European Commission cites risk of financial contagion to defend not restructuring Greece debt earlier

The Guardian reports that the European Commission is defending its failure to restructure the Greek (Irish, Portuguese, Spanish, ...) debt at the outset of the financial crisis citing the risk of financial contagion.

And what is financial contagion?

In theory, financial contagion is a domino effect through the banking system where the failure of one banks triggers the failure of other banks.

But does financial contagion exist in our global modern banking system?

No.  Banks have the capacity to absorb significant losses as they are designed to be able to operate with low or even negative book capital levels and still support the real economy.

Banks are able to do this because of the combination of deposit insurance and access to central bank funds.  With deposit insurance, taxpayers effectively become the banks' silent equity partner when they have low or negative book capital levels.

But don't banks need to be recapitalized immediately after they have absorbed the losses on the excess public and private debt?

No.  Again, the taxpayers are effectively backstopping the banks, so it is as if the banks had unlimited equity.  As a result, the banks can rebuild their book capital levels over several years by retaining 100% of pre-banker bonus earnings.

But won't depositors get nervous if the banks have low or negative book capital levels?

No.  There are two types of core depositors.

One type holds deposits that are below the deposit guarantee level and they trust that the government will honor its guarantee.

The second type of depositors is a business that has a reason, like making payroll, for holding deposits with the banks.  They too are insensitive to how much capital the bank has unless policymakers and financial regulators plan on seizing these excess deposit a la Cyprus to bail-in and recapitalize the bank.

So why are policymakers citing the risk of financial contagion to defend themselves against not restructuring excess public and private debt sooner?

Because policymakers were following the advice of the bankers advising them.  As shown by the European Commission, it was easy to succumbed to the irresistible temptation to push the losses onto the taxpayers and "protect" the banks.

In reality, all putting the losses on the taxpayer did was to protect the bankers' bonuses and shift who suffered as a result of the losses from the banks to the taxpayers.

The IMF criticism and the commission's defence of its performance boil down to a dispute over whether Greece's staggering debt level should have been restructured early in 2010 when the troika was fixing the terms for the bailout. 

While the IMF takes the view now that it was a cardinal error not to restructure, the commission argues strongly that there were too many unknowns, the risks were huge, such a move could have unleashed a rollercoaster of panic across the eurozone, and there was not yet any real eurozone firewall or bailout funds in place.

Actually, all the necessary firewalls have been in place for decades.

It would have been armageddon for banker bonuses, but this seems like a reasonable outcome given that the bankers were the ones who took on the risk in the first place.

"Even assuming it was inevitable and the only solution, the risks associated with an early Greek debt restructuring were huge," according to the commission. 

The European Commission is confirming that it knew what the only solution to end the financial crisis was (adopt the Swedish Model and require the banks to recognize the losses upfront) and that it instead chose to protect bank balance sheet and banker bonuses at all costs (the Japanese Model).

"The whirlpool in the financial markets in early 2010 was only beginning to subside, the banking system was extremely fragile and it was not possible to estimate financial and psychological effects of the largest bond restructuring in history or its potential ripples to the real economy of the euro area. Against this background, later restructuring allowed for time to build firewall capacity. An earlier restructuring would have also entailed risks of systemic contagion."

By 2010, governments around the world had put the financial system on life support.  Recognizing the losses that everyone knew were on the bank balance sheets would not have triggered panic.  In fact, it would have triggered relief.

Later restructuring allowed the banks time to offload their losses onto the taxpayers while the bankers continued to pocket their bonuses.  Not a good outcome for the taxpayers.

Charles Hugh Smith: The real Cyprus template

Regular readers know that at the beginning of the financial crisis, global policymakers and regulators operating under the policy of financial failure containment adopted the Japanese Model for handling a bank solvency led financial crisis.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.

In a must read post, Charles Hugh Smith examines the Cyprus bank bailout and one of the ways that banks are protected.

It appears the key preliminary step of the Real Cyprus Template is that money-center banks in Germany and other "core" Eurozone nations pull their money out of the soon-to-implode "periphery" nation's banks before the banking crisis is announced. 

As David observed, "I think this explains a lot about something that has always puzzled me: why the delay in resolving Cyprus after the Greek haircut?" 

"The Cyprus situation had been simmering for at least a year when in March of 2013 it finally broke; Cyprus had a week to take care of its banking situation or else face a cutoff of access to the eurosystem by the ECB. 

This brought matters to a head; the Cyprus Bail-In was finally settled upon, where uninsured depositors in the two largest banks in Cyprus took major haircuts, and must wait for return of their money until the assets of the banks are run down. 

The banking problems in Cyprus had their roots in the Greek Sovereign Default, and were known by the general public for about a year prior to the recent default; a New York Times article dated April 11, 2012 lays out the particulars. 

Looking at Cyprus bank security assets in data provided by the ECB, the problems were visible earlier - right after the first Greek haircut in mid 2011, and a second haircut finalized in early 2012. This was a 11 billion euro hole in a system with 100 billion in assets total, centered upon two banks that held half the deposits in the system.....

So why did the eurozone wait so long to resolve the problematic Cypriot banks with their 11 billion euro hole that was clearly serious in the middle of 2011, and becoming blindingly obvious by 2012? 

Therein lies a story - it has to do with banking, and how banks make money. The explanation is a bit complicated, but bear with me. 

Bank deposits are grouped into 3 primary categories: deposits from households, from corporations, and from other banks. Households and corporations typically have a long standing relationship with their bank; they only move their deposits slowly, and most of this sort of depositor uses time deposits to maximize their interest income. Deposits from other banks are what we might term "hot money." They arrive quickly, and depart just as fast. But why would a bank deposit money with another bank? The simple explanation is: interest rate spreads. 

Let's imagine you ran a German bank, and you paid very low rates to your overnight depositors. You have a great deal of really cheap money on your hands. What are your options to make money? ....

Rate	Deposit Type & Location
0.55%	German Overnight Deposit
1.1%	Cyprus Overnight Deposit
2.8%	Cyprus Savings Deposit (1 year)
4.9%	Cyprus Time Deposit (1 year)

Now then, if the Bank of Cyprus doesn't go under, this is free money. ....  But the key to this free money is, your bank must be able to get its money out of Cyprus prior to any trouble. 

And the barrier to getting the bank's money back is those Time Deposits (the deposits paying the most interest) are stuck in Cyprus for a year. So in order to avoid loss, you have to see into the future one year and stop rolling your bank's time deposits one year before those Cyprus banks go under. Otherwise you will have collected that 4.9%, then suffered a 30-60% uninsured depositor haircut. And a haircut is not a good way to ensure your banker bonus for the year. 

So with this hypothetical strategy in mind and being mindful of the dangers of default and the timeline of when things occurred, take a look at the following chart of "foreign deposit sources" (deposits in Cyprus banks that originated from outside Cyprus) and see for yourself how well each foreign participant did in anticipating the eventual banking system crisis.... 

Looking at the timeline, even as late as the end of 2011, when it was clear Greece would default and the banking regulator had to know the banks in Cyprus were doomed, the amount of Eurozone-bank derived deposits in Cyprus was over 20 billion euros, a good portion of which would be subject to massive losses if the Cyprus Template were to be applied at that moment....

But at that moment, as a result of the "collecting the spread" strategy, some big chunk of that money were likely in time deposits, unable to be withdrawn. That money couldn't flee, not just yet. 

But as time passed, those Eurozone bank deposits were slowly reduced down to 10 billion euros, a reduction of 50%. Presumably, as the time deposits expired, the money was brought back to the fatherland....

At the same time, the ECB would have been increasing its funding of the Cyprus banks and hence its ability to force the bail-in.

In looking at the movement of capital prior to the default, we can give a grade to each participant, as a result of their apparent ability to assess the the danger to their deposits.
The clear winner: Eurozone Banks. Those guys were geniuses. They were the only participant to seriously reduce holdings prior to the default. 

Participant	Grade
Eurozone [German & French] Banks	B+/A-: almost perfect
Cyprus People & Businesses	F: completely unaware
Cyprus Banks	C-: slightly more aware
Banks Outside Eurozone	F: completely unaware
Russian Mobsters	F: completely unaware

So it is expected (and a bit sad) that households and businesses don't leave their banks readily, so its not surprising they stayed on board right up until the end. 

What is fascinating to me is that the banks that were NOT in the eurozone clearly had no idea what was coming, and the banks actually ON Cyprus only had an inkling, and that only at the last minute. 

Given both the timing and the form of the Cyprus bank resolution was in the hands of the ECB, as well as French and German politicians, is this astounding ability of the Eurozone banks to avoid losses truly a surprise?...

One last point. Since now we understand how perfectly the well-connected eurozone banking establishment identifies issues in member nation's banks, and how adept it is at avoiding uninsured depositor haircuts, we might find it useful to watch deposit flows of these Eurozone banks going forward.... 

We can now see there are two Cyprus Templates:
1. The public-relations/propaganda model
2. The real one, that enables "core" eurozone banks to pull their deposits out of periphery banks before the deposit expropriation and capital controls kick in. 

Why are we not surprised the entire charade and expropriation is rigged to benefit the core banks?

Slovenia looks at how to rebuild its banking system

A Bloomberg article discusses how Slovenia needs to rebuild its banking system and the question of whether it needs outside resources to do so.

Regular readers know that the starting point for rebuilding a banking system is transparency.

It is only by having Slovenia's banks disclose their exposure details that the process of rebuilding can credibly begin.  Your humble blogger says this because without exposure detail disclosure, there is no way for market participants to know if each bank has recognized all of its losses or if it is still hiding losses.

Once each bank has recognized its losses, the question that must be asked is:  does the interest income on the bank's assets exceed the sum of the interest expense on its liabilities and its operating expenses pre-banker bonuses.

• If yes, the bank is capable of rebuilding its book capital levels and nothing more needs to be done.

• If no, the bank is not capable of rebuilding its book capital levels and should be shut down.

With this simple plan, Slovenia should be able to rebuild its banking system and, because of ongoing transparency into each bank's exposure details, prevent a similar problem from recurring.

Jazbec needs to restore public confidence at home and investors’ faith abroad in Slovenia’s banks as the economy struggles with its second recession since 2009, sparking a rash of corporate bankruptcies that have saddled lenders with a pile of bad debts. 

“The problems aren’t insurmountable,” Jazbec, who helped set up Kosovo’s central bank, said in an interview late yesterday. 

“We know we have to rebuild the banking system. With a common effort from all policy makers we can carry this through to ensure that assistance from outside the country won’t be needed.”

By making use of future bank earnings and transparency, Mr. Jazbec is likely to be proved right.

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.

Guardian's Seamus Milne calls for change in policy to save real economy

In his Guardian column, Seamus Milne channels what your humble blogger has been saying since the beginning of the financial crisis and makes the case for adopting the Swedish Model for handling a bank solvency crisis to save the EU and UK economies.

Europe's flesheaters are back. The claim that the worst of the eurozone crisis is behind us now looks foolish.

Please recall that your humble blogger predicted at the beginning of the financial crisis that until transparency was brought to all the opaque corners of the financial system that the global economy would spiral downwards (despite the best efforts at economic stimulus by central banks and governments).

The deal forced on Cyprus by the German-led Troika at the weekend isn't a bailout: it will effectively destroy the island's economy. Instead of getting a grip on its grossly inflated banks, it will impose a brutal credit contraction, combined with sweeping cuts and privatisations, wiping out perhaps a quarter of Cyprus's national income. Ordinary Cypriots, not Russian oligarchs, will pay the price. 

Of course Cypriot politicians are to blame for having allowed the country to be turned into an adjunct of a bloated financial sector and a refuge for hot Russian money. 

But what tipped the divided island over wasn't foreign investors' sharp practices, but the impact of Europe's wider crisis on its banks: in particular, their exposure to devastated Greece, currently also in the Troika's tender care. 

Some have hailed the fact the raid was carried out on Cypriot bank deposits over €100,000, rather than the public purse. 

At last the rich and those responsible for private banking failures are being made to cough up, it's been said. Which would have been a good thing. But it's savers, not bankers or shareholders, who are taking the 40% hit.  

And many of the targeted depositors, such as pensioners, are scarcely rich – or are small businesses which will now go bust. 

The Cypriot government should instead have learned from Iceland: taken over the banks, isolated the bad loans, protected deposits, imposed losses on the wealthy, and used a publicly owned banking sector to rebuild the domestic economy. That would have offered its citizens a better future, almost certainly outside the eurozone. 

But it would have also encroached on private capital's privileges and clearly couldn't be tolerated. ...

Please re-read the highlighted text as Mr. Milne has nicely summarized the benefits of the Swedish Model and why bankers are vehemently opposed to its adoption.

As the Greek economist Costas Lapavitsas argues, Cyprus has "reactivated" the European banking crisis. 

Not that it had been resolved. Only last month the Dutch government was forced to nationalise the Netherlands' fourth biggest bank, SNS Reaal, partly because of its over-exposure to losses in Spain.... 

Now the Troika's decision to help itself to Cypriot savings has paved the way for a new contagion. In the short term that may be contained because of the island's minuscule proportion of eurozone output. 

But the move has demolished confidence in bank deposits – a point rammed home by the Dutch finance minister's blundering signal that the deal had set a precedent. That could easily turn into bank runs in states likely to need new bailouts, as investors move cash to safer locations.

Safer locations like German government debt and not Deutsche Bank deposits.  Safer locations like money market mutual funds invested in UK or US government debt and not EU or UK banks.

Given the spectacular failure of austerity across the continent to overcome the crisis, rather than deepen it as output shrinks and debts mount, more such breakdowns are clearly on the cards.

The choice of austerity or stimulus didn't matter for ending the financial crisis.  If stimulus, all that was going to happen is the stimulus would ultimately be swallowed by the burden of debt service on the excess debt in the financial system.

Stimulus could buy a short-term reprieve from the downward spiral, but once the stimulus ended, the real economy would resume its contraction as money needed for growth and reinvestment was diverted to debt service on the excess debt.

The eurozone has now become a zombie zone.... 

Whatever the focus of the meltdown in each country – banking in Cyprus, property in Spain – all flow from the same crisis that erupted in 2007-8 out of a deregulated profit-hunting credit boom across the western world and has delivered a prolonged depression....

In Britain, the power and weight of the City of London are a particular block on sustainable recovery. 

But across Europe, people are being held to ransom by banks, bondholders and corporations determined to ensure that it's not they who bear the costs of the crisis they created – and politicians who regard it as their job to oblige them. 

Please re-read the highlighted text as Mr. Milne nicely summarizes why we have made no progress to addressing the underlying issues that caused the financial crisis and why the financial crisis continues.

Savers will be raided to pay for hidden bank losses

As reported by the Telegraph, the EU has decided that the way to break the bank-sovereign link is to have savers pay for the losses still hidden on the EU bank balance sheets.

This is a very important change in policy because savers have no way to assess the risk of the banks and therefore how much of their money will be seized to pay for the hidden losses.  A point that the Bank of England's Andrew Haldane made abundantly clear when he referred to banks as 'black boxes'.

EU policy makers would like savers to trust some combination of high capital ratios and the stress tests run by financial regulators.  However, there is absolutely no reason for savers to trust either the book capital reported by the banks or the results of the stress tests.

The history of book capital is that it is easily manipulated by both the financial regulators and the bankers.  As the OECD pointed out, regulators manipulate it by suspending mark-to-market accounting.  They also manipulate it by engaging in regulatory forbearance which allows the bankers to engage in 'extend and pretend' with their non-performing loans and turn them into 'zombie' loans.

The history of the stress tests is that passing the test with high capital ratios is not a good predictor that the bank will not subsequently be nationalize/closed due to insolvency.  This was shown first with the Irish banks, subsequently with Dexia and most recently with the Cyprus banks (July 2011 Cyprus banks pass stress tests).

What made the US stress tests "successful" was former Treasury Secretary Tim Geithner pledging the full faith and credit of the US to provide all the capital necessary to support the insolvent banks.  Previously, the EU made the same representation about its stress tests.

Regular readers know since the beginning of the financial crisis your humble blogger has been saying that if the policy makers and financial regulators want the unsecured creditors of the banks to be responsible for absorbing losses, the banks must first provide ultra transparency.

It is only when the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details that market participants have the information they need to assess the risk of the banks.

Under the FDR Framework, it is only when market participants have access to all the useful, relevant information in an appropriate, timely manner, which is what ultra transparency is, that market participants become bound by the principle of caveat emptor (buyer beware) and responsible for losses.

Without ultra transparency, savers, including large depositors and other unsecured creditors, are being asked by EU policy makers to blindly gamble on the contents of a black box.  Why should they?

I understand the reluctance of the EU policy makers and financial regulators to require the banks to provide ultra transparency before they seize the savers' money.  Ultra transparency will show just have negative the book capital level is for each bank.

Fortunately, it is not a problem if market participants know how negative the book capital level is for banks as banks are designed to operate with low or negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

Deposit insurance effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.  As a result, banks can continue to lend and support the real economy.

Your humble blogger has proposed on numerous occasions how to transition so that investors are responsible for losses:

1. Require banks provide ultra transparency.
2. Continue to protect large depositors and unsecured debt holders on all investment made at each bank until 6 months after the bank has begun providing ultra transparency.  This gives market participants a chance to assess the risk of the bank.
3. All new large deposits or unsecured debt purchased after the 6 month period has elapsed is subject to being bailed-in.

At the same time that investors become responsible for losses, the banks become subject to market discipline.

EU's Rehn asks for suggestion on how to get credit flowing in EU again

In defending the EU's austerity policies, the EU's top economic official, Olli Rehn, asked for a suggestion on how to get credit flowing again in Europe that was both financially and politically feasible.

If EU policymakers actually saw themselves as being responsible to the citizens of the EU, this is easy:  require the banks to absorb upfront the losses on the excess public and private debt in the financial system.

This would immediately restore growth in the EU and set the stage for credit to flow again.

Why?

Three primary reasons:

1. It ends the diversion of capital the real economy needs for growth, reinvestment and social programs from servicing the excess debt.  With growth and reinvestment in the real economy resuming, demand for credit would naturally pick up.
2. It ends the need for policies like zero interest rates, quantitative easing and austerity that create headwinds to economic growth.  With economic growth, demand for credit naturally picks up.
3. It ends pricing distortions caused by 'zombie' loans.  One of the toxic side effects of the regulators engaging in forbearance and letting the banks use 'extend and pretend' to turn non-performing loans into 'zombie' loans is that it distorts the valuation of the collateral backing the 'zombie' loans.  As secured lenders, this valuation distortion acts as a barrier to new loans as bankers have a hard time valuing new collateral knowing how much collateral is in the hands of 'zombie' borrowers.  Eliminating the collateral valuation distortion eliminates a barrier to new lending.

If EU policymakers see themselves as being responsible only to bankers, 100% of the policies adopted since the beginning of the financial crisis support this notion, then getting credit flowing again in the EU is not only far more difficult, but virtually impossible.

Bankers will immediately realize that if the banks absorb the losses on the excess debt as they are designed to do this would be very bad for banker cash bonuses.  As a result, they will try to block this solution.

Bankers will propose and support any alternative to the banks recognizing upfront the losses and their cash bonuses being reduced.

For example, bankers proposed and endorsed the notion that bank losses should be paid for by taxpayers by having the sovereigns recapitalize the banks.  Never mind that this undermined the creditworthiness of the sovereigns and was completely unnecessary as banks are designed to operate with low or negative book capital levels.

For example, bankers endorsed the notion that bank losses should be paid for by savers.  One way of getting the savers (actually all the taxpayers) to pay for the bank losses would be to tax their deposits at the banks.

Never mind that this tax violates the spirit of deposit insurance.  Never mind that this tax reintroduces bank runs that deposit insurance ended by making depositors not responsible for the losses that the bankers run up.

So long as the EU policymakers see themselves as being responsible to the bankers and not the citizens of the EU, EU policymakers will adopt a series of policies that will not get credit flowing again.

However, should EU policymakers ever decide that they represent the citizens of the EU, then it will be easy for them to adopt the necessary policies to get credit flowing again (Iceland did this at the beginning of the financial crisis and it worked).

Rather than confiscate insured deposits, could we please fix the global financial system

EU policy makers have crossed the rubicon and decided that insured deposit holders should no longer be protected from the financial performance of the banks, but rather are a source of funds to recapitalize the banks.

With this single action, EU policy makers have undermined the global financial system and dramatically increased its instability.

Why?

Because depositors trusted that their governments would honor their deposit guarantees.  They have repeatedly demonstrated this across countries like Greece and Spain where no matter how insolvent their banks looked, the depositors kept their money in the banks out of a belief it was safe.

This is simply no longer true no matter how EU policy makers try to spin it.

The burden is now on depositors to determine if their bank is sitting on losses that the depositor will now have to absorb.

We are about to experience the same response as happened with structured finance securities when investors suddenly discovered that they did not know what they owned.  Banks are "black boxes" and structured finance securities are "brown paper bags" when it comes to looking to find out what their underlying exposures are.

Depositors, like structured finance security investors, are going to look for the door.

Why stay and risk the possibility of loss for no return?

As part of confiscating insured deposits in Cyprus, the ECB is standing ready to provide the banks with funds to offset the run that is going to start next Tuesday.  So in fairly short order, the ECB will be the primary funding source for the Cyprus banks.

Please note that all of this is avoidable if policy makers stop listening to bankers (who got us into the financial crisis and truly only care about protecting their bonuses) and PhD economists (who frankly don't understand how a bank actually works so they excluded it from their models).

Policy makers have to start listening to individuals like your humble blogger who has a track record that shows they understand what is wrong with the global financial system and what it will take to fix it.

I am on record for "predicting" the financial crisis and with this blog have consistently been accurate when stating what policies will work and what policies will not work as soon as they are mentioned, let alone adopted.

My blueprint for saving the global economy is pretty simple.

First, use the banks as they are designed to be used.  Banks are designed to absorb the losses on the excess debt in the financial system and continue to support the real economy.

It is a myth that banks need to be recapitalized immediately after absorbing these losses.  Banks are designed to operate with low or negative book capital levels.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  Deposit insurance effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.  With taxpayers as a silent equity partner, banks have virtually unlimited "equity" so they can continue to extend credit to support the real economy.

Then, over time, banks can rebuild their book capital levels through retention of 100% of pre-banker bonus earnings.

Call step one:  freely spend as much as it takes in future bank earnings to absorb all of the losses on the excess public and private debt in the financial system.

Two, bring transparency back to all the opaque corners of the financial system.

For banks, this means requiring them 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 confirm that the banks have absorbed all the losses on their exposures.  With this information, market participants can exert discipline and restrain risk taking by bankers and gambling on redemption.

For structured finance securities, this means requiring observable event based reporting under which all activities like a payment or delinquency on the underlying collateral are reported to market participants before the next business day.  Observable event based reporting allows market participants to know what they are buying and know what they own.

Three, use expansionary fiscal policies to kickstart the global economy.

Four, raise interest rates back to the 2% minimum set by Walter Baghot in the 1870s by ending zero interest rate and quantitative easing policies.

This is critical because it ends the ongoing Retirement Plan Death Spiral.  Under this spiral, current demand is reduced as savers, both individuals and companies, try to offset the drop in earnings on their investments.  Raising rates allows savers to make some money which in turn shows up as current demand.

No matter what the economic models say, raising rates will not discourage business investment.  What discourages business investment is lack of demand.  This has been proven since the beginning of the financial crisis.

EU policy makers throw HSBC and Standard Chartered deposits under the bus

The BBC's Robert Peston reports that the EU policy makers only violated the sanctity of the deposit guarantee so as to punish money launderers.

There is a wee bit of a problem with this policy that goes by the name of HSBC and Standard Chartered.

For those of you who don't remember, both of these banks just paid a cost of doing business fine to the US for violating its money laundering rules.

If the EU policy makers are to be believed, HSBC and Standard Chartered are no longer covered by deposit guarantees.  After all, we know they have a substantial amount of laundered money in them.

Or are all money launderers not created equal....

A well-placed official rings to tell me why investors should not be panicking that the punishment of Cypriot depositors is a precedent, or that lenders to Spanish and Italian banks will be spanked as well before too long.

A call to control the damage from adopting a stupid policy and undermining the global financial system.

He says the structure of the Cypriot bailout has been determined by German politics. (Aren't all eurozone bailouts fixed in that way?) 

Here is the logic behind imposing a hefty levy on Cyprus deposits, according to this official: 

1) Regulators and politicians are convinced that a vast amount of cash in Cypriot banks belongs to Russian money launderers.
2) Few German politicians of any persuasion would have voted for a Cyprus rescue that simultaneously rescued these launderers.
3) So the only way to get the bailout through the Bundestag is for the launderers to be taxed to the tune of almost 10% of their allegedly ill-gotten cash. And if innocent savers are hurt too, that is the way this particular "Keks" will crumble.

And with that logic, HSBC and Standard Chartered deposit holders have just been thrown under the bus.

Since neither of these banks provides ultra transparency so we can determine if they are solvent or not (if not, it is a question of time before a depositor gets hit for a loss), the best thing a depositor can do is run, don't walk, to the bank and remove all of their money.

On that analysis, private sector lenders either to Spanish banks or to the Italian government - as two topical and relevant examples - need not fear that it is their turn next to take a write-off.

Only true if Cyprus is a one-time policy.  However, no reason to believe this as EU policy makers were willing to throw Greece and Spain into depressions while blaming their citizens.

That may be seen as comforting by investors, up to a point. 

Except that if we are to see the Cypriot rescue as a very public statement that "hot money", which might be deemed to be laundered, has no place in the eurozone, then this money may well be withdrawn from wherever it sits in the currency union.

Hence, HSBC and Standard Chartered are now front and center.

EU establishes principle of imposing losses on insured depositors

As reported by Bloomberg, EU policymakers are establishing the principle of imposing losses on insured bank deposits.

By doing so, in a single stroke, they have undermined the whole concept of deposit insurance and created massive instability in the financial system.  Deposit insurance is suppose to be an ironclad guarantee by the sovereign that up to a specified level, all money put into a bank is protected from the financial performance of the bank.

The EU policymakers have decided to unilaterally end this guarantee.

At a minimum, for countries like Greece, Spain, Portugal, Italy and France, this should accelerate the run on their banks.

Why should depositors take the risk of losing money when there is no way of knowing if the banks are solvent?

This is a global issue.  Just this past week, the Fed effectively said that JP Morgan was insolvent by calling into question its fortress balance sheet (I know JP Morgan passed a stress test, but banks around the world, see Dexia and banks in Ireland, have been nationalized shortly after passing a stress test).

In the absence of ultra transparency where banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, there is no reason to believe that a bank is solvent and that depositing money in the bank is nothing more than a chance to have a high risk of loss for zero return.

With the EU policymakers ending trust in the sanctity of the deposit insurance guarantee, the only way to re-stabilize the financial system is by requiring the banks to provide ultra transparency.

With this information, market participants can independently determine which, if any, banks are solvent and therefore safe to put money into.

Euro-area finance ministers agreed to an unprecedented tax on Cypriot bank deposits as officials unveiled a 10 billion-euro ($13 billion) rescue plan for the country, the fifth since Europe’s debt crisis broke out in 2009. 

Cyprus will impose a levy of 6.75 percent on deposits of less than 100,000 euros -- the ceiling for European Union account insurance -- and 9.9 percent above that....

A tax is just another name for a loss.

Officials have struggled to find an agreement that would rescue Cyprus, which accounts for just half of a percent of the euro region’s economy, without unsettling investors in larger countries and sparking a new round of market contagion....

The European Central Bank will use its existing facilities to make funds available to Cypriot banks as needed to counter potential bank runs. Depositors will receive bank equity as compensation. 

Finance Minister Michael Sarris said the plan was the “least onerous” of the options Cyprus faced to stay afloat....

Actually, there was a far less onerous option that I have been talking about since the beginning of the financial crisis:  Let the banks recognize their losses and rebuild their book capital levels out of future earnings.

There was absolute zero reason to impose losses on depositors other than the EU policymakers are trying to bailout banks in countries like Germany that invested in the Cyprus banks.

The option chosen by the EU policymakers was the absolutely worse option available.

While the tax on deposits will hurt wealthy Russians with money in Cypriot banks, it will also sting ordinary citizens. 

Some ATMs in the country have run out of cash, Erotokritos Chlorakiotis, general manager of the Cooperative Central Bank, told state-run CYBC.

A run on the banks that will not be limited to Cyprus.

Funds to pay the levy were frozen in accounts immediately, ECB Executive Board Member Joerg Asmussen said. The levy will be assessed before Cypriot banks reopen on March 19 after a March 18 national holiday.... 

“As it is a contribution to the financial stability of Cyprus, it seems just to ask a contribution of all deposit holders,” Dijsselbloem said... 

Asmussen said tapping deposit holders was needed to expand Cyprus’s tax base. 

European Union Economic and Monetary Affairs Commissioner Olli Rehn called the assessment a strictly fiscal measure. Rehn had warned against so-called haircuts on depositors to avoid setting a destabilizing precedent. 

When asked if a deposit assessment could be ruled out for future rescues, Rehn said in an interview: “It can and there is no concrete case where it should be considered.”

Mr. Rehn's comment that losses will not be imposed on depositors in other countries is completely unbelievable.  As Mr. Asmussen said, it was necessary to impose losses on the depositors in order to be able to recapitalize the banks today.

“This kind of stability fee is clearly a much better choice from the point of view of financial stability and Cypriot citizens than a full-scale bail-in, which would have led to very chaotic consequences in the Cypriot economy,” he said.

This stability fee is a loss assessed on depositors.

From the standpoint of Cypriot taxpayers, it would have been far better to have the banks recognize their losses today and let the banks slowly recapitalize themselves through retained earnings.

This was possible to do as the banks have deposit insurance and access to central bank funding.  The deposit insurance effectively made the taxpayers the Cypriot banks' silent equity partners until the banks had rebuilt their capital.

The lesson of the stability fee will not be missed by bank depositors globally.

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.

Dutch housing market slump continues

The Wall Street Journal reported on how the Dutch housing market is continuing to slump.  The slump in housing combined with a decline in exports is leading to a slowdown in the Dutch economy.

While the decline in house prices is not as bad as in Ireland and Spain, there are reasons to think that the decline in Dutch house prices still has a long way to go.

House prices in the Netherlands continued to fall in November, suggesting that the slump in the housing market will continue to disrupt the country's struggling economy next year.
Prices of existing homes fell by an annual 6.8% in November, national statistics agency CBS said on Friday....

Since the peak of 2008, house prices in the Netherlands have tumbled more than 16%, according to CBS. The slump isn't nearly as bad as the busts that have engulfed Spain and Ireland, but it is weighing heavily on the euro zone's No. 5 economy. 

The news followed a string of poor economic data released earlier this week that reflected the economic weakness in the Netherlands. The country's jobless rate rose to 7% in November, hitting a 10-year high, and consumer sentiment is again nearing a historic low, CBS said on Thursday. For 2013 and beyond, the outlook is bleak. 

The Netherlands, seen as one of the "core" members of the euro zone, is facing a long period of economic contraction that will likely drag on until the second half of 2013, according to several official forecasts. 

For the third time since 2009, the Netherlands is about to fall back into recession and some analysts say the crisis in the euro zone will give it a final push. 

"Exports were the key driver for the Dutch economy in the past years," said Maarten Leen, an economist at ING Bank NV. "But exports are falling away too, now that the euro zone is in a recession and the global economy is weakening." 

Mr. Leen noted that private consumption is being squeezed by the weak housing market and government spending cuts, and that it has spread to other segments of the economy. 

"Domestic consumption continues to decline, mainly because of the situation on the housing market. Against this backdrop, companies will postpone new investments." 

Falling house prices have caused an erosion of household wealth and this in turn has led to consumers cutting back their spending. Dutch households are among the most indebted in Europe due to their large mortgage debt.

It appears that there is a negative feedback loop that has the potential for accelerating significantly.

So far, only a small number of households are behind on their mortgage payments, but this number could rise if the jobless rate shoots up. Around 700,000 homes are now worth less than the value of their mortgage, according to government estimates, which means homeowners could suffer a loss if they have to sell their property.

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.....

Greek leader calls for conference saying only viable solution is 'haircut' for southern periphery debt

As reported by the Guardian, the leader of Greece's opposition party, Alexis Tsipras has called for a conference to 'haircut' the debt for all southern eurozone periphery countries and tying future debt repayment to economic performance.

Regular readers will immediately notice that Mr. Tsipras is effectively calling for adoption of the Swedish Model for handling a bank solvency led financial crisis.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt that they would otherwise realize going through the long process of default and foreclosure.  With the banks absorbing the losses, the real economy and the social contract are protected.

Only weeks after the EU and IMF announced a third plan in as many years to rescue Greece from insolvency, the country's most popular party – its radical left opposition – has called for a European debt conference to "finally" settle a crisis it claims is no nearer to being solved. 

Regular readers know that the financial crisis has never been solved since the policy makers adopted the Japanese model for handling a bank solvency led financial crisis.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  As a result, the burden of the excess debt is placed on the real economy.

As demonstrated by the eurozone's southern peripheral nations, this burden is too great for their economies as it diverts capital needed for reinvestment and growth to debt service payments.  The result of this diversion of capital has been a recession.  This has been compounded by the adoption of austerity policies to create a depression.

In an exclusive interview, Alexis Tsipras, who heads the stridently anti-austerity Syriza, insisted that with the debt drama spreading it was vital that foreign lenders take a leaf out of the history books by dealing with the eurozone's crisis-hit southern periphery in much the same way that Germany had been treated after the second world war. 

"It is quite clear that the latest agreement was a compromise that will only perpetuate the uncertainty … Merkel has to say to her people before [the 2013 German] elections that the programme is not working," he told the Guardian. 

"The only viable solution is a haircut not only for Greece but the entire southern periphery," said the leader, emphasising that the longer creditors postponed writing off a significant portion of Athens' staggering debt the greater the cost both socially and economically.

Please re-read the highlighted text again as Mr. Tsipras as this is the argument your humble blogger has been making about why it is necessary to adopt the Swedish Model today and drop pursuit of the Japanese Model and its related policies.

"That is why we are proposing a conference along the lines of the one that took place in London in 1953, which relieved Germany of around 60% of its debt. We want to agree with our lenders on a credible solution. It doesn't matter where it takes place but it should happen as soon as possible." 

As an allied power, Greece, ironically, had been present at the conference whose debt agreement would go on to lay the foundations for Germany's post-war economic miracle. 

The pact had allowed Hitler's destroyed country to not only repay its debt over a 30-year period but had also stipulated that its financial obligations would also be dependent on Germany's economic performance. 

If Greece's shattered economy was ever to recover, Tsipras said it was crucial that it, too, was also given "a growth clause" that would likewise tie the repayment of Athens' debt load to its ability to pay. 

"We are also asking for time, a moratorium, of servicing the debt so that we can redirect that money to growth," he said, adding that the suspended interest payments, projected to amount to about €13 every year, would be used to kick-start the moribund Greek economy. "It would be a win-win solution."

Regular readers will recall that in adopting the Swedish Model, Iceland also focused on having the banks recognize losses that were consistent with the borrower's ability to repay without creating 'equity' for the borrower.

The charismatic politician ... insisted that the piecemeal approach of international creditors to resolving the crisis would not only destroy Greece but the entire continent. 

"There are two pillars to Europe's economic problem, the first being the debt which has to be made viable and the second being austerity which has to finish. If we continue with such measures it is like putting oil on the fire," he said....

Japan has shown over the last 2+ decades that without making the debt viable the economy will remain in a prolonged economic slump.

This slump will get worse every time the government adopts austerity policies.  This is true even if these policies amount to nothing more than ending expansionary policies and returning to pre-financial crisis levels.

Greece's pursuit of austerity in the name of brutal fiscal adjustment has created record levels of poverty and unemployment, trapped it in recession and repeatedly resulted in missed budget targets that have plunged the country into an ever-deeper death spiral. 

It had opened up bottomless pits in Europe's south that taxpayers in the north were then called to fund.

Please note what happened to Greece as a result of the Japanese Model and its policies being pursued.  A bad situation was made worse.

Although the latest rescue includes a complex bond buyback scheme, which will shave about €30bn from the country's €340.6bn debt pile, it was, he argued, still a case of creditors "buying time" and, as such, was far from adequate. 

"When the crisis began in 2009 our debt stood at 120% of our GDP. This year it is projected officially to be 175.6 %. And now they [EU-IMF] say that to make the debt viable we must hit 124% of GDP by 2020," he said, shaking his head in disbelief. 

"Let's suppose they are right – but how do they want to get there? After 12 years of catastrophic austerity and measures totalling €19bn Greece will have become a no-man's land."

Dexia winddown poses danger to eurozone banking system

Bloomberg reports that winding down Dexia, the failed Franco-Belgian lender, could pose a danger to the eurozone banking system.  Specifically, if Dexia tried to sell its assets, it would expose the fact that there is no real bid for sovereign debt in much of the eurozone.

The directors of Dexia also trotted out fear of contagion across the eurozone's banking system as justification for a fourth, fifth and possibly more future bailout.

The directors of Dexia have warned that shutting down the Franco-Belgian lender too quickly could endanger the European financial system. 

In a message to shareholders, Dexia’s board said that forcing the bank to rapidly sell off assets could crystalise losses it cannot afford to take. 

Dexia said that if this were to happen it would likely default on its debt, which it said could cause a new European banking crisis. 

“Such a default would jeopardise the stability of the whole European financial system. Indeed, a default of the Dexia group would lead to assets being frozen in the short term and would affect the liquidity of the markets, with a significant risk of a spill-over effect to the rest of the eurozone, given the size of the group’s balance sheet,” said the bank.

The warning came after Dexia this month received its third state bail-out in four years, taking the total amount of money spent rescuing the bank to nearly €15bn (£12bn).....

However, the new warning about the impact its failure could have on the wider European financial system is based on its large holdings of assets, including sovereign debt, which, if sold off en masse, could lead to a sharp fall in asset prices. 

Taxpayer haircuts on Greece debt loom

In his Telegraph column, Ambrose Evans-Pritchard lays out why taxpayers are going to end up taking losses on Greece's excess debt.

Left out of the column is the simple fact that it was the banks that originally lent Greece more than it could afford to repay and governments have pursued policies that allowed the banks to transfer these losses to the taxpayers.

These policies reflect the choice of the Japanese Model for handling a bank solvency led financial crisis under which bank book capital levels and banker bonuses are protected at all costs.  A choice that the bankers advised policymakers to make at the beginning of the financial crisis.

Here we are five years later and it is the taxpayers, rather than the bankers, that are being stuck with the bill for the debt that the bankers should never have extended given the ability of the borrower to repay.

Germany, Holland, and the creditor states of northern Europe have not lost a single cent on eurozone rescue packages, so far. 

They have lent money, at a theoretical profit. They have issued a fistful of guarantees to Europe’s twin bail-out funds, covering Greece, Ireland, Portugal, Spain, and soon Cyprus. They have taken on opaque and potentially huge liabilities through the European Central Bank. 

Yet little has disturbed the illusion that the euro is a free lunch for the surplus powers. 

An assumption persists that the creditors will - and should - be spared the consequences of flooding Southern Europe with excess capital....

Regular readers know that this assumption is false and that taking action based on this assumption makes the situation worse.

Since the Great Depression, modern financial systems have been designed so that the creditors are suppose to recognize upfront the losses on the excess debt.  This is done to protect the real economy and society.

We are at last nearing the awful moment when the curtain is ripped away. Greece’s economy has contracted 7pc over the last year. Public debt will spiral to 190pc of GDP in 2013. Leaving aside the Gothic horror of youth unemployment at 58pc, Greece’s debt trajectory is simply out of control. 

The International Monetary Fund says the country cannot claw its way back to viability unless EU governments and bodies take their punishment. The Fund’s Board and the powers behind it - the US, China, Japan, Brazil - will withdraw if the current farce goes on. 

Greece needs €100bn of debt forgiveness to get back on its feet, according to Barclays Capital. 

I suspect the reality of what it will take to get Greece back on its feet is significantly higher.  Barclays Capital's estimate reflects what was needed when the financial crisis began and before the Greek economy was forced into a depression.

A lot of this is coming Germany’s way....

Der Spiegel says the looming cost for Germany is over €17bn, enough to leave a big hole in the country’s 2014 budget. A line item would have to be written into the finance bill. 

Chancellor Angela Merkel would have to explain to critics on Left and Right in the Bundestag why her past assurances had come to nought, and why anybody should believe fresh assurances that Portugal is a safer bet. 

Or that Spain, Italy and France are safer bets?

German taxpayers would at last discern - as some already suspect - that their elites have led them into a monetary Stalingrad. 

It was the choice of the elites, particularly the banking elites, to choose a monetary Stalingrad for the taxpayers.

Mrs Merkel was still trying to duck the ghastly implications of this last week. There will be no taxpayer losses, she insisted after a meeting with the French. "Of course we did not talk about debt haircuts: our view has not changed and nor should it." 

Not talking about something does not mean that the losses will not occur anyway.  Haircuts are voluntary.  When a borrower defaults, the creditor still gets the losses.

The fond hope of EU leaders and commissars is that the North-South chasm in competitiveness will be closed by "internal devaluations" in Club Med states before their democracies blow up. This morally indefesible policy relies on pushing unemployment to such traumatic levels that it breaks labour resistance to pay cuts, and as we can see from the youth jobless rates in Greece (58pc) Spain (55pc), Portugal (36pc), Italy (35pc) it can take carpet-bombing to achieve effect.... 

It is not just the policy of "internal devaluations" that is morally indefensible, it is the choice of the Japanese Model that is morally indefensible.

Putting bank book capital and banker bonuses ahead of the real economy, the social contract and society is simply wrong.

What is certain is that EU authorities have made the task much harder by fixing all key policy settings on contraction. Fiscal policy is too tight. Monetary policy is too tight. Regulatory policy is also too tight since it is forcing banks to raise capital buffers even as the slump deepens....

The combined effect of this triple-barrelled "pro-cyclical" shock is to push the eurozone into a second downward leg of the Long Slump. Last week’s confirmation of a double-dip recession hardly does justice. Euroland is sliding into structural depression. 

A downward slump that your humble blogger predicted and has been arguing since the beginning of the financial crisis is a result of pursuing the Japanese Model.

Regular readers know that there is an alternative that could be pursued at any time.  The alternative is to require the banks to recognize upfront the losses on the excess public and private debt in the financial system.

This lifts the burden of servicing this debt from the real economy and restores growth.

As for the competitiveness between North and South in the EU, that is a problem that is better left to be addressed to a time when the EU economy is growing.

Professor Paul de Grauwe from the London School of Economics said the deepening crisis is "entirely self-made" and "very dangerous" as passions fly.

The professor confirms my observation.

The ongoing crisis is the choice of the EU policymakers.  A choice that at a minimum is likely to dramatically increase the cost of the financial crisis that began in 2007 to the taxpayers.

Europe blames UK for eurozone debt crisis

According to a Telegraph article, Europe blames the UK for its debt crisis arguing that without the UK led financial crisis that preceded it the eurozone debt crisis wouldn't have happened.

This line of reasoning is easy to support if one ignores a small fact.  It was the choice of pursuing the Japanese Model and its related policies for handling a bank solvency led financial crisis that triggered the eurozone debt crisis.

EU policy makers had and still have a choice in how to respond to the financial crisis.  They could choose between protecting bank book capital levels along with banker bonuses at all costs (the Japanese Model) or protecting society and making the banks absorb upfront the losses on the excess debt in the financial system (the Swedish Model).

Do you wonder why Brussels seems so dead set on crushing the City? Bull-dog Brits reckon Europeans are jealous, they don’t understand free-market capitalism, and are itching to spread stifling state regulation and avenge Agincourt all at once. 

Sharon Bowles, MEP and Britain’s most powerful financial politician in Brussels, says we’ve missed the point: Europe blames Britain for the debt crisis. 

“In their eyes, we are responsible for everything they are suffering,” she says. “The Greek debt levels were their own doing but the situation escalated into a crisis because of the additional sovereign debt and the financial crisis. So the rest of Europe thinks the contamination went into their countries, through the single market, from the UK. That’s the whole point.”...

It was the choice of the Japanese Model and its related policies like bailouts, zero interest rates and quantitative easing, that escalated a banking crisis into a sovereign crisis.

“Think about it,” she demands with trademark directness. “They wouldn’t have the eurozone crisis if we had not had the financial crisis. Who was culpable in the financial crisis? We were - we’ve said so. We’ve sent our regulators round the world saying “sorry”. So in Europe they say, you’ve admitted you got it wrong, you are wrong.” 

It was the UK that took the lead in selecting the Japanese Model and bailing out its banks.

As your humble blogger has pointed out since the beginning of the financial crisis, the Japanese Model is the wrong choice.  It essentially sacrifices democracy, the social contract and the real economy to pay banker bonuses.

So when we demand control - or more often a veto - over new financial regulation because the City is the biggest financial centre, there’s only one response. “They say forget it,” she says. “'We’re not going to take it from you - you’ve ruined our economy, you’re the reason we’ve got all this austerity and you think you can march around saying you know it best?’...

Clearly, Iceland made a better choice for how to handle the financial crisis.  It chose to implement the Swedish Model.  The result was strengthening its democracy, reinforcing its social contract with more benefit programs and preservation of its real economy.

You can see the point: on top of the implosion of 2008, London has been rocked by scandals from PPI mis-selling, to Libor rigging and money-laundering. 

Never mind Brussels, just listen to our own politicians. Last week the Business Secretary Vince Cable lamented the “greed and stupidity” of the banks - last year he called them “spivs and gamblers” - and we can expect more mud-slinging from Ed Balls, the shadow chancellor at Labour’s party conference which is under way in Manchester.

It does cause one to wonder when the opacity in the financial system that lets all of this mis-behavior by bankers to take place will be addressed.

As head of the European Parliament’s Economic and Monetary Affairs committee since 2009, Bowles is closer than anyone to the vast swathes of new financial regulation passing through Brussels. While Angela Merkel & Co fight the crisis, Bowles is involved with what she calls “the other half of the game of nudge”: pushing through structural changes that are needed to make the crisis-fighting measures politically acceptable.

Politically acceptable or acceptable to the Blob (aka, financial regulators, bankers and their lobbyists)?

Transparency and the Swedish Model are politically acceptable to society.  After all, we have a financial system based on the philosophy of transparency and the principle of caveat emptor (investors are responsible for their losses and don't expect bailouts).

Opacity and the Japanese Model are politically acceptable to only the Blob.  After all, they protect the Blob, enhance its members personal finances (see: bonuses) and allows the Blob to grow by substituting more complex rules and regulatory oversight for transparency.

Germany, Netherlands and Finland seek to limit use of European Stability Mechanism funds for bank bailouts

In what might prove to be the defining moment in the adoption of the Swedish model to address the ongoing EU bank solvency led financial crisis, Germany, the Netherlands and Finland announced that they would like to limit the use of funds from the European Stability Mechanism for bank bailouts.

By limiting the use of funds for bank bailouts, they are forcing policymakers in Greece, Spain, Portugal and Italy to use their modern banking systems as they are designed.

Specifically, they are forcing these policymakers to follow the example set by Iceland and requiring the banks to recognize today all of the losses on the excess debt in the financial system that the banks would otherwise recognize by going through the long process of default, bankruptcy and foreclosure.

Having recognized the losses, those banks that can generate earnings to rebuild their book capital levels will do so.  Those banks that cannot generate earnings will be resolved.

Naturally as part of the resolution process, depositors will be protected and bank debt holders will absorb losses to the extent they exceed the capital in the bank.

Spain’s government bonds fell, with 10-year yields rising the most in almost eight weeks, after top- rated European countries said national authorities should bear the cost of earlier losses in their banking industry. 

Italian and Irish securities also declined as Germany, the Netherlands and Finland said late yesterday the region’s bailout fund, the European Stability Mechanism, should assume only a limited burden in bank recapitalizations.... 

“There’s an ongoing drip feed of negative news,” said Richard McGuire, a fixed-income strategist at Rabobank International in London. The ESM announcement “appears to cast some doubt as to whether Spain will be able to disburden itself of the liabilities it will assume via its banking bailout.”...

Of course, under the Swedish Model, there will not be a banking bailout.

Bank recapitalization “should take place based on an approach that adheres to the basic order of first using private capital, then national public capital and only as a last resort the ESM,” Finance Ministers Wolfgang Schaeuble, Jan Kees de Jager and Jutta Urpilainen said in a statement distributed by the Finnish Finance Ministry. That may rule out the bailout fund from being used to deal with the 100 billion euros in aid Spain sought for its banks in June....

This statement implies that Germany, the Netherlands and Finland want Spain to bailout its banks.

Why?

Because when it comes to resolution of the banks under the Swedish Model, banks in Germany, the Netherlands and Finland are going to recognize losses.

However, this is not a problem that Greece, Portugal, Spain or Italy should worry about.  Those banks are responsible for not having more exposure than they can afford to lose.  If they exceeded this exposure level, then it is up to the governments of Germany, the Netherlands and Finland to step up and apply the Swedish Model to these banks.

The statement by the German, Dutch and Finnish Finance Ministers “will come as a disappointment to the Irish government, who have been hoping for a significant element of ‘relief’ to their overall debt sustainability,” said Owen Callan, an analyst at Danske Bank A/S (DANSKE) in Dublin. 

Joseph Stiglitz: Time running out for EU to fix financial system

As reported in a Bloomberg article, Nobel prize winning economist Joseph Stiglitz says that time is running out for the EU to fix its financial system and he provides a broad blueprint for what the solution should look like.

European nations must share past debts to lift the burden of high interest rates on Spain and Greece and implement a banking union with deposit insurance to prevent capital flight, said Nobel Prize-winning economist Joseph Stiglitz. 

“If you don’t do that, you have this adverse dynamic: the weak countries get weaker and the whole system falls apart,” Stiglitz said today in an interview in Geneva. “And this has to be done fairly quickly” because in a couple of years, “there won’t be any money in Spanish banks.”...

“You have to have some form of mutualization of past debts,” said Stiglitz ... Delaying the implementation of a banking framework will see the situation in Europe deteriorate, he said. 

“The Spanish banks will be very weak if you wait that long,” he said. “The system may fail completely or lending will become so constrained that the economy will go further down and you’re involved in a vicious downward spiral. Things are bad now, and they’re going to be getting worse.”...

He isn’t optimistic because Europe’s policy makers lack urgency and continue to focus on austerity. 

“I haven’t heard from the critical people in Germany and France that, no, austerity isn’t going to work, that we need a new strategy, that we need a political settlement,” he said.

Regular readers know that your humble blogger agrees with Professor Stiglitz that austerity is not the solution for what ails the EU (or UK or US for that matter).

Austerity is a policy that results from the adoption of the Japanese model for handling a bank solvency led financial crisis and the decision to protect bank book capital levels and banker bonuses at all costs.

By definition, austerity negatively impacts the real economy.  In this case, austerity is just one of several  transmission channels, like zero interest rate policies, by which the Japanese model is relentlessly crushing the real EU economy.

Regular readers know that I disagree with Professor Stiglitz on the need for sharing past debts.

I disagree because our modern financial system is designed so that the banks can and should absorb all the losses on the excess debt.  Banks should because no one forced them to take on an exposure to a borrower who could not repay their debt.

As shown by Iceland, if the banks absorb all the losses on the excess debt today, the real economy is protected.  Iceland achieved this by requiring the banks to take losses equal to what they would have experienced if borrowers had gone through the long drawn out process of defaulting, filing for bankruptcy and the banks subsequently foreclosing.

By design, banks have deposit insurance and access to central bank funding.  As a result, banks can absorb the losses and continue operating and supporting the real economy even if absorbing the losses leaves them with low or negative book capital levels.

Deposit insurance effectively makes the taxpayers the silent equity partners while banks are rebuilding their book capital levels.

Professor Stiglitz properly identifies the need for EU-wide deposit insurance.  This is needed because EU policymakers have threatened to kick Greece out of the EU and in doing so have created the possibility of redenomination risk (deposit insurance is honored, but in a currency worth far less than the euro).

The source for the EU-wide deposit insurance should be the remaining funds in the European Financial Stability Fund and the European Stability Mechanism.  These funds should back each country's deposit guarantee.