Bringing transparency to all the opaque corners of the financial system is a conservative project

MIT Professor Simon Johnson wrote yet another column calling for the break up of the Too Big to Fail banks (his other topic is calling for banks to hold more capital).  What makes this column of interest is that it really makes the case for bringing transparency to all the opaque corners of the financial system.

The columnist George F. Will recently shocked his fellow conservatives by endorsing Richard Fisher, president of the Federal Reserve Bank of Dallas, to be Treasury secretary in a Mitt Romney administration. 

Fisher’s appeal, in Will’s eyes, is that he wants to break up the largest U.S. banks, arguing that this is essential to re- establish a free market for financial services. Big banks get big implicit government subsidies and this should stop. 

Will’s endorsement was on target: The true conservative agenda should be to take government out of banking by making all financial institutions small enough and simple enough to fail. As Will asks, “Should the government be complicit in protecting -- and by doing so, enlarging -- huge economic interests?”

Regular readers know that by failing to fulfill its responsibilities under the FDR Framework government is complicit in protecting the banks.

First, the government fails to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so the market participants can independently assess this information and make a fully informed investment decision.

Second, the government offers its own opinion as to the risk of the banks.  Prior to the crisis, financial regulators talked about how risk in the banking system was reduced because of financial innovation.  After the start of the financial crisis, financial regulators talked about how the results of a stress test the regulators ran showed the banks were adequately capitalized.

But Will could have gone further -- much of what Fisher recommends also is appealing to people on the left of the political spectrum. ...

As is transparency and the government fulfilling its responsibilities under the FDR Framework.

Unfortunately, Fisher’s views on “too big to fail” banks draw the ire of powerful people on Wall Street,

Transparency draws the ire not just of powerful people on Wall Street, but also powerful people in Washington (transparency doesn't draw the ire of economists as they assume that it exists).

Unlike the breaking up the Too Big to Fail or higher capital requirements, transparency is a threat to the Blob (aka, politicians, financial regulators, Wall Street and their lobbyists).

As FDR understood, with transparency, the Blob's power is limited.  As a result, policies like adopting the Japanese Model for handling a bank solvency led financial crisis and protecting bank book capital levels and banker bonuses at all costs would not be adopted.

Fisher and Harvey Rosenblum, executive vice president and director of research at the Dallas Fed, have laid the groundwork for a comprehensive reassessment of finance and banking -- and the effects on monetary policy. 

The closest parallel is the rethink that happened during the 1930s, as the gold standard broke down and the world descended into depression followed by chaos. 

But their approach is also reminiscent of the way that monetary policy was reoriented in the early 1980s, as Fed Chairman Paul Volcker and others brought down inflation. 

The world and the U.S. economy have changed profoundly. We need to alter the way we think about the financial system and monetary policy.

Actually, with the FDR Framework, your humble blogger laid the groundwork for thinking about the financial system and monetary policy.

Fisher and Rosenblum have expressed, separately and together, three deep ideas since the financial crisis erupted in 2008. 

First, very large banks are too complex to manage. “Not just for top bank executives, but too complex as well for creditors and shareholders to exert market discipline,” they wrote in a Wall Street Journal op-ed in April. “And too big and complex for bank supervisors to exert regulatory discipline when internal management discipline and market discipline are lacking.” 

Complexity, they say, magnifies “the opportunities for opacity, obfuscation and mismanaged risk.”....

And here is where Fisher, Rosenblum and Mr. Johnson make the case for bringing transparency to all the opaque corners of the financial system.  For banks, transparency requires that they disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Everyone knows that transparency is needed if market participants are to independently assess the risk of an investment and exert market discipline.

Without it, market participants have to rely on a third party for a risk assessment if they are going to invest.  For banks, the third party relied on prior to the financial crisis was the financial regulators.  For structured finance securities, the third party relied on prior to the financial crisis was the rating agencies.

Clearly, both of these were discredited at the start of the crisis as their risk assessments were shown to be wrong.  With their stress tests, the financial regulators have confirmed that their risk assessments have not improved.

As Fisher, Rosenblum and Johnson point out, without this disclosure bankers use complexity, a form of opacity, to magnify the opportunities to profit from opacity, obfuscation and mismanaged risk.  Which further confirms Yves Smith observation on Naked Capitalism that nobody on Wall Street is paid to create low margin transparent products.

Second, too-big-to-fail banks do actually fail, in the sense that they require bailouts and other forms of government support. This is exactly what happened in the U.S. in 2007 through 2009, and it is what is occurring in Europe today....

Regular readers know that a modern financial system is designed so that banks do not require bailouts.

Banks have deposit guarantees and access to central bank funding and as a result, they can continue operating and supporting the real economy when they have low or negative book capital levels.  The deposit guarantee effectively makes the taxpayer the silent equity partner while the bank has low or negative book capital levels.

The reason behind the bailout was the fear of contagion.  One bank would fail and it would bring down the entire banking system.  Contagion only exists when the the government fails to ensure adequate transparency.

Regular readers know that with ultra transparency not only can market participants assess the risk of each bank, but they can adjust their exposure to each bank based on its risk and what the market participant can afford to lose given this risk.

This ends contagion and any excuse for bailing out the banks.

Also, please note that Professor Johnson explicitly says that what we have is a bank solvency led financial crisis as the 'too-big-to-fail banks do actually fail'.

Third, monetary policy cannot function properly when a country’s biggest banks are allowed to become too complex to manage and prone to failure. 

In “The Blob That Ate Monetary Policy,” a Wall Street Journal op-ed published in September 2009, Fisher and Rosenblum pointed out that cutting interest rates doesn’t work when systemically important banks are close to insolvency. The funding costs for banks go up, not down, as a crisis develops....

The funding costs for the banks went up because of opacity.  Specifically, that the banks are 'black boxes' and nobody knows what is hiding on and off their balance sheets.

As the Financial Crisis Inquiry Commission documented, banks with money to lend could not assess the solvency of the banks looking to borrow and therefore they did not lend (aka, the interbank lending market froze).

There is no mystery why the cost of funding went up.  It was the result of opacity.

“Well-capitalized banks can expand credit to the private sector in concert with monetary policy easing,” Rosenblum wrote with his colleagues Jessica J. Renier and Richard Alm in the Dallas Fed’s “Economic Letter” of April 2010. “Undercapitalized banks are in no position to lend money to the private sector, sapping the effectiveness of monetary policy.”

This is a prime example of not understanding that the origination of loans is separate from the funding of loans.  The reason these are separate is that funding for the loan can come from the bank's balance sheet or by distributing the loan through a bank syndicate or by sale of the loan to pension funds, insurance companies, hedge funds or through an asset-backed security.

In our current financial crisis, the reason that lending has slowed dramatically is that the banks were not required to recognize upfront the losses they will ultimately realize on their bad debt exposures.  Instead, the financial regulators adopted forbearance that allowed the banks to engage in 'extend and pretend' techniques that turned bad debt into 'zombie' loans.

The collateral tied up as security for these 'zombie' loans undermines the ability of banks to lend.

Recall that banks are senior secured lenders.  The collateral tied up in the 'zombie' loans artificially increases the value of collateral on new loans (if the collateral were not tied up, the market value of all the collateral would be lower - an example of this is residential and commercial real estate).

The problem for lenders is they know the value of the collateral should be lower, but they just don't know how much lower.  As a result, they are reluctant to make loans.

Financial Policy Committee worried about losses from 2008 still on UK bank books

As reported by the Guardian, the UK's Financial Policy Committee

is worried that UK banks are still sitting on huge losses from loans to businesses and mortgage holders dating back to the Lehmans crash that have yet to be fully written down on their balance sheets.

The fact that these losses are still hidden on and off UK banks balance sheets is the direct result of the adoption of the Japanese model for handling a bank solvency led financial crisis.

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

As a result, policies like regulatory forbearance are adopted.  Regulatory forbearance allows banks to create 'zombie' loans by engaging in 'extend and pretend' rather than recognizing the losses on the loans and the related decline in bank book capital levels.

Equally troubling to your humble blogger is the idea that the UK's Financial Policy Committee might not know the actual size of the losses that are being hidden.  Doesn't this lack of information clearly call into question the ability of the Financial Policy Committee to do its job?

Regular readers know that your humble blogger has been calling for the adoption of the Swedish model for handling a bank solvency led financial crisis since the beginning of the crisis.

Under the Swedish model, banks recognize all of the losses on the excess debt in the financial system today.

This was done in Iceland and it has successfully put the financial crisis behind it.  Iceland required its banks to recognize the losses that they would have experienced if the banks had gone through the long drawn out process of default, bankruptcy and foreclosure without going through the process.

I have also been calling for requiring banks 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 exert discipline on the banks to both recognize their losses and clean up their troubled exposures.

Had ultra transparency rather than additional complicated regulations and more regulatory supervision been adopted in response to the financial crisis, the Financial Policy Committee would not have to worry in 2012 about losses occurred in 2008 still being hidden by the banks.

"Funding for Lending", yet another failed central bank experiment imported from Japan

In his Wall Street Journal column, Alan Blinder makes the case for the Fed to follow the Bank of England's lead in encouraging banks to lend by starting a "Funding for Lending" program.

Regular readers know that banks are awash in liquidity and fighting to achieve meaningless bank capital ratios.

So the question that should be asked is why does anyone think that access to funding is what is restricting bank lending as oppose to financial regulators crushing lending through regulation of bank capital ratios?

As the Telegraph reports about the UK "Funding for Lending" program,

[Danny Gabay of Fathom Consulting] was sceptical about the latest growth strategy of “funding for lending” to lower the cost of credit, arguing that households needed to reduce their debt by about a third – or about £440bn in current money. 

He said: “The Government wants banks to lend more to households when house prices on most metrics are still overvalued. It doesn’t sound like sensible policy to us. We need to be encouraging households to deleverage.” 

Ms [Deanne] Julius said that although it was “worth a try” she “does not have huge hopes” for funding-for-lending. 

“I met some Bank of Japan officials who said they had tried something similar and it had been another contributory factor to their zombie banks.” 

Sir John [Gieve] welcomed the effort and the indication that policy is joined-up between the Bank, the Treasury and the Financial Services Authority, but said: “I don’t think its going to make a massive difference.”

Not exactly a ringing endorsement for a program.

A review of the Bank of England's Financial Policy Committee performance after one year

Regular readers know that your humble blogger was not optimistic about the contribution that the Bank of England's Financial Policy Committee would make to promoting financial stability and, as a result, set the bar for success at "do no damage".

The reason for this low standard is the composition of the membership of the FPC.  It is long individuals with a PhD in Economics.

In addition, there is no one on the FPC who publicly predicted our current financial crisis.  I felt this might be a problem because in the absence of anyone who understood why the financial crisis occurred it was highly unlikely the FPC had the expertise to do anything to moderate the current crisis or prevent the next crisis.

Recall that the Queen also predicted that this was a problem when she asked the economic profession why it hadn't seen the current crisis coming.  The very question suggests that perhaps by training economists are very poorly suited for understanding the financial system and what might cause a crisis.

At its one year anniversary, I am sadden to report that the FPC could not get over the 'do no harm' standard.

Here is the performance of the FPC as described by external board member Robert Jenkins in a Telegraph column.

The financial policy committee of the Bank of England is now one year old. Its purpose is to identify and, where possible, mitigate threats to the British financial system. Financial stability is the goal.

Over the past 12 months, systemic fragility and troubles in the eurozone have been the key threats. 

Restoring confidence in the British banking system has been the priority.

Given this priority, has the FPC done the only thing that restores confidence in a financial system and called for banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details?  No.

Regular readers know that transparency restores confidence as it allows market participants to independently assess each bank.  Confidence is restored because market participants trust their own analysis (whether they do it themselves or they hire a third party to do it for them).

That banks should build balance sheet strength has been the primary recommendation and today the country's banking system is among the better capitalised and funded.

However, as everyone except the economists and other members of the FPC knows, bank capital is meaningless.  This is not just your humble blogger's opinion, but an opinion expressed by the OECD.

The reasons why bank capital is meaningless are extremely well known.

First, we have suspended mark-to-market accounting.  As a result, all those opaque, toxic securities and government bonds that still reside on and off the bank balance sheets have not been properly marked-to-market.  This results in an overstatement of bank book capital levels.

Second, bank regulators have engaged in regulatory forbearance that has allowed the banks to keep zombie borrowers alive using 'extend and pretend'.  Again, the banks have not taken losses and this too results in an overstatement of bank book capital levels.

So the primary recommendation for restoring confidence was to focus on a meaningless number as oppose to requiring the banks to provide ultra transparency and actually restore confidence.

Unfortunately, the primary recommendation to boost bank book capital also carried with it a well known and fully predictable  toxic side effect for the real economy:  a financial regulator induced credit crunch.

Since no investor is dumb enough to buy newly issued capital in a bank with large, undisclosed losses, to reach the higher capital ratios the FPC endorsed, banks had to shrink their balance sheets.  The number one place to shrink a bank balance sheet and get the most bang for the activity is by reducing loans.

The toxic side effect of the FPC's primary recommendation was to support a financial regulator induced credit crunch.  The FPC managed to take a situation where it was difficult for credit worthy borrowers to access bank credit and make it virtually impossible.  As a result, the real economy has been starved for credit to support it.  A clear violation of the "do no harm" standard.

Financial stability requires a healthy economy and a healthy economy requires financial stability.....

Is this true?

Couldn't we have financial stability in a recession (I would think a recession qualifies as a 'sick' economy)?

committee members have questioned whether there might be a trade-off between the strengthening of bank balance sheets on the one hand, and ensuring sufficient credit availability on the other.

In other words, was there a choice to be made between safer banks and a stronger economy? 

The discussion continues. To date, the following facts have informed the committee's recommendations: 

• Confidence must be maintained in our banks without which the banking system will cease to function. Loss of confidence in the banking system is the single biggest threat to lending. The strengthening of bank capital and liquidity has been critical to restoring confidence. 

Every part of the highlighted text is not a fact, but is rather something that only economists believe! (Of course. they are encouraged in this belief by bankers who tell them it is true as the bankers are looking to be paid their bonuses.)


It is a belief that results in the incredibly destructive policies adopted under the Japanese model for handling a bank solvency led financial crisis.


Regular readers know that under the Japanese model, bank book capital levels are protected at all costs.  This involves deception by the regulators and the adoption of policies like suspension of mark-to-market accounting and regulatory forbearance.


The result of these policies is that an accounting construct is held constant and the damage from excess debt in the financial system is forced onto the real economy.  This burden is more than the real economy can support and results in contraction of the real economy.


As your humble blogger has said many, many, many times, the combination of deposit insurance and access to central bank funding forever ended depositors' concerns about the book capital level or liquidity of a bank.  


(Let me give you two leading indicators of this simple fact.  First, to date, no economist I have asked what is the capital or liquidity level of the bank they have their checking account at as of the end of last quarter has known the answer to the question. Second, every economist I have asked that has helped a child open a banking account has answer the child's question of how do they know they will get their money back from the bank by saying the government guarantees the child will get their money back.)


Deposit insurance shifts the concern to the issue of can the government make good on its deposit guarantee.  If you live in Japan, the UK or the US, by definition the answer is yes because the government can always 'sell' bonds to the banks who can use these bonds as 'collateral' at their central banks to access funds that can be given to the depositor.


In the EU, until the politicians threatened to kick countries out and force them onto a new currency, depositors continued to believe that their governments would make good on their deposit guarantees.  By introducing re-denomination risk, the EU politicians have lowered the value of the deposit guarantee (you still get your 'money', it is just paid back in a currency worth significantly less than the euro).


What everyone, except the economics profession, learned during the Savings and Loan Crisis in the late 1980s is that bankers will continue to lend even when there is little confidence in the solvency of their institution.  Based on the commercial real estate boom that resulted from this lending, the link between 'solvency' and lending has been shown not to exist in the real world.


Our current crisis shows that bankers will also continue to gamble in the securities casino even when there is little confidence in the solvency of their institution.  In short, since bankers are compensated for gambling and lending they will continue these activities regardless of the solvency of their institution unless the financial regulators intervene with policies like higher capital ratios.

• The balance sheets of Britain's major banks total some £6 trillion. The aggregate of British lending to small and medium sized enterprises is below £200bn. The committee is concerned about that portion of SME lending which seeks and merits credit. It is also concerned about the loss-absorbing buffers needed to support the other £5.8 trillion. 

Leading up the financial crisis, the structured finance market was a significant source of funds for the SMEs.  The structured finance market is a fraction of its former size. This is a direct result of current disclosure practices that do not provide investors with the timely performance information on the underlying collateral that they need to know what they own.

Investors prefer not to blindly bet and instead are investing in asset classes that provide transparency.

To attract investors back to structured finance and reinvigorate SME lending will require that each security provide observable event based reporting.  Under observable event based reporting, every activity, like a payment or default, that occurs with the underlying collateral is reported to all market participants before the beginning of the next business day.

With current information, investors can know what they own and prospective buyers can independently assess the value of the security.

• There is a difference between capital levels and capital ratios. Higher capital levels absorb loss, inspire confidence and support lending. By contrast capital ratios can be "improved" by reducing lending without increasing capital. 

There is a difference between bank capital that is used to protect the real economy from the excesses in the financial system and bank book capital levels that are meaningless.

Bank book capital levels that are used to protect the real economy vary over time.  In times when there are excesses in the financial system, bank book capital levels decline dramatically as the losses on the excesses are absorb today.  If the losses are large enough, bank book capital levels can become negative.

Bank book capital levels that are meaningless tend to increase during a financial crisis.  This increase is a sure sign that the losses on the excesses in the financial system are being shifted onto the real economy and that there is a financial regulator induced credit crunch.

• Capital is not something locked away in the vault. An incremental pound of capital can fund an incremental pound of loans. And given current bank leverage, each £1 of additional capital can support £20 of additional small business lending – provided, of course, that the liquidity funding is available. Alternatively, some portion of incremental equity could support new lending with the remainder used to build buffers and reduce leverage. 

Of course, once again this focus on capital is irrelevant as it implies a link between lending and capital that does not exist.

What is well known to everyone except perhaps the FPC is that banks make loans when the opportunity arises and then look for how to fund the loans.

While many people think that structured finance was the original originate to distribute banking model, it wasn't.

For decades before structured finance became significant in size, banks would sell participations in their loans or the whole loans themselves to other banks, insurance companies and pension funds.  This was a classic way for smaller banks to diversify their loan portfolio by geography and industry.  It also resulted in matching loans to deposit funding already in the system.

• Allowing capital ratios to fall might lead to new real economy lending – but it might not. It might merely fuel intra-financial risk-taking with little positive impact on small business requests. 

• And even if lower ratios did lead to new business lending, to which businesses would the loans go: to a manufacturer in Manchester or a shoe factory in Shenzen?....

Of all the financial regulators, the FPC should know that it is not the job of regulators to approve or disapprove of individual positions taken by banks.  Doing so explicitly substitutes the regulators for the market in the allocation of capital.

Recently the Chancellor announced that the committee would add an economic growth objective to that of stability. 

How disappointing as it would have been far better for the UK and global financial stability if the Chancellor had put the FPC out of existence so that it could do no further harm to the real economy.

Is rescuing banks a prerequisite for rescuing economies?

According to a Guardian column, US Treasury Secretary Tim Geithner for years has lectured Europe on the need for rescuing the banks as a prerequisite for rescuing their economies.

While clearly an argument for adopting the Japanese model for handling a bank solvency led financial crisis, is this statement true?

The experience of Iceland and Sweden before it would appear to show the statement is false.  As discussed by Iceland's president in a must read previous post, saving the economy, democracy and society in fact required that the banks not be rescued.

The Guardian column looks at what has happened to the US as a result of rescuing the banks.

America's banks are bigger than ever. 

JP Morgan Chase, Bank of America, Citigroup, Wells Fargo and Goldman Sachs have emerged with more firepower than before the financial crisis following Hank Paulson's generous bailouts and the freedom to swallow rivals on the cheap....

For several years the US treasury secretary, Tim Geithner, lectured Europe on the need to rescue banks as a prerequisite for rescuing economies. Without a massive injection of cash, a co-ordinated guarantee scheme and a monster dumping ground for the bank's most toxic assets, foreign investors would look elsewhere. Worse, a constrained banking sector would discourage domestic companies from investing.

Where did the US banks' most toxic assets go?  While TARP was originally seen as a monster dumping ground for these assets, it morphed into a vehicle for making massive injections of cash.

Instead, the banks were allowed to hide these assets on and off their balance sheet through the suspension of mark-to-market accounting and adoption of mark-to-management's preferred valuation accounting.

Banks in the EU and UK have been allowed to do the same thing.

Apparently, Mr. Geithner's argument also includes the idea that a constrained banking sector would discourage domestic companies from investing.  What discourages domestic companies from investing is their perception of investment opportunities.  How an investment is financed is a trivial consideration compared to issues like how much revenue will the investment generate or cost will the investment save.

Look at the US economy now. While it may be cooling a little, the figures for growth and employment are streets ahead of anything the UK and Brussels can claim...

Comparing three areas that rescued their banking system tells nothing about whether rescuing the banks is a prerequisite for rescuing economies.

To answer that question, you have to compare these three areas against Iceland that did not rescue its banking system.

When this comparison is done, it is clear that rescuing the banks is not a prerequisite for rescuing economies.  In fact, it appears that rescuing the banks, slows down if not makes it impossible to rescue the economies.

Geithner says they should look no further than the pathetic self-flagellating treatment of the banks, which remain hamstrung by excessive regulation and poorly designed and generally puny rescue packages....

Compared to the US banks which effectively have no regulation?

The only route to growth is sorting out the finances of the banks and letting them lend again.

Not true as shown by Iceland.

Taxpayers are the only source of funds and should, like their US counterparts, bite the bullet....

Again, not true as shown by Iceland.

But Geithner has also created a monster that after only three years of recovery is already too big to fail. 

Without subsequent reforms, JP Morgan and the others will sow the seeds of the next crash. 

Their assets will be found again to be toxic and while the accounting may be clearer, there will still be lots of toxic loans to deal with. 

It is a dilemma that is hard to escape.

Actually, Iceland showed how easy it is to escape the dilemma.  First, realize that rescuing banks is not a prerequisite for economic growth.  Second, let the banks go.  Third, focus fiscal spending on supporting economic growth.

Barack Obama vowed to eliminate the possibility of the financial sector being too big to fail. 

Rightly he put growth first, but there is no doubting that restraining banks is harder once they have recovered their powers and legitimacy. It will be a severe test for the next administration.

Actually, it appears that he listened to Tim Geithner and as a result has managed to achieve a miraculous outcome.  He has managed to squander his opportunity and gotten the worst of all worlds - limited growth and a financial sector with firms that are too big to fail.

Patrick Honohan: Bank regulators as barrier to ultra transparency

Prior to becoming the Governor of the Irish Central Bank, Professor Patrick Honohan wrote a number of articles that are relevant to our current financial crisis.

In 1997, he wrote BANKING SYSTEM FAILURES IN DEVELOPING AND TRANSITION COUNTRIES:  DIAGNOSIS AND PREDICTION.

I would like to call attention to his discussion of setting financial policy to reduce vulnerability and the political obstacles to effective regulation.

Weak enforcement due to political interference is the Achilles' heel of any regulatory
system. 

Early response to emergent banking problems has been repeatedly inhibited by the political
protection against closure which unsound banks and imprudent or self-serving bankers appear to have enjoyed. The resulting delays have deepened the ensuing crisis. 

Designing institutional and political arrangements that will make such protection less
likely is a difficult challenge.

Actually, this is one of the benefits of requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this disclosure, market discipline is applied to the banking system.

For one thing, bank intervention is often not seen as a desirable political good. Two of the possibilities that have been suggested to enhance the political desirability of sound
banking and thereby strengthen the hand of the regulator, namely limiting deposit protection and greater disclosure, are worth considering. 

When depositors are fully indemnified from banking failure, the major potential beneficiaries of sound banking are the taxpayers, who represent a normally diffuse lobby. Not only will unprotected but better informed depositors be more cautious about where they place their funds, but they will also see the regulators as their agents and clamour for early regulatory intervention.

Professor Honohan goes on to talk about disclosure.

Is it really a good idea to disclose full details of a bank's balance sheet and income
position? 

Many authors insist that this must be so, given the ability of market participants to process information and the distortions that arise when information is asymmetrically distributed. Ensuring prompt disclosure of all relevant information is also a central concern of the regulators of securities markets. 

This disclosure also just happens to be necessary if the invisible hand of the market is going to work properly.

Without ultra transparency into each bank's asset, liability and off-balance sheet exposure details, market participants do not have the information they need to assess the risk of each bank.  If market participants cannot properly assess the risk of each bank, they cannot properly price their exposure to each bank.

It is noteworthy, however, that not all bank regulators agree. Their concerns appear to be
with the risk of an irrational depositor response aggravating the position of a bank which is suffering from temporary and recoverable weakness. It is sometimes argued that, by forcing early liquidation of such a bank's portfolio, such depositor withdrawals may impose avoidable social costs. 

Your humble blogger has documented that depositors do not care about the solvency of the financial institution.  They only care that the government is capable of honoring its implied 100% deposit guarantee - note, this covers deposits and not unsecured debt or equity.

Examples of financial institutions operating in insolvency for years include the US Savings & Loans and Security Pacific (losses on it loans to less developed countries exceeded its book equity).

From an analytical point of view, the issue of disclosure is closely related to that of forbearance. If the purpose of non-disclosure is to facilitate the continued operation of a bank which the market would close if it had the relevant information, then it also implies that the authorities (who have the information) are forbearing to take closure action themselves.

It is only regulators who can close an insolvent bank and their are given discretion in choosing when to close an insolvent bank.

Market participants are restricted in what they can do.  Most will require a guarantee and hence limit their investments in insolvent banks to deposits. Others will invest in the equity of the bank if they feel it can restore itself to solvency.

The bottom line is that a bank can continue in operation until such time as its regulator chooses to close it.

Although some theoreticians have dreamed up circumstances under which forbearance would be desirable it is widely accepted that forbearance and non-disclosure weaken incentive structures and ease the work of political lobbyists who would seek to restrain regulatory action. 

In other words, regulators promote the interest of Wall Street's Opacity Protection Team.

Disclosure multiplies the number of watchful eyes and should induce a more cautious
management stance. 

Inevitably, disclosure may shorten the time interval between the emergence of liquidity and solvency problems at a bank, as it will improve the information on which depositors and
other lenders to the bank will base their decisions. 

However, early regulatory intervention in the affairs of an insolvent bank is desirable anyway. Recalling the earlier discussion of contagion, specifically its relative infrequence and the tendency for runs to be focused on banks that are truly insolvent, we conclude that the advantages of extensive disclosure outweigh the risk of some destabilisation.

Please recall, with every bank providing ultra transparency, each bank is able to adjust its own exposures to what it can afford to lose and as a result end the risk of contagion in the financial system.

The Euro crisis deepens

In his Guardian column, Aditya Chakrabortty lays out all the facts that support his observation that the Euro crisis is getting worse.

He then asks the question of why have the Eurozone policymakers and financial regulators been unable to end the crisis.

The answer is that the Eurozone and the rest of the global financial system are facing a solvency crisis that they have been treating as a liquidity crisis since 2008.  Treating the symptom is kicking the can down the road and not curing the cause.

Europe's leaders have spent most of the euro crisis denying there's a euro crisis....

The denialism ended this summer, as the financial bushfire moved to Italy and even began to menace Belgium and France.... If the rhetoric and the not-so-faint snobbery have vanished, to be replaced by panic about "a last wakeup call" and "a crucial crossroads", the actual policy-making is as clueless as ever.... 

The eurocrats can impose austerity, and bring in Goldman Sachs employees such as Mario Monti to run newly impoverished economies; but anything that might actually break the fire still eludes them. 

In the meantime, the crisis has just kept growing. 

Which is exactly what you would expect given that they are focused on treating the liquidity symptoms and not the underlying solvency cause of the crisis.

In February 2010, Greece needed to raise just €53bn for the entire year; now euro leaders are looking for a trillion euros and counting. Compare and contrast: in his memoirs, Alistair Darling recounts that it took ministers and officials 10 days and one curry-fuelled all-nighter in autumn 2008 to hammer out the complex and costly combination of ready cash, loans and guarantees that saved the British banking system....

Actually, they did not save the British banking system.  They kicked the can of solvency down the road.

Incidentally, these same policies were adopted by both the US and the Eurozone.

Does anyone really believe that the large British banks are solvent given the fact that their exposure to Eurozone governments and banks vastly exceeds their equity?

A good rule of thumb in this crisis is that when a European state pays more to borrow than an ordinary taxpayer shells out for a bank loan, the government eventually has to call in the rescue brigade. 

For much of November, Italy was borrowing at a rate of 7% – and probably the only thing that has kept interest rates from going higher still is that the European Central Bank (ECB) has been buying Rome's IOUs. 

In other words, the markets trust the Italian state – with its own tax-raising powers – less than it does a couple in Kettering who'd quite like a new kitchen. Which, given that Italy plans to roll over more than €360bn (£310bn) of debt next year, is hardly sustainable for the new prime minister Mario Monti. Indeed, on 1 February, Rome will have to either repay or renew €28bn of loans. Even now, no one has the faintest idea how it will do that.  

Over the next couple of months, Italy's crisis can go one of three ways: either the ECB keeps on buying its bonds, with the blessing of northern-European voters and markets; or ECB head Mario Draghi pledges to fund financially distressed eurozone governments; or Rome gives in and calls for a bail-out. If the last even looks likely, financiers will almost certainly panic that Italy is about to default on its debt. With about a third of the country's bonds held abroad, this could wreak chaos in world markets – including in Britain, which is by far the biggest foreign owner of BTPs. That's the sort of event Barack Obama has in mind when he remarks that Europe's crisis is "scaring the world". 

The idea that owners of Italy's debt might have to take a haircut is not what scares the world.  What scares the world is no-one knows who is holding onto the losses.  It is the possibility of contagion pulling down the global financial system that scares the world.

Regular readers know that the way to eliminate the fear of contagion pulling down the global financial system is not more expensive bailouts, but disclosure.  Specifically, every bank must be required to provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this data, everyone knows who is holding the losses.  More importantly, market participants can take steps to adjust the amount and price of their exposure so that they do not lose more than they can afford to lose.

As for the banks in any country that sees its sovereign default, what is needed is a backstop to the sovereign's guarantee of the banks' deposits.  In Europe, this backstop could be provided by the EFSF or the ESM.  The backstop is needed to prevent a run on the banks.

It must be remembered that history has shown that banks with negative book equity can continue to operate and provide loans and payment services.

Rome's not the only government whose finances are in jeopardy; Madrid is in the same boat, while Brussels and Paris have also seen a surge in loan rates. 

Less often talked about is that many of Europe's banks, even well-known French names, are unable to borrow unless from the ECB. "You have European banks nowadays claiming they're not European at all because they're worried the very word will scare away investors," says Grant Lewis, head of research at Daiwa Europe. That credit crunch cannot carry on for much longer without causing either a full-scale banking crisis or throttling economic growth. 

Not that there's much growth to be had, because the prescription of austerity for sick economies simply makes them sicker. By the IMF's own projections, 2012 will be Greece's fifth straight year in recession, which by now should really be termed a depression...

Liam Halligan and the Telegraph call for disclosure rather than more 'sticking plaster' solutions

In his weekly Telegraph column, Liam Halligan once again makes the case for why detailed disclosure is needed to end the solvency crisis that began on August 9, 2007.

He assets that the Eurozone leaders are deluded if they think the most recent 'sticking plaster' treaty can solve the solvency crisis.

This Brussels summit was an unseemly combination of law-bending and posturing. The coup de grace, for me, was the quiet agreement to drop any requirement for private sector holders of dodgy eurozone sovereign debts to incur losses. So much for moral hazard. 

Dropping the requirement to 'incur losses' does not mean that the losses have gone away.  This is the same problem with extend and pretend.  The losses are still there lingering on bank balance sheets.

Since everyone knows that the banks are holding losses, the question then becomes, how big are these hidden losses.  Said another way, who is solvent and who is insolvent.

When no-one knows who is solvent and who is insolvent, the following solvency driven liquidity symptoms emerge.

The fundamental problem remains that Europe’s banks remain locked-out of traditional funding markets, leaving them reliant on the ECB – which, in turn, is now increasingly reliant on covertly printed money and whatever the Chinese and others will ultimately chip-in. 

Faced with a funding freeze, banks are shrinking their balance sheets and strangling growth by refusing to lend, a problem the ECB’s “special measures” will do nothing to address. 

The use of the ECB’s emergency lending facility rose last Wednesday to €9.4bn, the highest daily total since early March, pointing to deep-seated banking sector distress. 

Such distress relates, above all, to a lack of trust. 

Eurozone banks can’t raise cash, and won’t even lend to each other, due to crippling fears of counter-party risk, given that many continue to hide massive liabilities in so-called “special purpose vehicles”. Lawmakers, after all, still lack the courage to force them to fully disclose their losses. 

This lack of disclosure is the nub of the sub-prime problem. Nobody wants to hear it, but it’s true. 

Please re-reading the previous bolded text as your humble blogger has been making this point since the beginning of the credit crisis.

Last week’s “stress tests” suggested Europe’s banks have a deficit of €115bn, up from €106bn in October. But these government-run tests lack credibility. The first round cleared some big Irish banks, which then went bust. A subsequent round gave Belgium’s Dexia a clean bill of health, just weeks before it imploded. And now the European authorities want the markets to believe this latest exercise in high-stakes financial spin. 

No one knows who is solvent. 

The drip-drip of stress test information causes more problems than it solves. 

So stand-behind retail depositors, impose “full disclosure” and let the cards fall, forcing our bombed-out banks to consolidate. 

This really is the only solution – in the US, the UK and the eurozone. But the eurozone’s failure to grasp it will be far more explosive, given the pressures being created by this absurd monetary experiment.

FDR and his administration showed that this solution worked to break the back of the Great Depression (see here).

To date, we have tried everything else.  It is time to require banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Banks and sovereigns 'inter-dependent'

The Telegraph published a column by Christine Johnson, a corporate bond fund manager for Old Mutual, that is a must read piece.

Mrs. Johnson cuts straight to the heart of the problem in the financial markets when she observes

But the reality is that the Santander deal is emblematic of a much wider – and in my view permanent – disruption to fixed income markets. 

Banks are now clients of state. States own bank equity and banks own state debt. Banks depend on the state, by way of monetary authorities, for their liquidity. 

What has developed is an intense, introverted, inter-dependent patron-client relationship. States and banks have become equivalent, and equally distressed. 

For bond investors, the outcome is brutal. Santander is not alone. Other banks are also keen to make their bond-holders offers they can’t refuse. It is being called by the euphemism ‘liability management’ but in essence it is a form of default. 

The rules that once applied are no longer relevant. Once the state is involved regulation can be re-written, as can the law. Where politics is concerned, etiquette is soon brushed aside....

The conclusion should not be hard to draw, though it is quite different to the one we are used to hearing. Neither governments nor banks are capable of providing a safe-haven in the challenging times we face. They are not the solution. They are the problem.

Over the last several months, this blog has documented how the relationship between banks, regulators and sovereigns has perpetuated the financial crisis to the detriment of investors and society.

I know I have said this before, but requiring the banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details is the only way to solve the problems created by the relationship between banks, regulators and sovereigns.

Ultra transparency ends, at a minimum:

• regulators hiding a bank's condition from the market while they try to stabilize the bank (think extend and pretend).  Instead, it substitutes market discipline with the idea being to prevent the bank from becoming a problem in the first place;

• the focus on meaningless, highly manipulated bank book capital.  Instead, it substitutes the combination of a bank's solvency (the market value of its assets less the book value of its liabilities) with the reality that so long as depositors trust in the guarantee of their deposits, they will keep their money in the bank regardless of its solvency.  With this combination, banks can spend the next several years retaining earnings to restore their solvency; and

• regulators, and by extension sovereigns, incurring the moral obligation to bailout investors when the regulators announce that a bank has passed a stress test.  Instead, investors know that they are responsible for all gains and losses which gives them the incentive to assess the risk of each bank independently using the data disclosed under ultra transparency.

Despite low interest rates, Irish house prices continue falling...83% in one case

The Independent reports that Irish house prices are now down 45% from their 2007 peak and continuing to fall despite a very low interest rate policy.

What makes this statistic particular worrying is that like the banks in the US, the Irish banks have not dealt with the losses in their mortgage book.  Despite the fact that the Irish banks received a significant equity infusion from the government, they have not modified these mortgages so that the borrowers can service them.

The result of not modifying the mortgages is that there continues to be downward pressure on house prices.

HOUSE prices fell last month at their fastest rate for two-and-a-half years, official figures have revealed. 

In further signs that the crash has yet to bottom out, average property prices are down 15.1pc in the last year, the largest annual decline since March 2010. 

The housing index from the Central Statistics Office (CSO) also showed the cost of a home is now 45pc cheaper than the peak in early 2007. 

A breakdown of the property market revealed that average prices in Dublin are down 51pc while outside the capital the fall is much lower at 42pc. 

The collapse has hit apartments much harder, with values down 60pc in the last four-and-a-half years. 

The fall of 2.2pc in average property prices in October is the largest monthly drop since April 2009. 

It emerged last week that more than 100,000 people are now struggling to repay their mortgages. 

This is made up of around 62,000 homeowners in arrears of three months, or more, and just less than 40,000 who have restructured their repayments, Central Bank figures revealed.... 

It equates to four out of 10 households in mortgage arrears with the four domestic banks who have now been behind on their repayments for a year or more. 

These families have missed so many of their monthly payments that they have run up an average of €27,000 each in arrears, according to the Central Bank. 

The Central Bank study of mortgages at AIB, Bank of Ireland, EBS and Permanent TSB also found that troubled home loans at these lenders represented 56pc of all the mortgages in arrears.

A separate Independent article reports how one Irish house sold at auction for 17% of what its peak price was in 2007.

IF you ever needed proof that the property market had collapsed, here it is. 

A Dublin father yesterday bought his ideal family home for €65,000 -- three years after walking away from the three-bed house when the asking price was €380,000. 

"We looked at that exact house three years ago and it was €380,000," the man -- who didn't want to be identified -- told the Irish Independent as he left the Merlin Property auction in Dublin. 

"It's unbelievable; I thought that when I went in I wouldn't get it. It is the best value I have ever seen.... 

The attractive, three-bed terraced home in East Wall, Dublin, sold for €65,000. 

But the previous owner was happy enough to sell the house he had grown up in with his parents. 

Noel Langrell (55) said that while it had been on the market for a number of years, he was unable to sell it and decided to go to auction when Merlin advertised. 

"If you have a property sitting there and it's going nowhere, this is the way to go," he said afterwards. 

"What can I say? What's the point of holding on to it? It was a family home since the 1920s, my mam died and I was on my own by then." 

Just four of nine properties at the small auction were sold by last night, with three remaining under auction and two withdrawn. 

Their collective earnings were €305,500 compared to a peak market value of €1.03m....

"It's frightening; it's scary," observed a bidder who asked to be identified only as Dermot from Kildare. "And it reflects your own house; if you can pay your mortgage or if you don't have one that's okay but if you have to sell then that's when the issue comes in."

Moody's downbeat on Irish banks

Despite Ireland being praised as a bailout role model, the Irish Times reports that Moody's is downbeat on Irish banks.

Left off of Moody's list of concerns is the ongoing run on Irish bank deposits and the continuing fall in real estate prices.

Finally, no mention was made of the fact that the banks are delaying recognizing their bad mortgage debts and how this artificially boosts the banks capital.

Moody’s Investors Service said today the outlook for Ireland’s banking system remains negative, citing the banks’ weak funding and liquidity profiles and a very challenging operating environment. 

“The substantial weakening in the funding and liquidity profiles of the banking sector is a key driver of the negative banking system outlook,” Moody’s said. 

“The banks continue to rely on short-term central bank funding from the European Central Bank and in some cases from the Central Bank of Ireland.” 

.... Moody's also believes that profitability will remain weak, and said the improved capital positions of Irish banks only partly mitigate these weaknesses. 

The Government has also weakened its own credit profile through supporting the banks, the agency said, and warned the banks would have to deal with the implications of this as the Government tries to cut the debt burden. 

The reduction in Government spending could put "considerable pressure" on the country’s recovery prospects, Moody's said, weakening asset quality and putting pressure on the bank's profitability. 

“We expect the operating environment for Irish banks to remain very difficult over the outlook period, primarily as a result of Government’s considerable austerity efforts, the continued financial market turmoil in the euro area, and deterioration in the global economic environment,” said senior analyst Ross Abercromby.

Central bankers - stop dithering. do something.

Adam Posen, a member of the Bank of England's Monetary Policy Committee, wrote a column in the NY Times in which he called on central bankers to do something.

As I was reading the column, I kept asking two questions:

• Why should monetary policy be a solution for a solvency crisis; and

• Has anything changed since the 1870's when Walter Bagehot observing that savers have a strong distaste for low rates said in the Economist that "John Bull can stand many things but he cannot stand two percent"?  This was the lower bound for monetary policy for the Bank of England until the financial crisis in 2007.

Regular readers know I am not an economist, although I did work in the area of the Fed during Mr. Volcker's chairmanship that produced the monetary policy that is credited with defeating inflation.

The following comments about Mr. Posen's column are really more Walter Bagehot type observations.

BOTH the American economy and the global economy are facing a familiar foe: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the United States in the 1930s, or in Japan in the 1990s, every major financial crisis has been followed by premature abandonment — if not reversal — of the stimulus policies that are necessary for sustained recovery. Sadly, the world appears to be repeating this mistake.

The right thing to do right now is for the Federal Reserve and the European Central Bank to engage in further monetary stimulus. Having lowered short-term interest rates, they should buy (or in the case of the Fed, resume buying) significant quantities of government securities to help push down long-term interest rates and encourage investment. 

Is there any evidence that says since the beginning of the solvency crisis that pushing down long-term interest rates has actually encouraged investment?

Since the beginning of Japan's solvency crisis, it has had over two decades of low long-term interest rates.  Is Japan experiencing an investment boom?

If anything, it is past time for the Fed and its European counterpart to act. The economic outlook has turned out to be as grim as forecasts based on historical evidence predicted it would be, given the nature of the recession, the cutbacks in government spending and the simultaneity of economic problems across the Western world....

There is one prediction that is left out of here.  That is the prediction by Walter Bagehot that 2% is the lower boundary for effective monetary policy.  Any lower and bad things happen to the economy.

Is it possible that zero interest rate policies and quantitative easing actually make the economic situation worse?

There is a significant amount of anecdotal evidence to suggest that these monetary policies do in fact make the situation worse.  This evidence includes:

• Low interest rates increase the amount of money that businesses must put into their pension plans to keep them fully funded --- additional contributions are needed to offset the decline in earnings on the plans assets from the low interest rate policies.  Money contributed to a pension plan is not money the company can reinvest in its core businesses.

• Low interest rates decrease demand from individuals who are savers.  They need to reduce current consumption to offset the drop in earnings on their savings.  The lower demand triggers a death spiral.  Business sees the decline in demand from individuals and delays making investments.  Central banks try cutting rates further.  This increases the amount savers need to cut consumption by.  Business see further decline in demand and the cycle repeats itself.

• Low interest rates provide a greater incentive for de-leveraging.  For all borrowers, their highest risk-free return is to pay down their borrowings.  For most of the last two decades, this was not true as the increase in asset prices was greater than the cost of borrowing.

[I]nvestment has been held back because of uncertainty over the economy’s future prospects. And the ability to attract investors is being limited by the giant burden of private-sector debt. In other words, a financing problem is inhibiting the restructuring of our economy. 

Alleviating generalized financing problems and low investor confidence is precisely what monetary stimulus does.... 

In Japan in the 1990s, a period of insufficiently aggressive monetary stimulus fed lending to “zombie companies” — unproductive borrowers on whose loans the banks could not afford to take losses. 

Actually, this lending to 'zombie companies' was the result of the extend and pretend policies adopted by bank regulators.  These same policies have been adopted globally today.

It is this policy that is the single biggest barrier to economic recovery.

Extend and pretend distorts markets.  This blog has discussed how extend and pretend makes it very difficult for banks to lend against real estate - the banks have to factor in what would happen to real estate prices if all the bad loans on their balance sheets had to be recognized.

Regular readers know that there is no such thing as a bank that cannot afford to take its losses - banks can continue to operate with negative book capital until such time as the banking regulators close them.

There are bankers who don't want the bank to take losses to preserve their bonuses.  There are regulators who do not want banks to take losses because it highlights how poorly they performed their supervision function.

It was only when macroeconomic policy led a recovery in Japan in the first decade of this century that capital flowed out of the places it had been trapped and into new and growing businesses. 

Actually, it was only when Japan tried to force the banks to write-down their bad assets that capital began to flow out of the places it had been trapped.

Unfortunately, bank regulators stopped the write-down process well before all the bad assets had been written off.  The reason for stopping was the book capital levels at the banks.  The regulators wanted to preserve positive book capital levels.

Similarly, after the American savings-and-loan crisis, real reallocation of credit from bad banks and borrowers to worthwhile investment began in earnest only when monetary policy eased in the late 1980s.

Actually, the real reallocation of credit from bad banks and borrowers to worthwhile investment began in earnest only when the financial regulators stopped engaging in policies of extend and pretend.

It was only when assets had been written-down that it became easier for a good borrower to access credit than it was for a bad borrower - under extend and pretend, bad borrowers have an easier time accessing credit because the additional credit is needed to make their loan look like it is performing.

Japan and the savings and loan crisis are examples that show monetary policy is impotent during a solvency crisis when financial regulators are engaged in extend and pretend policies.

Central banks and governments can engage in forms of coordinated action that will target the burden of past debts that is hanging over the global economy. 

In the United States, that means resolving the distressed mortgage debt that is weakening our financial system and reducing labor mobility, thereby constraining not only our growth but also our ability to grow. It is time for the Federal Reserve and elected officials to explore ways to jointly tackle that housing debt....

Given that the Fed is the banking regulator leading the extend and pretend policy, the statement that it is time to address the solvency crisis is quite a statement.  It is even more of a statement given that the Bank of England is going to become the regulator leading the extend and pretend policy when it inherits supervising banks from the FSA.

Regular readers know that the Fed does not have to talk with elected officials to tackle the housing debt problem.  It simply has to end the extend and pretend policies it is implementing.

Is the Bank of England going to end extend and pretend in the UK?