should a failed bank be allowed to continue to operate and support the real economy?

So long as the bank can continue to generate earnings, it should be allowed to continue to operate.  100% of these earnings before banker bonuses are retained and used to rebuild the bank book capital level and reduce the taxpayers' exposure to the bank.

To prevent the bank's managers from gambling on redemption, the bank must provide ultra transparency and disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.  With this information, market participants and regulators can exert discipline to restrain the banks risk taking.

Under what condition should a failed bank be resolved?

When it cannot generate earnings for its core banking franchise.

But doesn't this mean that the taxpayer is on the hook for the losses when this bank is resolved?

No, the industry is on the hook for the losses.  The industry pays for deposit insurance.  The cost of deposit insurance increases to cover these losses.

So the answer to the question of who pays for all the losses on the legacy assets is first, the bank that holds these assets if they have a franchise that lets them generate earnings and second, the banking industry through higher assessments on their deposit insurance.

European Union chiefs pledged to seek a joint strategy for handling failing banks as German Chancellor Angela Merkel demanded taxpayers be spared the costs. 

Leaders agreed to start work next year on a single resolution mechanism for euro-area banks to complement the European Central Bank oversight role approved yesterday by European finance chiefs. Lenders should underwrite financial stability by repaying governments as needed, EU leaders said. 

Resolution “may not be at the cost of the taxpayers, but has to be structured so that those responsible for the failures of the banks carry the burden,” Merkel told reporters at 2:15 a.m. after nine hours of talks in Brussels. 

Bolstering confidence in banks is a key component of policy makers’ effort to defeat the debt crisis that has rattled markets since late 2009. They must decide how to handle existing bank weakness as well as future failures that emerge after the ECB takes on its oversight duties. In the first half of 2013, they will seek a deal on the terms of allowing the EU’s 500 billion-euro ($656 billion) rescue fund to provide direct aid to banks. 

“We made progress” on a resolution mechanism, said ECB President Mario Draghi. He pressed government leaders to confront how they will handle banking woes that spread across borders and exacerbate financial crises.....

Spain's retail customers whacked under unnecessary bank bailout

As the final terms of the bailout of Spain's nationalized banks become known, it is clear that the retail customers who were duped into buying hybrid securities in these banks are going to take a sizable loss.

My question is why are they being forced to take a loss?

Regular readers know that banks in a modern financial system are designed not to need to be bailed out.  The combination of deposit insurance and access to central bank funding allows them to continue operating and supporting the real economy even when they have low or negative book capital levels.

Given that the banks don't need to be bailed out, why are retail customers being forced to incur a loss?

From a Reuters article,

Spain's four nationalized banks will more than halve their balance sheets in five years, slash jobs and impose hefty losses on bondholders, under plans approved by the European Commission on Wednesday. 

The measures open the door for nearly 40 billion euros ($52 billion)in euro zone bail-out funds for the state-rescued banks, offering hope for an end to Spain's banking crisis which has pushed the country to the brink of asking for sovereign aid....

There is zero chance that this ends Spain's banking crisis.  Spain has 180+ billion euros of bad debt associated with real estate alone in its banking system.

"Our objective is to restore the viability of banks receiving aid so that they are able to function without public support in the future," said European Union Competition Commissioner Joaquin Almunia said....

By design, banks have public support.  Public support that takes the form of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers become banks silent equity partners when they have low or negative book capital levels.

Therefore, all a bailout does is change a silent equity partner into a shareholder.

Almunia said the nationalized banks would have to close up to half their branches during the five-year overhaul process. 

The biggest of the banks, Bankia, said it would lay off over a quarter of its workforce amounting to over 6,000 staff, reduce its branch network by around 39 percent and aim to return to profitability by 2013.

Neither of these required an "investment" by the taxpayer to accomplish.  Both could have been required by the banking regulators.

Bankia, formed from the merger of seven savings banks in 2010, said holders of hybrid debt would contribute up to 4.8 billion euros to the recapitalization, through losses incurred by swapping their holdings for shares....

Please remember, Bankia "sold" this hybrid debt to its retail customers because there were no institutional buyers for its capital securities.

At the time, your humble blogger observed that nobody would invest in Bankia without ultra transparency and disclosure of its current asset, liability and off-balance sheet exposure details as there was no way to assess the risk of the investment.

This prediction was true.

Many hybrid debt holders at the nationalized banks are retail customers who say they were conned into buying complex financial instruments that buoyed banks' capital levels instead of fixed-term savings accounts.

What was required to find investors was to misrepresent the investment to unsophisticated buyers.  As I recall, the representation was the investment was just as safe as buying a time deposit. Unlike time deposits, these securities were not guaranteed by the government.  An important misrepresentation.

Patrick Honohan: Some lessons from Irish experience on when and how to recapitalize banks

Irish central bank governor Patrick Honohan delivered an interesting speech at the 44th annual Trinity College Money, Macro and Finance conference on some lessons from the Irish experience on when and how to recapitalize banks.

He concludes

Prompt, transparent over-capitalisation in a systemic crisis should remain the preferred option for dealing with failing banks that it is deemed necessary to save.

Regular readers know that with the design of a modern banking system, it is not necessary to bailout and recapitalize any bank.  By design, banks can continue to operate for years and support the real economy while they have low or even negative book capital levels.

The reason they can do this is deposit insurance.  Deposit insurance effectively makes the taxpayers the bank's silent equity partner during periods when they are rebuilding their book capital levels.  There is no need to bailout the bank and make the taxpayer the explicit owner of the bank.

Losses should be shared by both junior and senior creditors where necessary (unless the amounts involved are small) in cases where the banks are put into resolution. 

This is call for implementing the Swedish model and requiring banks to absorb the losses on the excess debt in the financial system and not have these losses socialized.

Experience shows, however, that this may be a counsel of perfection not always achievable.... 

Why would this always not be achievable?

it proved hard to generate reliable and precise information quickly. Clearly it would have been better if comprehensive accurate estimates of future loan-losses had been available from the outset.  However, despite best efforts, accurate information emerged only slowly. 

Please re-read the highlighted text again as Professor Honohan has made the case for requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This disclosure provides the precise, reliable information needed.

With this disclosure, market participants have the information they need to analyze each bank and create an up to date estimate of future loan-losses.

Given the early decision to socialise the losses by guaranteeing all senior debt and some subordinated debt for two years, the scope for over-capitalisation was very limited in Ireland because the Government’s finances quickly became over-stressed. 

By removing the possibility of more extensive burden-sharing with private creditors, the initial guarantee narrowed the options available to Irish policymakers and pushed public debt levels to the limits of sustainability.  

Not only was over-capitalisation no longer a serious option and the chance of deeper burden-sharing with bank creditors shut-off, but in addition some resolution actions had to be deferred lest they trigger an immediate cash call on the guarantee...

And who offered the advice to guarantee all senior debt and some subordinated debt before getting the precise, reliable information to determine exactly how much in the way of future loan losses might be on the banks' balance sheets?

Why the bankers!

Bankers with an extraordinary conflict of interest who stood to gain substantially if the advice they provided was acted on as it would be the Irish economy and taxpayer who absorbed the losses on the excess debt in the financial system and not the banks.

I bet the bankers did not explain to the Irish government how their advice was likely to bankrupt Ireland while at the same time letting the bankers escape any losses for having made bad lending or investment decisions.

Recapitalizing banks without first determining precise losses is waste of money

Reuters reports that 'recapitalizing the Spanish banks without first determining precise losses' could be a waste of money.

Regular readers know that a modern banking system is designed so that it does not need governments to bailout the banks.

With deposit guarantees and access to central bank funding, banks can operate and support the real economy for years while they have negative book capital levels.  As a result, bailouts are unnecessary as banks can rebuild book capital levels through retention of 100% of future pre-banker bonus earnings.

However, the idea that the losses the banks are currently holding should be precisely determined and realized today is important.

Regular readers know that precisely determining and recognizing the losses hidden on and off the banks' balance sheet is the first step in implementing the Swedish model for handling a bank solvency led financial crisis.

The Advisory Scientific Committee said in a report to the European Systemic Risk Board (ESRB), that if losses at the Spanish banks were not determined and balance sheets not cleaned up then EU funds may well be insufficient for recapitalisation. 

"Adding capital without knowing what the assets are actually worth and how much capital is really needed entails a serious risk that the funds may simply be lost as the necessary resolution of the banks is delayed further," the committee said in a report to the ESRB published on Tuesday. 

The first loans are not expected to be handed out until October and Spain will have to restructure its banks in return for the money. 

The committee also backed the controversial principle that all debtholders of a bank, including unsecured senior bondholders, should be forced to take a hit to shore up an ailing bank. 

So far in the financial crisis, senior bondholders have been largely shielded, with shareholders and junior bondholders bearing the brunt of a bank failure. 

"The examples of Ireland and Spain suggest, already at the national level, that the full protection of all senior creditors may exceed the government's fiscal capacity," the committee said. 

"The buyers of such debt should know what they are letting themselves in for, and should have the strongest possible incentives to assess the creditworthiness of, and exercise discipline over, their debtors," the report said.

In theory, buyers of senior debt should have the strongest possible incentives to assess the creditworthiness of and exercise discipline over the banks.

In practice, this is impossible as the financial regulators have a monopoly on all the useful, relevant information that investors need to independently assess the risk of the banks.  Remember, banks are in the words of the BoE's Andy Haldane "black boxes".

Furthermore, the stress tests create a moral obligation on the part of the government not to inflict losses on the senior debt holders.  If the financial regulator says the stress tests show that a bank is solvent, it is reasonable for investors to rely on this representation.

In equally blunt terms, it criticised the "vagueness" of plans by EU leaders to turn the ECB into the supervisor for euro zone lenders, saying they fell short of giving Frankfurt the power to close down ailing lenders.

"Unless the power to close a bank is effectively transferred from national to supranational institutions, the 'single supervisory mechanism in the euro area' will not be effective," the committee of academics and finance industry officials said. 

In such a case, the use of the bloc's bailout funds could very expensive without actually solving the problems, the committee added.

The only banks that need to be closed are those that do not have a franchise that allows them to generate earnings with which to rebuild their book capital levels.

ECB calls for senior bank debt holders to share losses is implicit endorsement of Swedish model

The ECB has taken the first step towards endorsing adoption of the Swedish model for handling a bank solvency led financial crisis by calling for senior bank debt holders to absorb losses.

Under the Swedish model, banks recognize the losses on all of their on and off-balance sheet exposures today.  Subsequently, they rebuild their book capital levels by retaining 100% of pre-banker bonus earnings.

Included in the losses that banks would realize are the losses on the senior debt of other banks, particularly in the EU peripheral countries.

According to a Wall Street Journal article,

The European Central Bank, in a sharp turnaround, advocated imposing losses on holders of senior bonds issued by the most severely damaged Spanish savings banks—though finance ministers have for now rejected the approach, according to people familiar with discussions.... 

It marks a contrast from the position the central bank adopted during the 2010 bailout of Irish banks—which, like Spain's, were victims of a property meltdown—when it prevailed in its insistence that senior bondholders in bailed-out banks shouldn't suffer losses.

Under the Japanese model for handling a bank solvency led financial crisis that was adopted at the beginning of the crisis, bank book capital levels are protected at all costs.  As a result, senior bondholders couldn't absorb any losses.

In shifting to the Swedish model, bank senior bondholders are now not only not protected from loss, but required to recognize the loss.

The ministers rejected the advice from the July 9 meeting out of concern financial markets would react badly....

The ministers' advisors, bankers, know their bonuses are at risk, hence the concern that the markets would react badly.  If the ministers adopt the ECB recommendation, their banks are going to have losses and they might not receive a bonus.

The ministers' decision confirmed a pattern in the euro zone for dealing with bank troubles in which senior bondholders have been spared even in the most brutal failures. 

But the ECB's shift may be a sign that the tides are turning on the issue, as the euro zone embarks on a fundamental overhaul of the way bank failures are dealt with within the currency union....

Imposing losses on bondholders reduces the amount of money taxpayers need to inject into struggling banks. One euro-zone official said the desire to avoid putting more public money at risk than necessary was one reason behind the ECB's change of heart since 2010.

As your humble blogger has said repeatedly, there is no reason that governments need to put more money at risk.  They already have plenty at risk through the deposit guarantee.


Regular readers know that a modern banking system is designed to continue to operate even if the banks have negative book capital levels.  The reason this is true is the existence of deposit guarantees and access to central bank funding.


With the deposit guarantees, the taxpayer through the government guarantee has become the silent equity partner in the bank when it has a negative book capital level.  This is the reason why it is only governments that can shutdown a bank.  


As the silent equity partner, the government has the option of looking at the bank and seeing if it has a franchise that would allow it to earn its way back to a positive book capital level or can be sold in such a way as to minimize the losses incurred by the taxpayer.

Bowing to the bankers, Spain bails out Bankia

Despite overwhelming evidence that governments injecting funds into an insolvent banking institution does not

• restore confidence in the banking system, 
• restore confidence in the bank, 
• promote lending to the real economy, or 
• lead to the bank recognizing its losses and cleaning-up its balance sheet, 

the Spanish government decided to bailout Bankia.

Despite overwhelming evidence that governments injecting funds into an insolvent banking institution does

• deprive the real economy of the use of these same government funds to promote economic growth, 
• increase runs on the banks as depositors realize that the government has less ability to stand behind it deposit guarantee, 
• increase the government's cost of funds as investors realize that the government is committing itself to finance the black hole of losses throughout its banking system, and 
• continue the downward spiral in the real economy caused by the excess debt in the financial system, 

the Spanish government decided to bailout Bankia.

According to an article in the Telegraph,

Spain's finance minister said the government would inject “at least €9bn” (£7.2bn) into ailing lender Bankia while insisting it was an isolated problem which would not spread to the rest of the country’s banking system. 

Luis de Guindos told the Spanish parliament that the government would do whatever was needed to rescue Bankia, while stressing that the situation “shouldn’t be extrapolated to the nation’s entire banking system”. 

In what amounted to an attempt to bolster confidence and prevent a run on Spanish banks... 

Mr de Guindos said a total restructuring of the bank would occur after a thorough assessment and that the government would seek to sell Bankia once it has been cleaned up, as part of a strategy to restore investor confidence in the country’s banking sector.  

The minister sought to ease concerns as fears about the health of the Spanish banking system have mounted in recent weeks because of their exposure to the collapsed property market. 

Spanish banks have an estimated €184bn of what the Bank of Spain describes “problematic” real estate-linked assets.... 

“The question is now about the long-term solvency of parts of Spain’s banking system, especially what is going to happen with mortgage loan default. This concern is not being addressed,” said Martin van Vliet, senior economist at ING.

The fact that mortgage loans are not being addressed undermines what limited credibility the Spanish government has when it comes to dealing with the banking system.

It is clear that the government does not know what is going on and is doing what its advisors, who naturally enough come from the banking industry, tell it to do.

Spain's nationalization of Bankia won't achieve stated goals

The Guardian ran an article that provided more insight into the three reasons why the Spanish government decided to effectively nationalize Bankia.

"It is a necessary first step to ensure solvency, the tranquility of the depositors and to dispel the doubts of the markets on the capital needs of the entity," the finance ministry said.

Regular readers know that this nationalization will not achieve the stated goals.

First, it does not ensure the solvency of the bank.  Bank solvency is defined as the market value of the banks assets minus the book value of its liabilities.  If the result is positive, the bank is solvent.  If the result is negative, the bank is insolvent.

Bankia has more than €30bn of exposure to troubled loans to property developers and repossessed land and buildings. 

The government is expected to lend or give Bankia up to €10bn aid overall, although some analysts say it will need more....

The 10 billion euros of aid is to address troubled loans to property developers and related collateral.  What about all the other bad assets on the bank's books?

As the analysts point out, Bankia will need more aid if the goal is to ensure its solvency today.

Second, it does not ensure the tranquility of the depositors.  In fact, it has exactly the opposite effect.

The tranquility of depositors is directly a function of whether they think the Spanish government has the resources to make good on the deposit guarantee.  Bank bailouts use resources and diminish the ability of the government to honor the guarantee.  Depositors flee when there are doubts about the guarantee.

Third, it does not dispel the markets' doubts about the capital needs of the bank.

The measure is further proof that Spain's banking sector has failed to digest a huge pile of toxic assets and debt left over by a property bubble that burst four years ago.... 

Extra reforms will include yet another round of provisioning against toxic real estate with banks ordered to set aside a further €35bn on top of the €54bn already provided, financial sources told Reuters. 

Bankia was created just 17 months ago by the merger of seven regional savings banks in an attempt to shore up their combined defences against the bad real estate loans, worthless building land and unsold apartment blocks they had accumulated. 

Savings banks, many controlled by local politicians, were the most reckless lenders to developers, land speculators and building companies, which have left Spanish banks burdened with €184bn of problem loans and assets.

Regular readers know that the only way to dispel market doubts is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

It is only when the market can independently assess this information that it can determine exactly how much additional capital is needed to return Bankia to solvency.

If ultra transparency is not required, the market will always assume the reason is that Bankia (and the other banks) have something to hide.  The market did this when Ireland tried bailing out its banks in a similar fashion and were proved correct.

How to tackle Spain's banking issues is anyone's guess

The new Spanish government has said that having the banks clean up their balance sheets is its first priority.  A Wall Street Journal article asks how are they going to do this?

Regular readers know that this requires two steps.

• First, the banks must be required to write the assets down to where an independent third party would be willing to buy them in an arm's length transaction.

• Second, the banks must be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure detail.  

Ultra transparency is needed so that market participants can assess whether the banks have really recognized all their losses.  This is needed so that market participants can assess the on-going risk of the banks as they gradually rebuild their capital base through retained earnings and, if possible, equity sales.

September was another month of slim pickings for Spanish bankers. 

Data out today from the central bank indicated that lending to households, companies and the governments fell at the sharpest annual rate on record. 

And bad loans ticked higher for a sixth straight month, to a new crisis-high of €128.1 billion, or 7.16% of the total, as more of the country’s ailing real estate developers went out of business. 

Popular Party chief Mariano Rajoy... has made cleaning up the balance sheets of Spain’s banks one of his priorities... 

But he has not said how he wants to tackle the problem, leaving analysts to dream up solutions. 

Some expect the new government to create a state-owned bad bank where lenders can dump their toxic real estate. But such a scheme would require considerable government fundraising upfront, something that looks challenging at a time when the very existence of the euro zone is under question. 

Other analysts expect Spain to increase the provision requirements on their most toxic assets: some €175 billion in problem assets tied to real estate. Banks have set aside just over 30% to cover losses from these assets at the moment. 

Analysts at Credit Suisse reckon the new government may decide to increase the provisioning levels to 45%-50%, which in turn would generate a capital shortfall of between €40 billion and €60 billion. In this market, it’s not clear where the money will come from to foot such a large bill.

The money is not needed immediately.  Spain's banking industry can retain sufficient earnings over time to cover this capital shortfall.

Spanish banks have been kicking the can for years on their real estate problems. A clean-up, while painful, is necessary.

UniCredit, facing a run on its deposits, tries to raise capital

According to a Telegraph article by Harry Wilson, UniCredit is going to attempt a massive stock offering as part of its attempt to restructure.

As part of this restructuring, UniCredit is going to write-off the goodwill related to its international bank acquisitions as well as take new losses on its sovereign debt holdings.

Like the Spanish Cajas, why would anyone invest in UniCredit without disclosure of it current asset, liability and off-balance sheet exposures detail?  Without this data, it is impossible to assess the risk or solvency of the bank.

The article also highlights the fact that UniCredit is suffering a modest run on its deposits.  This bank run probably reflects a combination of a loss of confidence that Italy can make good on its deposit guarantees and the question surrounding UniCredit's ongoing solvency.

The bank was hit by new losses on its holdings of sovereign debt and a massive writedown against the value of acquisitions made during the boom years. 

Unicredit said it would raise half its market capitalisation of €15bn in new shares to help it rebuild its capital base and meet new international requirements for loss-bearing capital. 

More than 80pc of the loss resulted from an €8.7bn goodwill writedown taken by UniCredit against "acquisitions made over the past few years". The bank said it had entirely written off goodwill held on its books from purchases made in the Ukraine and Kazakhstan. 

The bank also recognised an €662m writedown against the value of some of its biggest brands, including Germany's HVB and Bank Austria. 

European Banking Authority-led stress tests last month identified an €7.4bn capital shortfall at UniCredit and the bank said it would launch an €7.5bn rights issue to rebuild its core capital ratios. The rights issue will be subject to the approval of a shareholder vote at an extraordinary general meeting on December 15. 

As part of its attempts to conserve capital the bank said it not pay a dividend for 2011, as well as engaging in what it termed "RWA [risk weighted assets] management". 

UniCredit's holding of eurozone sovereign debt, particularly its portfolio of Italian government debt, weighed on its performance. Writedowns of Greek government debt cost the bank €135m in the three months to the end of September. Third-quarter trading losses related to holdings of government bonds were €285m. 

In addition to raising new capital the bank has put in place a turnaround plan to return it to profitability with the aim of achieving a 12pc return on equity by 2015.... 

"The ultimate goal of the plan in Italy is to restore the role of UniCredit as an efficient and innovative leading commercial bank, close to and well entrenched in the territories it serves whilst offering domestic clients full access to a broader international network," said the bank in a statement on Monday....

One of the bank's biggest challenges will be growing its deposit base. The turnaround plan demands that Italian deposits grow between 2010 and 2015 by 15pc. However, in the three months to the end of September total deposits shrank by 3.5pc to €393bn, with Western European desposits declining 5.3pc quarter-on-quarter....

Monday's loss compared to an analysts consensus forecast of an €6bn profit, showing the drastic deterioration in the economic outlook with eurozone lenders looking to build capital and cut risk.

European finance ministers focus on shoring up sagging bank capital blocks opportunity to save Eurozone

According to a Reuter's article, European finance ministers failed to find a united front for shoring up Eurozone banks.

Thank goodness.

Now, rather than worrying about the meaningless bank capital numbers and socializing the banks' losses, the finance ministers can worry about requiring the banks to perform their role as the safety valve between financial market excesses and the real economy.

The bank safety valve function is their ability to absorb unlimited amounts of losses.  They can absorb the losses necessary to restructure the debt to a level where the borrowers can afford to service their debt.

By reducing debt payments to what the borrowers can afford, banks re-establish the conditions for economic growth.

European Union finance ministers failed to agree on Tuesday how to shore up sagging banks and avert a credit squeeze, as rising borrowing costs for Italy threaten to unleash a new and more dangerous phase of the euro zone debt crisis. 

Against the worsening economic backdrop, European banks are finding it hard to borrow and are increasingly reluctant to lend to one another. 

The solution to this problem is to require each bank to provide disclosure of its current asset, liability and off-balance sheet exposure details.  This would unfreeze the interbank lending market as lenders would know exactly what was happening at the borrowers.

In an attempt to arrest this creeping credit freeze, ministers examined offering state guarantees to borrower banks on Tuesday but became bogged down in deciding whether to pool such guarantees in Europe or ask countries to go it alone. 

"The point is to what extent you pool together guarantees for banks," said one official. "There are differences of views on that point." 

Austria's finance minister and others said two schemes were now being considered -- one a common "harmonized" model of guarantees for banks that need to borrow and another a "consortium" where state guarantees for banks are gathered.... 

Rather than guarantee interbank loans, the guarantee should be saved for deposits.  So long as the depositors feel that their funds are not at risk, they are willing to stay with a bank which is insolvent.

It is the deposit guarantee plus current detailed disclosure that makes it possible for the banks to absorb the losses related to credit excesses.

Michel Barnier, the EU official in charge of financial regulation, said he would write a law to empower supervisors to push banks that need to beef up their capital by curbing their dividend or bonus payouts....

This law should be applied after the banks have absorbed the losses and restructured the debt.

Amid indecision, the EU's attempts to support its lenders may be overtaken by events. 

Recapitalizing banks was in part intended to cope with a default by Greece. But if debt-ridden Italy -- the euro zone's third biggest economy -- were also to need financial assistance, the scale of the problem would change entirely. 

It is only the bank balance sheets that are large enough to absorb the losses.

 

Surprise! Europe's banks to raise little new capital from investors as a result of 9% Tier 1 mandate

According to a Bloomberg article, the analysts have crunched the numbers on the European regulators requiring Eurozone banks to hit a 9% Tier 1 capital ratio and discovered the Eurozone banks will require little in the way of new capital from investors.

The analysts reached two conclusions.

First, the 9% Tier 1 capital ratio will not restore investor confidence as the issue is what are the banks' current exposures and the lack of credibility of their risk models.  In addition, it is the peripheral banks and not the core "systemic" banks that need to raise capital.

This conclusion is not a surprise to regular readers as they know that it will take disclosure by each bank of its current asset, liability and off-balance sheet detail data to restore investor confidence.

Second, the 9% Tier 1 capital ratio mandate is just another exercise in "extend and pretend" by the Eurozone policymakers and financial regulators designed to buy time.

Europe’s largest banks may raise just a tenth of the total capital shortfall estimated by regulators, fueling concern policy makers’ plans to bolster the region’s lenders could fail.... 

Rather than tapping investors or governments, firms are trying to hit the 9 percent core capital target by adjusting risk-weightings, limiting dividends, retaining earnings, reducing loans and selling assets. Banks had threatened to curb lending, risking a recession, to meet the goal rather than take government aid that would bring limits on bonuses and dividends...

“The issue is how much fresh capital will be brought in,” Philippe Bodereau, head of credit research at Pacific Investment Management Co. in London, said in a telephone interview. “It would be positive if we saw banks launching rights issues, but they won’t. This is hardly shock and awe.” 

Lenders may sell as little as 6 billion euros of new stock to investors to plug the shortfall, according to Alastair Ryan, an analyst at UBS AGin London. That’s seven times less than the amount banks will raise from retaining earnings and adjusting risk-weightings, he said. 

Before last week’s summit, analysts at JPMorgan Chase & Co. and Credit Suisse Group AG had estimated banks might need as much as 250 billion euros more capital. 

Now, only Banco Bilbao Vizcaya Argentaria SA of Spain, Germany’s Commerzbank AG, France’s BPCE SA, Austria’s Raiffeisen Bank International AG and four Italian banks -- UniCredit SpA, Banco Popolare SC, Banca Monte dei Paschi di Siena SpA and Unione di Banche Italiane ScpA -- need to raise money, according to [Morgan Stanley analyst] Van Steenis. 

“Surely, no one thinks that by allowing banks to avoid raising capital in all these various ways it’s going to give investors more confidence,” said Peter Hahn, a professor of finance at London’s Cass Business School and a former managing director at New York-based Citigroup Inc. “Part of the issue for a long time has been the lack of credibility of bank balance sheets and their risk models. This isn’t going to help.” ...

Greece’s six banks will need to raise about 30 billion euros, more than any other EU member state, the EBA said. That shortfall is covered by existing backstop arrangements with the EU and International Monetary Fund, so Greek lenders wouldn’t have to tap investors, according to the EBA. 

Spanish banks have the next-biggest deficit, according to the regulator. Yet Banco Santander SA and BBVA SA, the country’s two biggest lenders, have said they won’t raise capital. 

They will instead rely on profit and changes to the way they calculate risk-weighted assets to meet the target.

Under the Basel rules, firms use internal models to decide how much capital to assign to assets based on their own assessment of a default. The models aren’t disclosed and banks can reach different risk-weightings for the same assets, regulators and analysts say....

Italian banks have a 15 billion-euro shortfall, according to the EBA. UniCredit, which has a 7.4 billion-euro deficit, said it may be able to reduce that to 4.4 billion euros by counting 3.3 billion euros of hybrid securities as core capital. The Milan-based lender, the country’s biggest, said it’s working to identify “capital management actions to be put in place,” without adding further details.... 

France’s BNP Paribas SA and Societe Generale SA, which in September began programs to trim a combined 300 billion euros in assets, said last week they can meet the new capital targets without tapping shareholders or the government. 

President Nicolas Sarkozy said on Oct. 27 he has asked the banks to shift “almost all” of their dividend payments into strengthening their balance sheets and make their bonus practices “normal.” 

Deutsche Bank AG and Commerzbank AG, Germany’s biggest lenders, also are cutting assets and selling businesses to meet the threshold. 

The method used to determine how much capital banks need to raise “puts the onus on peripheral banks and limits the impact on core banks,” said Pimco’s Bodereau. “The big weakness is that banks that are truly systemic are headquartered in London, Paris and Frankfurt and not in Athens.” 

Southern European banks that can’t raise capital may still need to shrink their balance sheets by as much as 40 percent to meet the new requirements and run the risk of having to rely on state injections, Mediobanca analysts including Alain Tchibozo wrote in a note to clients on Oct. 28. 

“They’ve cobbled together a sticking-plaster solution,” said Jonathan Newman, an analyst at London-based Brewin Dolphin Holdings Plc, which manages about 25 billion pounds ($40 billion). “While it’s desirable for them to have been tougher, the reality was they couldn’t afford to be tougher. Banks wouldn’t have been able to raise the money privately, so they would have had to go to governments, which then puts the sovereign at risk.”

What does 'recapitalizing banks' really mean?

In an excellent Economix column in the NY Times, Princeton Professor Ewe Reinhardt defines what he means by recapitalizing banks.

Regular readers will recognize his definition as it is the one that your humble blogger uses.  This definition of recapitalization looks at the market value of the bank's assets and subtracting from it the book value of the bank's liabilities.  If the market value of the assets is less than the book value of the liabilities, then the bank needs additional equity .... this is the amount needed to recapitalize the bank.

Unfortunately, Professor Reinhardt's and my definition of bank recapitalization is not the same one used by global financial regulators and policymakers.

They use the book value of the bank's assets and the book value of the bank's Tier 1 capital (primarily equity).

In the recent European agreement to deal with the sovereign debt and bank solvency crisis, the Eurozone policymakers and financial regulators said that all Eurozone banks must reach a 9% Tier 1 capital ratio or raise equity.

This 9% ratio is calculated by dividing the book value of the bank's Tier 1 capital by the book value of the bank's assets.

Regular readers know this is a meaningless ratio for showing whether a bank is solvent or not.  Solvency is defined as the market value of the bank's assets minus the book value of the bank's liabilities.  If the result is greater than zero, the bank is solvent.  If less than zero, the bank is insolvent.

Regular readers also know that the reason global policymakers and financial regulators do not use Professor Reinhardt's and my definition of bank recapitalization is because banks do not disclose their current asset, liability and off-balance sheet detailed data so that market participants can determine what the market value of the bank's assets is.

It is this lack of disclosure that effectively blocks Eurozone banks from raising new equity from the capital markets.  After all, what investor is going to want to buy stock in an insolvent bank with great book Tier 1 capital ratios if that bank could end up like Dexia and be nationalize shortly after their investment.

Update

Please note that there is an important distinction between determining how much is needed to recapitalize a bank and when this capital is needed.

In a modern banking system with deposit insurance and access to central bank funding, banks do not need to be recapitalized today.  Rather, they can rebuild their capital through retention of future earnings.

Citizens of any country have reasons to smell a rat when the country’s elite speaks to them of “recapitalizing” banks. In this regard, for example, theUnited States bailout of its troubled banks, and Ireland’s bailout of its banks, are hardly reassuring. The Occupy Wall Street movement appears to be fed in part by this suspicion. 

Recapitalization is a generic term. It can be done in different ways, some more unseemly than others. My inquiry among a nonrandom sample of educated adults suggests that many people do not actually know exactly what recapitalization means. Can we blame them, given that financial experts speak mainly to one another in opaque jargon, and government shuns transparency in these matters? 

To see clearly what is involved, it is helpful to start with a simple accounting identity that describes a business company’s financial position, at market values, at any moment in time as “t.” It is 

A_t – L_t = E_t 

Here A_t denotes the total, realistically realizable dollar value of assets to which the firm has legal title; L_t denotes the total dollar value of the company’s liabilities, if it paid off all of that debt at time t; and E_t denotes the company’s net worth or “owners’ equity” – all as of the point in time t. 

A business is solvent as long as the realizable value of its assets exceeds its debt (A_t > L_t).

It bears repeating that global policymakers and financial regulators do not use this definition when they are talking about recapitalizing a bank.  They are strictly looking at the book value of the bank's assets and the book value of the bank's equity.

This blog, however, uses Professor Reinhardt's definition.

Even such a company, however, may find itself illiquid if it does not have on hand enough cash or liquid assets that can quickly be converted to cash to meet short-term debt coming due within the next month or year. An illiquid but solvent business can easily be helped through a short-term bridge loan secured by other assets or an open credit line at a commercial bank that can be tapped in such cases. For solvent banks the central bank is a short-term lender of last resort. 

Prudent executives manage the balance sheet of their enterprises so that, at any time t, the realizable dollar value of the company’s assets are enough, under most foreseeable future contingencies, to repay all of the company’s debts and, it is to be hoped, leave some positive net worth for the owners.... 

These assets consist mainly of the right to cash flows inscribed in financial contracts – Treasury and corporate bonds, short-term commercial loans to businesses. In the United States, the banks’ assets also included so-called “structured loans” secured by mortgages (increasingly subprime mortgages) and other derivative securities, including rights to cash flows implied by in bond-insurance contracts (credit default swaps).

European bankers, too, invested in such risky securities – often sold to them by their American colleagues. In addition, they loaded up on loans to governments living way beyond their means (Greece) or loans to real estate developers thriving in a real-estate bubble (Ireland, Spain).... 

By mid-2007, news had penetrated all the way to the banks’ executive suites that a good many of the structured securities on the asset side of their balance sheets were secured by dodgy mom-and- pop mortgages that had been extended to people unlikely ever to earn enough to be able to make their monthly mortgage payments on time. The market value of these securities began to shrink. 

In Europe, on the other hand, it became clear that some governments – especially that of Greece — would not be able to pay debt service on the sovereign bonds they had sold as investments to European bankers. 

Eventually, then, it dawned on everyone, even bankers, that, realistically, the ... banks were not just illiquid, which could easily have been fixed by central banks. Many of the banks were effectively insolvent, if all assets were realistically marked to realizable values.

We can think of the generic term “recapitalizing the banks” simply as “restoring the balance sheets of the banks to financial health.” It requires that somehow the banks’ debt-to-asset ratio L_t/A_t be reduced to more prudent levels, which is the same thing as saying that its complement, the equity-to-asset ratio, E_t/A_t, also known as the “capital ratio,” provide a robust enough cushion for possible future declines in asset values (L_t/A_t and E_t/A_t add up to 1, of course).

Opacity has a high price: Iceland shows a path not taken

In his NY Times column, Paul Krugman discusses the high price of opacity through the failure of the bank bailout doctrine to remedy a solvency crisis.

He looks at the case of Iceland and its decision not to bailout its banks.

He makes the incredibly important point that we did not have to make our citizenry pay the entire painful price.

I agree with Professor Krugman that as it was implemented, the bank bailout doctrine is a failure.  The problem was the implementation including the fact that it did not make capital pay a large part of that price.

Regular readers know that before bailing out the banks the government needed to require that each bank disclose its current asset, liability and off-balance sheet exposure detail.  With this information, market participants could figure out who was solvent and who was insolvent.

More importantly, market participants could figure out which of the insolvent banks had the capacity to "earn" its way back to solvency based on the strength of its franchise and which insolvent banks either needed a bailout or needed to be closed.

It is only by going through the steps of disclosure and then analysis that the market participants can be confident that the solvency issue is addressed.

It is only by going through these steps that banks are forced to recognize their losses and mark their assets to market.  This is where banks perform their safety valve function and protect the real economy and its citizenry from paying the full painful price of the banks' follies.

It is only when the assets are marked to market that banks are comfortable making new loans against similar assets and investors are comfortable buying these loans when packaged in structured finance securities that also have current asset level performance disclosure.

Under my proposed implementation of the bank bailout doctrine, the impact on the real economy, the pain placed on the citizenry and the amount of debt taken on by the government is minimized.

But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine — a doctrine that has inflicted huge damage both in Europe and in the United States. 

The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So a crisis brought on by deregulation becomes a reason to move even further to the right; a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed. 

This doctrine was sold both with claims that there was no alternative — that both bailouts and spending cuts were necessary to satisfy financial markets — and with claims that fiscal austerity would actually create jobs. 

The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks...

Now, however, the results are in, and the picture isn’t pretty. Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared....

So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? Well, that’s why I’m in Iceland, attending a conference about the country that did something different. 

... Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position. 

But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver. 

So how’s it going? Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph. 

And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.