Bundesbank chief: ECB cannot solve Eurozone crisis

Reuters reports that Jens Weidmann, the Bundesbank chief, said the ECB's monetary policy could buy time to end the Eurozone crisis, but it cannot solve the Eurozone crisis.

Please recall that Anna Schwartz, Milton Friedman's co-author, said the Fed and the policies that Ben Bernanke chose to pursue also would not end the US financial crisis.

The reason that monetary policies will not end the global financial crisis is that we are dealing with opacity in large parts of the global financial system that has expressed itself in a bank solvency led financial crisis.

Until transparency is brought back to all the opaque corners of the financial system, pricing in the global financial market is distorted and capital is misallocated.

Contributing to this distortion and misallocation are the low interest rate and quantitative easing policies being pursued by central banks.  Since they are contributing to the distortion of prices and the misallocation of capital, by definition we know central bank policies cannot end our financial crisis.

Anna Schwartz made this point when she Bernanke's policies would not end the problem of bank solvency.

The European Central Bank cannot solve the euro zone crisis, Bundesbank chief Jens Weidmann told economists on Sunday, pressing the bloc's governments to get their economies in shape and tighten their fiscal rules. 

Weidmann addressed an economists' conference in Aix-en-Provence, southern France, only three days after the ECB broke with precedent by declaring that it intended to keep interest rates at record lows for an extended period and may yet cut further. 

"Monetary policy has already done a lot to absorb the economic consequences of the crisis, but it cannot solve the crisis," Weidmann said in his speech. 

"This is the consensus of the Governing Council. The crisis has laid bare structural shortcomings. As such, they require structural solutions."... 

While he does not see sufficient support in the euro zone for governments to give up sovereignty on fiscal matters to forge a fiscal union to prevent such crises in the future, Weidmann pressed them to stiffen Europe's fiscal rules. 

"To fully unleash the common currency's potential, efforts are needed on two fronts: structural reforms as well as the abolition of implicit guarantees for banks and sovereigns (government bonds)," Weidmann said. 

"In addition to stronger rules, we need to make sure that in a system of national control and national responsibility, sovereign default is possible without bringing down the financial system. Only then will we really do away with the implicit guarantee for sovereigns." 

The Bundesbank chief also called for euro zone governments to sever what he describes as the "excessively close links" between banks and sovereign governments, saying that European banks hold too many of their own governments' bonds. 

"This is because banks do not have to hold any capital against their government debt, as the risk-weight assigned to sovereign bonds is zero. 

To counteract excessive investment in sovereign bonds, Weidmann believes that the capital rules need to be changed to take account of risk and exposure levels. 

"Only then will banks be able to cope with the repercussions of sovereign default."

Thomas Hoenig calls attention to well known fact: banks operating without much capital

Thomas Hoenig created a ruckus by pointing out that Deutsche Bank is "horribly undercapitalized".  Naturally, Deutsche Bank responded that in the make believe world of Basel capital requirements Mr. Hoenig was wrong.

To settle the matter, Zero Hedge weighed in and noted that EU banks, including Deutsche Bank, needed upwards of 500 billion euros of capital.  Citing the work on EU banks by Benink and Huizinga, Zero Hedge noted

Banks are already saddled with ample unrecognised losses on their assets, estimated by many observers to be at least several hundreds of billions of euros and mirrored by low share price valuations...

This whole debate highlights two important facts about our current financial crisis.

1. Everyone knows that the banks are hiding losses and the extent of their hidden losses exceeds their current book capital levels.
2. Banks are holding policymakers and central bankers hostage by threatening that disclosure of these losses and the related lack of capital will result in financial instability.

Please note that if everyone already knows the banks have low or negative capital, then revealing the exact amount should not result in financial instability.  Revealing the exact amount simply confirms what market participants already know and lets market participants know how close their estimates of the losses were to reality.

Your humble blogger is confident in his statement that revelation of the losses won't result in financial instability for several reasons including: market participants might have overestimated the extent of the losses and we have 6 years of experience that show that banks can continue to operate with what in reality is low or even negative book capital levels because of the combination of deposit insurance and access to central bank funding.

If revelation of the exact amount of losses is not going to result in financial instability, then policymakers and central bankers don't have to remain hostages of the banks.  And if policymakers and central bankers don't have to remain hostages, then there is no reason to continue to pursued the failed Japanese Model and preserve bank book capital levels and banker bonuses at all costs.

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.

European banks need to be recapitalized when?

In his Financial Times column, Jean Pisani-Ferry asserts that European banks need to be recapitalized now.

Why recapitalize now?

Europe also made two mistakes in responding to the crisis. First, it failed to recognise the true extent of its banking problem. It believed – or pretended to believe – that the guarantees and recapitalisations of 2008-2009 had addressed the issue whereas weaknesses were in fact much more widespread. Second, it failed to appreciate that excessive private-sector debt was not just an American problem. In Europe too many households and companies needed to deleverage....

The first priority is financial repair. Banks with weak balance sheets lend on too expensive terms or lend to insolvent borrowers to keep them afloat and do not grant credit to new firms. This prevents profitable investment and the growth of new, more efficient firms.

A comprehensive bank balance sheet assessment is needed....

The first priority should be a comprehensive bank balance sheet assessment and this can only by accomplished by requiring the banks to provide ultra transparency.  With on-going disclosure of their current asset, liability and off-balance sheet exposure details, market participants can assess each of the exposures.

Market participants can then exert discipline so that banks recognize their losses on the excess debt in the financial system.  This market discipline ends the practice of lending to insolvent borrowers to keep them afloat.

This market discipline also rewards banks for making new loans to borrowers who can afford to repay the loans.

The ECB should not and will not accept undercapitalised – let alone insolvent – banks to fall under the common supervision. 

With this statement, Mr. Pisani-Ferry moves into the world of theory.  He assumes there are solvent banks in Europe.

In the real world, there is no such thing as a European bank that is not insolvent under the traditional definition of insolvency (the market value of its assets is less than the book value of its liabilities).  Supporting evidence for my statement comes from the need to nationalize several European banks that had passed the stress tests (for example, Dexia).

Mr. Pisani-Ferry also asserts that the ECB should not accept undercapitalized or insolvent banks.

As I discussed in a previous blog, were Walter Bagehot, who wrote the book on modern central banking, alive today he would recognize the existence of deposit insurance. This recognition would change his definition of bank solvency and result in the central bank acting as lender of last resort to banks with substantial negative book capital levels.

Mr. Bagehot would recognize that a bank that does not qualify for access to central bank funds is a bank where its interest income is not greater than its interest expense plus pre-banker bonus operating costs.

National authorities therefore have to initiate a recapitalisation of undercapitalised banks and a resolution of the insolvent ones. The moment is now. 

I agree that the moment for cleaning up the banking system is now.

Using the income driven approach to bank solvency, clearly those banks that are insolvent need to be resolved.

Using the income driven approach to bank solvency, those banks that are solvent should be required to retain 100% of their pre-banker bonus earnings until such time as they have rebuilt their book capital levels to regulatory standards.

While this may take years, it is not a problem as banks can continue to make loans to support the real economy.

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.

Sheila Bair: capital ratios let regulators make banks look safer than they are

In her Wall Street Journal column, former FDIC chairwoman Sheila Bair drives a stake through the heart of bank capital, the Basel capital requirements in particular, by observing that capital ratios let regulators make banks appear safer than they actually are.

Ms. Bair's conclusion is exactly what your humble blogger has been saying since the beginning of the financial crisis.

Bank capital ratios suffer from two fundamental flaws:

• They are easily manipulated by banks, regulators and policy makers.  Banks manipulate the ratios by gaming the calculation of risk adjusted assets.  Regulators manipulate the ratios by practicing regulatory forbearance and letting banks engage in 'extend and pretend' to turn their non-performing loans into 'zombie' loans.  Policy makers manipulate the ratios by insisting on the suspension of mark-to-market accounting for securities.

• They are designed to hide the true condition of the banks.  Having been involved in the development of Basel I, I can tell you the basic idea behind Basel I was to hide the amount of leverage that banks were taking on so they could generate a high return on equity.  Regulators bought into the idea that banks needed a higher return on equity to attract capital.

There is only one way to assess the risk of a bank.  That is to look at a bank's current global exposure details.

This is why your humble blogger has been saying that banks need to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the true condition of the bank.

With this information, market participants can, if they want, calculate a capital ratio that is not subject to measurement errors introduced by banks, regulators or policy makers.

The recent Senate report on the J.P. Morgan Chase JPM +0.77% "London Whale" trading debacle revealed emails, telephone conversations and other evidence of how Chase managers manipulated their internal risk models to boost the bank's regulatory capital ratios. 

Risk models are common and certainly not illegal. Nevertheless, their use in bolstering a bank's capital ratios can give the public a false sense of security about the stability of the nation's largest financial institutions. 

At a minimum, risk models introduce measurement error and the ability for banks to manipulate their appearance of safety and soundness.

Capital ratios (also called capital adequacy ratios) reflect the percentage of a bank's assets that are funded with equity and are a key barometer of the institution's financial strength—they measure the bank's ability to absorb losses and still remain solvent.

Capital ratios are nice in theory, but don't work in practice for two reasons.

First, capital ratios are easily manipulated, they are not an accurate measure of a bank's ability to absorb losses and remain solvent over the long term.

Second, banks are uniquely designed so they can continue to operate even when they are insolvent for a period of time.

This is a very important point as it highlights the simple fact that only in the world of bank regulators and academic economists are capital ratios important.

As I highlighted in my hierarchy for dealing with insolvent banks (where the market value of the bank's assets is less than the book value of its liabilities), the first place to absorb losses and the primary source of a bank's financial strength is the bank's ability to generate earnings before banker bonuses in the future.  It is a bank's ability to generate earnings in the future that allows it to rebuild in book capital levels.

This should be a simple measure, but it isn't. That's because regulators allow banks to use a process called "risk weighting," which allows them to raise their capital ratios by characterizing the assets they hold as "low risk."...

As we learned during the 2008 financial crisis, financial models can be unreliable. Their assumptions about the risk of steep declines in housing prices were fatally flawed, causing catastrophic drops in the value of mortgage-backed securities. 

And now the London Whale episode has shown how capital regulations create incentives for even legitimate models to be manipulated....

The ease with which models can be manipulated results in wildly divergent risk-weightings among banks with similar portfolios. 

Ironically, the government permits a bank to use its own internal models to help determine the riskiness of assets, such as securities and derivatives, which are held for trading—but not to determine the riskiness of good old-fashioned loans. 

The risk weights of loans are determined by regulation and generally subject to tougher capital treatment. As a result, financial institutions with large trading books can have less capital and still report higher capital ratios than traditional banks whose portfolios consist primarily of loans.

Regulators need to use a simple, effective ratio as the main determinant of a bank's capital strength and go back to the drawing board on risk-weighting assets. 

It does make sense to look at the riskiness of banks' assets in determining the adequacy of its capital. 

But the current rules are upside down, providing more generous treatment of derivatives trading than fully collateralized small-business lending.

Your humble blogger has been saying since the beginning of the financial crisis that the only way to determine the riskiness of a bank is by looking at its assets.  Here is Ms. Bair confirming that point.

All of this makes the case for requiring banks to provide ultra transparency and disclose their current exposure details as it takes away the ability of either banks or regulators to distort the true safety of the banks.

It is intuitively ridiculous to have capital requirements that assign a lower risk weighting to derivatives that fully collateralized loans.

The main argument megabanks advance against a tough capital ratio is that it would force them to raise more capital and hurt the economic recovery....

That is the beauty of requiring the banks to provide ultra transparency.  It doesn't force the banks to raise more capital.  It gives them the alternative to shrink by eliminating proprietary bets and subsidiaries that exist solely to engage in regulatory or tax arbitrage.

If deposits safe in EU, Schaeuble should have banks provide transparency to prove it

Reuters reports that German Finance Minister Wolfgang Schaeuble says that deposits are safe in the eurozone and won't be used to bailout insolvent banks.

If this statement is to be believable after uninsured depositors were effectively wiped out in Cyprus, Mr. Schaeuble should have the banks provide transparency and prove that they are not insolvent.

Naturally, the first banks to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details should be in Germany.

It is only with this information that market participants can assess the solvency of each bank and assess the risk that they might be called on to bailout an insolvent bank.

The failure of Mr. Schaeuble to back up his claim that deposits are safe by insisting that eurozone banks provide transparency is the equivalent of waving a big red flag and saying of course the banks have something to hide and we need depositors to keep their money in the banks so that we can seize it.

German Finance Minister Wolfgang Schaeuble has said savings accounts in the euro zone are safe, adding that Cyprus is a "special case" and not a template for future rescues....

"Cyprus is and will remain a special one-off case," Schaeuble said. 

"The savings accounts in Europe are safe."

Prove it! 

Require the banks to provide ultra transparency so that market participants can confirm this statement.

Schaeuble said the problem in Cyprus was that two large banks in Cyprus were in effect no longer solvent and the Cyprus government did not have enough money to guarantee savings. 

"That's why the other euro zone countries had to help," he said. "Together in the Eurogroup we decided to have the owners and creditors take part in the costs of the rescue - in other words those who helped cause the crisis."... 

"Yes, you could see that during the Cyprus crisis," he said. "The entire turbulence did not have any impact on the other countries in Southern Europe."...

Except for the fact that uninsured depositors are now quickly figuring out how to reduce their exposure so that all their deposits are insured.

Slovenia to make banks pay for existing losses out of their future earnings

Reuters reports that Slovenia has rejected the EU model of confiscating deposits to pay for losses currently on its bank balance sheets and has decided instead to make the banks pay for these losses out of their future earnings stream.

Regular readers know that your humble blogger has been arguing that in a modern banking system, banks are designed to absorb existing losses in the financial system and recapitalize themselves through retention of future earnings.  It is nice to see my ideas are gaining international attention and acceptance.

Clearly, the Slovenia government accepts my premise.

As for the implementation...

Slovenia has been thrown into the spotlight as the next eurozone country likely to seek an international bailout, given the fragile state of its banking sector.... 

Part of the uncertainty still surrounding the country is due to adjustments that the new governing coalition - led by Prime Minister Alenka Bratusek - has pledged to make to the original 'bad bank' proposal put forward by the previous Janez Jansa administration. 

One of the key tweaks now under consideration, according to RBS, is the creation of internal bad banks within each of the country's largest financial lenders, postponing any transfer of toxic assets to an external bank asset management company to a later date. 

"Initially, bad assets would be transferred to the internal bad banks and backed simply by government guarantees," said Abbas Ameli-Renani, an emerging market strategist at RBS.

By keeping the bad assets on the bank balance sheets, the source for paying off the losses on the bad assets is future bank earnings and not the taxpayer.

Under the original proposal, assets would have been transferred immediately to the BAMC in exchange for newly-issued government bonds.

This would have taken the banks and bankers off the hook for paying for the losses on the bad debt and instead socialized the losses and made the taxpayers pay for the losses on the bad debt.

While there will be a simultaneous recapitalisation of banks under both arrangements, the new version would not result in an immediate spike in the government's debt level, because the authorities would initially provide banks with guarantees rather than newly issued securities. 

One of the downsides, however, is that the plan will keep bad assets on banks' balance sheets and under the same management.

Keeping the bad assets on banks' balance sheets is not a 'bug', but a feature.  By making the banks absorb the losses on all the excess debt in the financial system, the government is establishing how much in the way of future earnings must be retained to recapitalize the banks.

Going forward, the banks will retain 100% of pre-banker bonus earnings until they have rebuilt their book capital levels.

As for the new guarantees, because of deposit insurance, the guarantees are effectively already in place.


Please note, market participants already know a) that the banks are hiding significant losses and b) that the Slovenia government is standing behind its deposit guarantees.  This is why the banks are still operating despite the fact that they would have a low or negative book capital level if the losses were recognized.

To avoid the bankers gambling on redemption or trying to hide the losses on the bad assets, going forward the Slovenia government should require that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert restraint on bank management behavior and ensure that the banks rebuild their book capital levels without excessive risk taking.

BBC's Robert Preston searches for how to restrain bank risk taking

In a terrific column, the BBC's Robert Preston examines how both bank regulators and Basel capital requirements failed in the run-up to the financial crisis and asks what can be done to restrain bank risk taking.  Mr. Preston proposes a cap on bank leverage as a solution.

Regular readers know that the only way to restrain bank risk taking is to subject the banks to market discipline by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is not the size of the bank nor the leverage that it has, but the riskiness of all of its exposures that needs to be restrained.

Leverage is the ratio between what banks lend and invest on the one hand and the capital they hold to absorb potential losses on their loans and investments. 

So all else being equal, which they never are of course, a bank with a lower leverage ratio is a safer bank, because it has relatively more capital to protect depositors from losses.

But that doesn't necessarily mean that you should always place your precious savings in the bank with the lowest leverage ratio: the bank with the low ratio might be lending and investing in a particularly reckless and risky way; although it might have more capital than other banks, its losses might turn out to be massively bigger than those other banks. 

That's why a low leverage ratio is not a guarantee that a bank is safe..... 

Please re-read the highlighted text as Mr. Preston makes a very important point that a bank's leverage ratio is not necessarily a good indicator of how much or little risk it has.

Dexia confirms this.  Dexia had one of the lowest leverage ratios as measured by the Basel capital requirements in the EU shortly before it was nationalized.

Here are the important points: riskier loans and investments provide bigger rewards to banks, until the loans and investments go bad; and capital is expensive for banks. 

Which is why governments did not trust banks to behave prudently if they were subject to a simple gross leverage restriction. 

The assumption was that if every bank was told it could not lend - for example - more than 20 times its capital, large numbers of those banks would lend everything they could to reckless gamblers prepared to pay the highest interest rates, till gamblers and banks went bust. 

Instead governments hired regulators to check that banks were not taking insane risks. And the regulators invented the Basel system of risk-weighted capital ratios, which stipulates different leverage ratios for different categories of loan, in theory to take account of the riskiness of those loans. 

To put it another way, governments set up a system that in effect treated bankers as naughty children or ravenous puppies who could not be trusted not to eat too much of the dangerously fattening stuff - and regulators were to be the health conscious parents. 

The perhaps predictable result is that the bankers lived up to the low expectations of their common sense, and devised ever more clever ways to raid the biscuit tin without being seen. And the regulators turned out to be the worst kind of parents: ignorant of what was really happening in the world; prescriptive in all the wrong ways....

In the many hundreds of pages of Basel rules in their assorted iterations since the 1980s, each bank became an amalgam of hundreds of different leverage ratios, reflecting the perceived riskiness of the different categories of the loans it made and indeed of the age and size of the bank....

With good intentions on the road to ruin, regulators through the Basel rules were trying to provide a framework in which the risks and rewards of lending were properly captured. 

In practice they did precisely the opposite: the Basel system provided the following arguably insane incentives: 

1) banks had incentives to become bigger and bigger, to benefit from "advance" status that rewarded them with relatively lower capital requirements; 

2) banks had a disincentive to know their corporate and personal customers, but instead had an incentive to insist that each loan was a mortgage backed by property - thus encouraging a dangerous boom in property lending; 

3) banks had an incentive to become huge in trading loans and investments; 

4) banks had incentives to convert risky loans into opaque AAA bonds that appeared - spuriously - to be safe. 

In other words, regulation in the form of the Basel rules contributed directly to so much that is wrong with today's banks....

Please re-read the highlighted text as Mr. Preston has nicely summarized why when it comes to restraining bank risk taking the combination of complex rules and regulatory oversight doesn't work.

Besides, all of the Basel capital requirements have been designed to provide opacity so that banks can increase their leverage and their return on book equity.

And the big banks could stick to the letter of the Basel rules and appear to be sound, when in fact they were massive, fiendishly complex and impenetrable institutions taking insane risks....

Please re-read the highlighted text as Mr. Preston makes the case for why banks should be subjected to market discipline and required to provide ultra transparency.

With ultra transparency, banks cannot hide behind the facade of appearing sound under either the complex Basel capital requirements or leverage ratios.

With ultra transparency, banks are no longer impenetrable institutions and their complexity and risks are exposed.

Now the 2008 Crash made it impossible any longer to pretend that the system of keeping banks on the straight and narrow was working. 

But government's response has been a bit skewed and odd. 

On the one hand, the collapse of the financial system has been taken as proof that bankers are incorrigibly, irredeemably naughty children. 

By contrast, there is a presumption that the regulators who got it so wrong - the useless parents - can be redeemed.

Who can forget former Treasury Secretary Tim Geithner assuring us that the regulators had learned their lesson from the 2008 Crash?

Actually, the response of the regulators and policymakers was predictable because they are simply continuing with their existing policy of financial failure containment and its corollary, the Geithner Doctrine.

One consequence is that the Basel rules that were so hopelessly flawed have been redrafted, and in the process have become even more complicated and impenetrable. 

And regulators have been given more powers to interfere in banks, to supervise them, and deter them from misbehaving. 

Some might say that the banks have been punished, and the regulators - who arguably were just as much at fault - have been rewarded.....

Actually, neither the banks or the regulators have ever been punished.

Which brings us back to where we started, the bloomin' gross leverage ratio. And it is to ask the question whether the global financial system, and the economies of developed countries like Britain, would be in such dire straights if banks had been subject to a simple leverage ceiling, limiting how much banks could lend in total, irrespective of the nature of their loans, as a multiple of their capital....

It brings us back to the issue of how to restrain bank risk taking as Mr. Preston has already acknowledge that a bank with a low leverage ratio can be carrying substantially more risk and incur far greater losses than a bank with a higher leverage ration and lower risk profile.

All that said, some might argue that this important debate still misses the big point. Because any leverage ratio is being seen - in Basel and Westminster - as a backstop, or only a bit of background insurance in case the Basel rules prove inadequate yet again. 

There is no serious discussion of the idea that a low leverage ratio should be the first line of defence, and that the Basel risk-weighting rules should be less prescriptive and more in the form of guidance....

The entire discussion needs to be taken off of leverage ratios or Basel risk-weighting rules.

The discussion needs to be focused on requiring the banks to provide ultra transparency and disclose on an ongoing basis their exposure details.  It is the exposure details that reveal the risk a bank is taking.

Ultimately, it is the amount of risk that a bank takes that needs to be restrained.  And the best way to limit bank risk taking is to have the investors who are first in line for absorbing any losses exerting discipline to restrain bank risk taking.

All of which is perhaps to point out that the terms of the debate about how to sanitise the bloated financial system have been set by a regulatory community whose legitimacy should perhaps have been destroyed but which still seems (amazingly?) to be in loco parentis.

Please re-read the highlighted text as Mr. Preston confirms Jeff Connaughton's observation about why Wall Street always wins.  The Blob (aka, policymakers, regulators and Wall Street's lobbyists) set the terms of the debate.

Do you think it is by accident that transparency is not in the discussion by regulators and policymakers as a means for restraining bank risk taking?

Are European policymakers about to trigger EU-wide bank run

Reuters reports that EU policymakers are looking at making bank depositors bear some of the cost of bailing out the banks in Cyprus.

Once established, this policy will apply to banks in Spain, Italy, France ... and the EU-wide run on the banks will be on as a) no one can tell if any EU bank is solvent and b) there is plenty of anecdotal evidence that none of the EU banks is solvent.

European policymakers are split over how to handle a bailout of Cyprus, with Germany and some other countries pushing for bank depositors to bear part of the cost and many other member states worried such a move will cause a bank run. 

Euro zone officials say momentum has built in recent days behind the idea of "bailing-in" Cypriot bank shareholders and depositors, although the specifics of how such an operation would be carried out have not been pinned down....

Germany, Finland and the Netherlands are among those who say taxpayers cannot be expected to go on financing euro zone bailouts, saying it is time for owners and depositors in risk-laden banks to accept losses on investments. 

The concern is that announcing such a move will provoke the immediate, large-scale withdrawal of deposits from all Cypriot banks, where a large number of international investors, including many Russian and British companies, hold accounts....

While Cyprus is the euro zone's third smallest economy with annual GDP of only around 18 billion euros, a bank run could have repercussions across the single currency bloc and re-ignite the debt crisis, officials warn. 

"We have to consider that risk," said one euro zone officials whose country is undecided about whether a bail-in of depositors is the right course of action. "It's a real option but some countries don't want it."

I happen to agree that unsecured bank debt and equity holders should bear losses.

However, the necessary condition for these investors to hold losses is that the banks provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

With this information, investors can assess the risk and solvency of a bank and can adjust both the amount and price of their exposure to a bank to reflect this assessment.  As a result of having the information on which to make an informed investment decision, the investor is responsible for all losses on their exposure.

Unfortunately, this is not the case.  As the Bank of England's Andrew Haldane says, current bank disclosure leaves them resembling 'black boxes'.

If they were only black boxes, then losses could be imposed on the gamblers who buy the unsecured debt and equity of these black boxes.

Banks are not just black boxes.  Banks are black boxes where the bank regulators have been making public comments about the content of these black boxes.  Specifically, bank regulators have been saying that they are solvent.

Oops.  How can you impose a solvency related loss on an investor who relied on the bank regulators' statements that the bank was solvent?

The simple solution is to realize that banks are designed to operate with low or negative book capital levels and to not bail out the banks.

By requiring the banks to provide ultra transparence, the market can exert discipline so that the bankers do not gamble on redemption as they retain future earnings to rebuild their book capital levels.

Is the banking system healthy?

The Washington Post carried an article in which it asked the question of is the banking system healthy and then tried to explain why it is despite the fact that bank stocks trade at depressed levels.

Regular readers know that in the absence of banks providing ultra transparency and disclosing their current global asset, liability and off-balance sheet exposure details, it is impossible to tell if the banks are healthy.

What is known is that financial regulators suspended mark to market accounting and engaged in regulatory forbearance that allows the banks to engage in 'extend and pretend' and transform non-performing loans to 'zombie' loans.

The fact that neither of these policies have been reversed and the banks don't voluntarily provide ultra transparency suggests the banks are hiding massive amounts of losses.

In addition, as the article notes, the banks have tremendous potential for litigation related losses.  Despite a number of get out of jail free cards from the Obama Administration, see mortgage servicing and mortgage backed securities, there are numerous other examples of bad bank behavior, like manipulating Libor, that could give rise to losses that render the banks insolvent/needing to be closed.

On paper, the nation’s banks are making a comeback: More money is being set aside in case of trouble, there are fewer losses on loans and there is less reliance on volatile funding. 

What has happened on paper has been incredibly good for the bankers in terms of the bonuses that they have received.

Put that is only on paper that is easily manipulated by both the banks and their regulators to provide the impression of financial health when in fact the bank could be insolvent (see all the EU banks that failed shortly after the regulators pronounced them well-capitalized as a result of a stress test).

Too bad the markets don’t seem to care.

The market aren't fooled by paper.

One of the reasons that nobody is fooled is that each of the banks knows how much it is hiding in the way of losses on its balance sheet as a result of regulatory forbearance and suspension of mark to market accounting.

Another reason that the market is not fooled is that banks with deposits to lend know that in the absence of ultra transparency they cannot evaluate the solvency and risk of banks that are looking to borrow.  As a result, the unsecured interbank lending market remains frozen.  This is a red flag!

Despite the strides banks have made to repair their balance sheets since the financial crisis, their stocks are trading below book value. Wall Street remains skeptical about the overall health of these institutions, even as profits have soared in the past year. 

But why? 

“Investors expect more losses ahead,” said Mark Williams, a former bank examiner who teaches finance at Boston University. “Many of these banks still have loans that could go bad if the economy goes south.”...

Investors know that with current disclosure practices the banks are black boxes that cannot be evaluated.  Investors cannot determine how many zombie loans a bank has or make an estimate how many loans will go bad if the economy goes south.

What investors do know is the fact that banks refuse to provide ultra transparency so investors can answer these questions.  This is a big red flag that banks have something to hide.

The largest banks have also been engulfed in a sea of litigation with no clear end in sight, Williams said. Dozens of cases brought by investors who claim they were misled about securities deals are still winding through the courts. 

Meanwhile, prosecutors have yet to reach agreements with many of the banks, including JPMorgan Chase, Bank of America and Citigroup, being investigated for manipulating the global interest rate known as Libor. Resolution of these investigations could take another year at least, placing an ominous cloud over some of the nation’s largest institutions. 

Regulators, nonetheless, are encouraged by gains in the banking system that point to continued improvement of a once beleaguered industry. 

Testifying before the Senate Banking Committee last week, Thomas Curry, the comptroller of the currency, said conditions at the more than 1,800 banks his agency supervises continue to improve.

One of the problems that led to the financial crisis was bank regulators making misleading statements about the financial condition of the banks.

Mr. Curry's commets are an example of this.  Investors know that the banks could all be insolvent and Mr. Curry would be saying that their condition is improving as conveying the true financial condition of the banks violates the principle of say nothing bad about the banks for fear of risking the safety and soundness of the financial system.

The way to end the regulators saying anything about the banks is to require the banks to provide ultra transparency.  Then there is no reason for the regulators to offer an opinion as market participants can assess the solvency and risk of each bank for themselves.

“The banking system is arguably as strong as it has ever been,” Mark Zandi, Moody’s Analytics chief economist, said. “Capital is at record levels, and there is ample liquidity. Credit quality is good and improving rapidly.”

The counter argument could also be made:  the banking system has never been weaker as low interest rates are reducing bank net interest margins and earnings, credit quality continues to deteriorate as unemployment rates remain at elevated levels, and bank book capital has no basis in reality as a result of suspension of mark to market accounting and regulatory forbearance.

BoE says that Lloyds and RBS need billions more in capital

The Telegraph reports that the Bank of England has said Lloyds and RBS need billions more in capital to shore up their balance sheets.

This "news" confirms that the Swedish Model and not the Japanese Model is the appropriate choice for handling a bank solvency led financial crisis.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt in the financial system.  This protects the real economy and eliminates the need for policies like austerity that undermine the social contract.

A modern financial system is designed so that banks can protect the real economy by absorbing the losses on the excess debt.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

This combination allows the banks to continue operating and supporting the real economy while they have low or negative book capital levels because deposit insurance makes the taxpayers the silent equity partners of the banks.

The need for billions more in capital is an explicit confirmation that a modern financial system works as designed.  These banks have been operating with we now find out were low or negative book capital levels for the last several years after the losses hidden on their balance sheets have been taken into account.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  One of the policies adopted to achieve this goal was to bailout the banks.

The need for billions more in capital also confirms that the bailouts under the Japanese Model were unnecessary.  Again, the banks operated just fine with the taxpayers as silent equity partners.

Finally, the need for billions more in capital confirms that the only beneficiaries of the Japanese Model are the bankers.  Think of all the money paid as cash bonuses by these banks since the beginning of the financial crisis.

Cash bonuses that would not have been paid had the Swedish Model been pursued and banks required to retain 100% of their pre-banker bonus earnings until their book capital levels had been rebuilt.

UK regulators have given Royal Bank of Scotland and Lloyds Banking Group until March to begin dealing with a black hole that Brooks Newmark, a Tory member of the Treasury Select Committee, suggested could be as large as £30bn. 

Bank officials refused to quantify the capital shortfall in evidence to the TSC yesterday, but they confirmed it was substantial. Michael Cohrs, a member of the Bank’s Financial Policy Committee, said it was “a big number” while Andy Haldane, the Bank’s executive director for financial stability, agreed it was “material”. 

The warning came as regulators admitted that the government had overpaid when rescuing the banks in 2008 and that the taxpayer would never make as large a profit from the bail-outs as the US, if at all. 

Asked whether returns for the UK taxpayer might match the 15pc made in the US, Mr Cohrs said: “I don’t think the UK taxpayer will get those returns.” Pressed on whether the taxpayer would make a profit at all, he added: “I don’t know.” 

Sir Mervyn King, the Bank’s Governor, said: “The sad truth is, in 2008, the idea of focusing efforts on recapitalising the banking system was a UK idea. We got there first but, like many UK ideas, the Americans developed it faster and better.”...

Given that both the UK and US have modern financial systems, the bailouts were unnecessary in the first place.

Although RBS and Lloyds will have to take action to boost their capital, the taxpayer may not have to inject any more than the £65bn already invested, the regulators said. 

The two banks can sell assets or “reduce their investment bank balance sheets, for instance”, Andrew Bailey, head of prudential regulation at the Financial Services Authority, suggested....

Of course there is a third alternative, the banks can boost their capital by retaining 100% of pre-banker bonus earnings.

The UK’s other banks and building societies are under similar regulatory scrutiny, following the FPC’s warning in November that the industry had up to £60bn of hidden losses on its balance sheet – from understated bad debts to underestimated provisions to cover fines and compensation for Libor rigging and other scandals. 

Lloyds and RBS need billions more in capital despite a taxpayer funded bailout that supposedly took into account all the losses hidden on and off their balance sheets.

Given that the UK financial regulators appear to have under-estimated the true amount of capital Lloyds and RBS needed, there is no reason to believe that the FPC's estimate does not suffer from the same problem.

The only way market participants will ever know if the banks are solvent again is if the UK requires its banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency will give UK banks a global competitive advantage.  Market participants will be able to assess the risk of the banks and adjust the amount and pricing of their exposure to the banks based on each bank's risk.

At the same time, market participants know that any bank not providing ultra transparency is undoubtedly hiding something and is far riskier than the UK banks.  As a result, market participants will require a higher return to provide capital to these banks.  This gives the UK banks a competitive advantage until the other banks also provide ultra transparency.

The FPC wants capital positions reinforced to support economic growth....

Regular readers know that it reinforcing bank capital positions is not necessary to support economic growth.  The solution so that credit is available to support economic growth is the originate to distribute model with transparency.

Under this model, structured finance securities ranging from covered bonds to securitizations provide observable event based reporting on all activities like payments or delinquencies on the underlying assets by the beginning of the next business day so that investors can know what they own.

It is the ability to know what you own or know what you are buying that will bring investors back to the structured finance securities and insure that there is sufficient capacity to support economic growth.

Sir Mervyn argued the best course of action was to deal with a lack of capital “straight away”. “Banks have two options – either they raise more capital or they restructure... Investors may not like it, but they will be better off over time,” he added.

Sir Mervyn is wrong.

The best course of action is to adopt the Swedish Model and the originate to distribute model with transparency.

Mr Bailey said: “If you want to sell the Government’s shareholding [in RBS and Lloyds], you have to have a balance sheet and business model that have a stable future.” The taxpayer owns 41pc of Lloyds and 82pc of RBS.

Spain confirms that insolvent banks can continue operating

Your humble blogger has frequently said that modern banking systems are designed so that banks can continue to operate even when they are insolvent (whether or not their book capital levels reflect this insolvency).

Banks can continue operating when the market value of their assets is less than the book value of their liabilities because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, when the banks become insolvent, taxpayers become their silent equity partner.

The Spanish government confirmed this statement while setting up its plans to needlessly use government debt to recapitalize several banks.  Each of these banks was operating before its state rescue and it is only now that the extent of their insolvency is being acknowledged.

As reported by Reuters,

Spain's bank restructuring fund has unveiled a negative valuation of three state-rescued banks ahead of an injection of European funds to recapitalise the troubled lenders. 

Galician lender NCG Banco is worth a negative 3.09 billion euros (2.51 billion pounds) and Catalunya Banc a negative 6.67 billion euros, the restructuring fund FROB said in a statement late on Monday. 

It said the valuations would serve as basis for the amount of European aid it will give the nationalised lenders in coming days. 

The FROB last week received 40 billion euros in euro zone funds to resolve its sickly banking sector after a burst property bubble. 

Banco de Valencia, which was recently sold to Caixabank (CABK.MC: Quote, Profile, Research) for a symbolic one euro, was valued at a negative 6.34 billion euros.

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.....

Deutsche Bank: Show of strength or fiction shows ultra transparency necessary

A follow-up article in the Financial Times on Deutsche Bank potentially hiding $12 billion in losses confirms the Bank of England Financial Policy Committee's call for banks to come clean about the losses hiding on and off their balance sheets.

Regular readers know that for banks to come clean requires that it is necessary they provide ultra transparency.  Without the ongoing disclosure of a bank's current global asset, liability and off-balance sheet exposure details, it is impossible for market participants to independently confirm that the bank has come clean about its losses.

In the absence of ultra transparency, investors have reason to doubt claims by either the bank's management or the bank's regulators that the bank's balance sheet has been cleaned up?  The mere fact that the bank is unwilling to provide ultra transparency raises a bright red flag saying that the bank has something to hide.

Confirmation that the investors see this bright red flag comes from the frozen interbank lending market. Banks with deposits to lend know they cannot assess the risk of the banks looking to borrow because of the lack of ultra transparency and therefore they are unwilling to lend.

Josef Ackermann was bullish. Even as the global financial industry was reeling, the Deutsche Bank chief executive began 2009 by boldly declaring that his bank had plenty of capital and would return to profit that year. 

In an investor call that February, Mr Ackermann said he would provide “as much clarity as we can on all the positions” to refute the suggestion that banks such as his had “hidden losses, and one day that will pop up, and then ... we need more capital and the only way to go – to ask for capital – is to see the governments”. 

Please note what Mr. Ackermann claimed the bank would do:  provide as much clarity as we can on all positions to refute the suggestion the bank has hidden losses.

The only way to have met this standard would have been to provide ultra transparency and disclose the individual exposure details.  Since the beginning of the financial crisis, Deutsche Bank has never provided ultra transparency and the individual exposure details.

As a practical matter, I am not sure that they have provided any other type of disclosure beyond what is necessary to maintain the bank's balance sheet as a "black box". 

During the public relations campaign waged by Deutsche, its share price recovered from €16 in January to €39 at the end of April 2009, when it reported pre-tax profit of €1.8bn for the first quarter. 

But three of the bank’s former employees say the show of strength was based on a fiction. 

In a series of complaints to US regulators, two risk managers and one trader have told officials that Deutsche had in effect hidden billions of dollars of losses. 

“By doing so, the bank was able to maintain its carefully crafted image that it was weathering the crisis better than its competitors, many of which required government bailouts and experienced significant deterioration in their stock prices,” says Jordan Thomas, a former US Securities and Exchange Commission enforcement lawyer, who represents Eric Ben-Artzi, one of the complainants....

A series of complaints that Deutsche Bank naturally dismisses, but that investors need to take seriously as the lack of ultra transparency casts doubts on its financial reporting and solvency.

By 2012, many of the trades have matured or have been unwound. With credit markets back to more normal levels, Deutsche’s dalliance with exotic derivatives is no longer life-threatening. A person familiar with the matter says that for all the sturm und drang over gap risk, at no time was the collateral jeopardised.

First, how do we know that Deutsche's involvement with exotic derivatives is no longer life-threatening given the lack of ultra transparency?  Perhaps the bank has a different exposure.

Second, that many of the trades have matured or have been unwound does nothing to address the fact that without ultra transparency no one can tell if Deutsche is solvent or not.

But the three former employees told the SEC that this outcome does not mean the allegations should be forgotten. 

“If Lehman Brothers didn’t have to mark its books for six months it might still be in business,” says one of the men. “And if Deutsche had marked its books it might have been in the same position as Lehman.”

Please re-read the highlighted text as in confirms the second important reason why ultra transparency is necessary.  With ultra transparency banks are subject to market discipline so that they do not take on risks that might ultimately result in their being in the same position as Lehman.

China faces hidden risk of 'shadow finance' led financial crisis

It appears that China is going to experience its version of the 2008 structured finance meltdown that almost brought down the global financial system.  The Wall Street Journal carried an article that highlights how loans made by China's opaque shadow finance sector may be coming back to haunt its banks.

The solution for China, just like it was and is for shadow banking in the EU, UK and US, is to bring transparency to the shadow finance sector.

Specifically, China should require that there be observable event based reporting for all activities like a payment or delinquency involving the underlying loans before the beginning of the next business day.

With this disclosure, investors could independently assess the risk of the loans and would know what they own.

Mr. Wang's case highlights the hidden risks to banks from their links to China's fast-growing "shadow-finance" industry, a term for all types of credit outside formal lending channels. 

Shadow finance in China totals about 20 trillion yuan, according to Sanford C. Bernstein & Co., or about a third the current size of the country's bank-lending market. In 2008, such informal lending represented only 5% of total bank lending. 

China's shadow-finance industry has experienced similar growth to the global shadow banking system in the years leading up to the financial crisis.

The sector is lightly regulated and opaque, raising concerns about massive loan defaults amid a softening economy, with ancillary effects on the country's banks. 

Just like the shadow banking system, China's shadow-finance industry is lightly regulated and opaque.  As a result, no one knows what is going on.

Banks often work with private lenders by selling loans to them or marketing investments on their behalf for a fee. 

"Regular banking and shadow banking are not isolated from each other. Many activities in the two systems feed into each other, and could influence each other if things start to deteriorate," wrote Xiao Gang, chairman of Bank of China Ltd., in an editorial in the China Daily newspaper. 

Although China Credit has the legal responsibility to repay investors, according to Chinese law, "for reputation's sake and potential social stability reasons, a portion of these loans can be banks' contingent liabilities," said David Cui, China strategist with Bank of America Corp.'s BAC -0.66% Merrill Lynch unit. 

Just like the shadow banking system, nobody knows what the exposure of the regulated banks are to the shadow banks.  As a result, nobody knows if the regular banks are solvent or insolvent.  This sets the stage for a systemic financial crisis.

Others agree. "Banks might be held liable if bank representatives didn't adequately evaluate the products' risks for their clients," said Peng Junming, a former official at the People's Bank of China who now runs his own investment firm, Empire Capital Management LLP.

With opacity and a lack of observable event based reporting, it is impossible for the banks to have adequately evaluated the products' risks for their clients.

Just like shadow banking leading up to the beginning of the financial crisis, China's version of shadow-finance is a powder keg ready to blow up.

Experienced bankers might have saved failed UK bank

By asserting that experienced bankers might have saved a failed UK bank, George Mitchell, an ex-bank direct provides another reason for requiring banks to provide ultra transparency.

When banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, independent, experience bankers can look at this information, see if the banks are taking on excessive risk and bring market discipline on those banks who are taking on too much risk.

As reported by the Telegraph,

George Mitchell, chief executive of the bank’s corporate division until the start of 2006, said HBOS’s failure was caused by “aggressive growth” in 2006 and 2007 that left it loaded with bad debt. 

As a result, it was more vulnerable than rivals when the panic struck in 2008 because the market knew its loans had been made at the peak of the boom. 

Addressing the Parliamentary Commission on Banking Standards (PCBS), he said: “It was the rapid rate of loan growth, not just in corporate but the whole of HBOS, while others scaled back that spooked the market ... and led to HBOS being disproportionately impacted. Any bank that had grown at that speed in 2007 would have had the same difficulty.”...

Giving evidence to the PCBS, Mr Mitchell rejected the idea that HBOS was felled by a shortage of deposits – its notorious “funding gap”. He said the market lost confidence in the bank due to the high levels of risk on its books.

Markets knew HBOS had risk from when they were making their loans, but without disclosure of the exposure details, the market had no way of telling how risky the loans were.

As a result, HBOS was particularly vulnerable to a loss of confidence.

“It was the aggressive growth not the quantum [of wholesale funding] that was the problem. When markets have lost confidence, the amount [of funding] you want becomes partially irrelevant... You won’t get it,” he said....

Regular readers know that transparency is the foundation for confidence in the financial markets, particularly for banks.

With ultra transparency, market participants can do their own independent assessment of a bank like HBOS.  Market participants have confidence in their own independent assessment and as a result they can have confidence in the amount and price of their exposure to a bank like HBOS.

Mr Mitchell claimed that had he remained head of corporate between 2006 and 2008 it would have grown more slowly. “Corporate lending is all about knowing when to lend and at what part of the cycle. When I left it was becoming increasingly difficult to source transactions with the right risk profile,” he said....

“Its important to know where you are in the cycle. It wasn’t they type of lending but the quantum of growth – and that doesn’t just go for corporate but the whole of HBOS,” Mr Mitchell said. 

“Whilst it postdates my departure, I think it is fair to say that more directors with direct banking experience may have been beneficial as the financial crisis took hold.”

Bottom line, if market participants had seen the lending risks that HBOS was taking on, they could have exerted market discipline to restrain its risk taking before HBOS got itself into a position where it could not be saved.