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?

Harvard's Carmen Reinhart: "The crisis isn't over in the US or Europe"

In her Der Spiegel interview, Harvard economist Carmen Reinhart makes the point that the financial crisis isn't over and the best way to solve it is if debt is written-off.

Furthermore, she points out that the policies that have been pursued to address the problem of too much debt in the financial system are placing the cost of the financial crisis on the real economy and everyday savers.

If this sounds like what your humble blogger has been saying since the beginning of the financial crisis, well....

SPIEGEL: Ms. Reinhart, central banks around the world are flooding the markets with cheap money in order to spur economies and support governments. Are these institutions losing their independence? 

Reinhart: No central bank will admit it is keeping rates low to help governments out of their debt crises. But in fact they are bending over backwards to help governments to finance their deficits. .... 

SPIEGEL: Is that true of the European Central Bank as well? 

Reinhart: Less than for other central banks, but yes. And the crisis isn't over yet -- not in the United States and not in Europe.... 

SPIEGEL: As a historian who knows the potential long-term consequences very well, doesn't such short-sighted decision-making frighten you? 

Reinhart: I am not opposing this change, I am just stating it. You have to deal with the debt overhang one way or the other because the high debt levels are an impediment to growth, they paralyze the financial system and the credit process. One way to cope with this is to write off part of the debt. 

SPIEGEL: You mean some kind of haircut? 

Reinhart: Yes. But we are in an environment where politicians are very reluctant to do write-offs.

Please re-read the highlighted text as Ms. Reinhart has explained both the Swedish Model (where banks  absorb upfront the losses on the excess debt in the financial system) and the Japanese Model (where bank book capital levels and banker bonuses are protected at all costs).

As Ms. Reinhart says, politicians have chosen the Japanese Model.  As a result, the burden of the excess debt is place on the real economy and savers.

So what happens is that money is transferred from savers to borrowers via negative interest rates....

SPIEGEL: So what should be done? 

Reinhart: The best way of dealing with a debt overhang is to never get into one. Once you have one, what can you do? You can pray for higher growth, but good luck! Historically it doesn't happen -- you seldom just grow yourself out of debt. ... 

And the way to ensure that you don't get into a debt overhang is to bring transparency to all the opaque corners of the financial system.  Then, market participants can assess the risk of each of their exposures and limit their exposures to what they can afford to lose.  This puts a cap on how much debt can be in the financial system.

SPIEGEL: But is it not a declaration of bankruptcy for democracy if central bankers, who haven't even been elected, have to step in to fix the problem in the end? 

Reinhart: I think the biggest mistake that European policy-makers are now making is not to put debt restructuring more explicitly on the table. 

Ms. Reinhart calls for adoption of the Swedish Model.

SPIEGEL: Are you referring to Greece? 

Reinhart: Greece has had its restructuring, that's history. But look at Ireland and Spain. Private senior bank debt has not been written off, despite the fact that underlying asset prices in those countries have collapsed and are still collapsing. 

SPIEGEL: So closures of some banks would be helpful? 

Please note that banks recognizing the losses on the excess debt in the financial system may or may not lead to bank closures.

Banks are designed to be able to absorb these losses and continue to operate and support the real economy.  They can do so because of deposit insurance and access to central bank funding.  With deposit insurance, the taxpayers effectively become the banks' silent equity partners when the banks have low or negative book capital levels.

A bank can continue in operations so long as the interest income it generates on its assets exceeds the interest expense on its liabilities plus its pre-banker bonus operating expenses.  The excess earnings can be retained and used to rebuild bank book capital levels.

The only banks that need to be closed are those that where the interest income on their assets is less than the interest expense on their liabilities plus their pre-banker bonus operating expenses.

Reinhart: What is sacrosanct about bank debt? 

SPIEGEL: Well, the bankruptcy of banks can have a considerable effect on the financial system. 

Reinhart: Let me be a little blunter: A haircut is a transfer from the creditor to the borrower. Who would get hit by a haircut? French banks, German banks, Dutch banks -- banks from the creditor countries. So you can see why this is politically torched. This is why it is not done, it's a redistribution. But ultimately it is going to happen, because the level of debt is too high. 

As Ms. Reinhart says, ultimately the Swedish Model will be adopted and banks will be required to recognize their losses.  The question is how much damage to the real economy and the social contract will occur before politicians accept this fact.

IMF's Lagarde: big banks "more dangerous than ever"

Oops.  It appears that the global policymakers and financial regulators decision to protect bank book capital levels and bankers bonuses at all costs since the beginning of the bank solvency led financial crisis might not have been the right decision.

The Telegraph reports that the IMF's Christine Lagarde sees big banks as "more dangerous than ever".

And why are they more dangerous than ever?  Because

"many banks are still in an early stage of repair – not enough capital and too many bad loans on their books. Even outside the periphery, there is a need to shrink balance sheets, reduce reliance on wholesale funding, and improve business models,” she said. 

Because the banks are broken, cheap credit is not getting through to the parts of the economy that need it. 

“Because of insufficient financial repair, monetary policy is “spinning its wheels” – meaning that low interest rates are not translating into affordable credit for people who need it,” she said. 

“So the priority must be to continue to clean up the banking system by recapitalising, restructuring, or – where necessary – shutting down banks.” 

Please re-read Ms. Lagarde's comments as she has confirmed what you humble blogger has been saying since the beginning of the financial crisis about why the policy response doesn't work and what it takes to fix the global economy.

The necessary first step is to fix the global banking system by requiring it to recognize upfront all the losses on the excess public and private debt in the financial system.

Banks can absorb these losses because they are designed to continue operating and supporting the real economy even when they have low or negative book capital levels.  Banks can do this because of deposit guarantees and access to central bank funding.  Deposit guarantees effectively make the taxpayers the banks' silent equity partner when they have low or negative book capital levels.

After absorbing the losses, the banks whose interest income exceeds their interest expense and pre-banker bonus cost of operating can rebuild their book capital through retained earnings.

To ensure that these banks don't take on too much risk while rebuilding their book capital, they must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this disclosure, market discipline will restrain banks gambling on redemption.

After absorbing the losses, the banks whose interest income is less than their interest expense and pre-banker bonus cost of operating should be resolved.

Please note that this solution, what I call the Swedish Model for handling a bank solvency led financial crisis, results in the bankers paying for the losses in the financial system that they created.

Policy success: Bankers carry on unabashed, unscathed and unashamed

In his Guardian column, Nick Cohen documents how since the beginning of the financial crisis bankers have carried on unabashed, unscathed and unashamed.

This is the direct result of the policy choices made by the global policy makers and financial regulators.  Specifically, they adopted the policy of failure containment and its corollary the Geithner Doctrine.

These policies are best expressed as 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.  Yves Smith phrases it as: do nothing that will harm the profitability or reputation of big and/or politically connected banks.

To the extent that bankers have in fact carried on unabashed, unscathed and unashamed with their bonuses intact, except for a one year dip, the implementation of these policies has been very successful. So one can easily imagine why policy makers and financial regulators are expecting praise for their actions.

Unfortunately, it is the "protected at all costs" part of the Japanese Model that is proving problematic.

The problem is that by protecting banker bonuses, the burden of the excess debt in the financial system was placed on the real economy.  This burden has overwhelmed the real economy as predicted at the beginning of the financial crisis by your humble blogger.

The burden is in fact so large that despite massive fiscal and monetary stimulus the best that has been achieved is a Japan-style economic malaise (also known as on-going economic slump).

Regular readers know that there is in fact an easy way to end this economic malaise without resorting to central banks practicing new forms of money printing.  Simply adopt the Swedish Model and protect the real economy by using the banks as they were designed.

In a modern financial system with deposit guarantees and access to central bank funding, banks are designed to be able to absorb all the losses on the excess public and private debt in the financial system.  Banks can do this because the deposit guarantee effectively makes the taxpayers the banks' silent equity partner when they have low or negative book capital levels.

Of course, using the banks as they are designed results in bank book capital taking a hit, banker bonuses dropping precipitously and a shrinkage in bank consulting opportunities for current policy makers and financial regulators.

For most, that is a small price to pay to protect the real economy and preserve the social contract.  For policy makers and financial regulators, that is a price that to date they are unwilling to pay.

Conservatives, of all people, ought to have been horrified when the state used taxpayers' money to prop up lame-duck banks. Conservatives, who shout the loudest about scroungers living off the taxpayers, ought to have been the most concerned about sponging financiers.... 

In the 21st, honest conservatives might describe the public purse "as a vast source of corporate welfare for the moneyed classes"....

The right's folly lies in its inability to understand that bankers have not been bashed. Indeed, they have barely been slapped. The courts have jailed no one responsible for the crash. Instead of "a never-ending trial for financial war crimes", there have been no trials whatsoever. No one has sought to compensate the taxpayer by confiscating the bonuses taken in the bubble.... 

This palpable injustice allows me to summarise the coalition's failure to convince the public that "we are all in this together" in a paragraph.

The taxpayer injected about £65bn into RBS and HBOS in share capital. Those shares are currently showing a loss of £20bn. The overall cost to taxpayers is incalculably higher because we must now manage in a zombie economy with a crippled banking system that can't send credit to where it's needed. Yet rather than punish those responsible, the coalition has cut their taxes....

The parliamentary commission on banking standards' report on the collapse of HBOS, just published, has many virtues. Its greatest is that parliamentary privilege – a right to free speech Parliament will not extend to the rest of us – allows the commission to speak without authoritarian lawyers and judges blacking out the detail.

The commission's account of how HBOS's pre-tax losses reached £30bn breaks the bankers' mythology....

It was the same line Gordon Brown endlessly parroted. "A crisis that began in America" destroyed the British banking system. If it had not been for sub-prime loans in California and Bush's refusal to bail out Lehmans all would have been well. 

The banking commission, a strange but surprisingly intelligent group of MPs, peers and – only in England! – His Grace the Archbishop of Canterbury, takes the wishful thinking apart with admirable brutality. 

Lord Stevenson and his colleagues' version of events "represents a model of self-delusion", it says. HBOS suffered from a solvency, not a liquidity, crisis.... 

There is a more glaring fault. The banking commission condemns the FSA but, like the Tories and Labour, it will not recommend breaking up the banks by splitting their high street businesses from the investment business. Banks that were too big to fail and had to be bailed out by taxpayers in 2008 are still too big to fail in 2013. 

Grasp this point, and the complaints about "banker bashing" turn from the ridiculous into something more sinister. 

The banking lobby is so unscathed – so unbashed, unbattered and unbruised – it has the muscle to prevent an urgent and necessary reform and can act as if the crisis never happened.

A banking reboot would create necessary condition for economic growth

In his Telegraph column, Liam Halligan lays out the argument for rebooting the banking sector as this creates the necessary condition for economic growth.

Mr. Halligan effectively calls for the end 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.  Instead, he calls for adoption of the Swedish Model where banks are required to recognize upfront their losses on the excess debt in the financial system.

Where Mr. Halligan refers to the UK, please feel free to substitute EU, Japan or US.

Five years on from this sub-prime collapse, though, and ... 

The debate about how the UK escapes from this economic torpor remains deeply entrenched, largely along party lines. Our politicians are locked in a "growth versus austerity" soap opera, trading ideological jibes as they argue over tax and spending plans that are, anyway, largely fiction. 

The truth is that, if the UK economy is to fire on all cylinders again, our banks badly need to raise fresh private sector capital, then extend finance to the creditworthy businesses that will generate sustainable recovery. 

A little bit of extra government spending here, a new "scheme" there, while driving endless political spats, will have zero impact on growth compared with forcing a banking sector reboot. 

Debates over tiny dabs of unaffordable state largesse amount to posturing and political parlour games. Such energy-sapping policy tweaks don't affect our growth trajectory in the slightest, but are mere exercises in temporary media management. 

Sorting out the opaque, wealth-destroying mess that is the UK banking system, by contrast, requires courage and a sustained determination to face down powerful vested interests. 

I wonder, after decades of relative prosperity and the complacency that breeds, if the UK and much of the Western world has leaders who are willing and able to do this. I see much evidence to the contrary....

Please re-read the highlighted text as Mr. Halligan has nicely summarized the current situation under the Japanese Model and just how difficult it will be to adopt the Swedish Model.

The British economy is suffering not from a lack of government spending, as the Keynesian spend-a-holics would have it, but from a chronic lack of private sector investment.... 

An even more significant explanation, though, of why our capital stock is stagnating – it grew by just 1.1pc in 2012, a 20-year low – is that our banks are failing to extend commercial credit to SMEs, or are often doing so only on terms so harsh as to kill stone dead what would otherwise be feasible business plans. 

If the UK economy is to recover, our banks need to raise capital and then extend the finance needed to kick-start investment and commerce. 

One reason this isn't happening is that banks are doing nicely lending out small volumes at high rates. 

More fundamentally, their capital raising is stymied as investors don't trust banks' financial statements, given that risks are often understated and huge, smouldering sub-prime related losses remain buried off-balance sheet. 

Bank of England policymakers recently warned that UK banks need to raise additional capital of £25bn. Market estimates put the figure at nearer £50bn. 

The banks insist that refinancing themselves would make lending even more difficult, but the truth is that no one really knows the state of our banking system. 

Politicians remain deeply reluctant to push the big banks into "full disclosure" for fear of what will be found.

Please re-read the highlighted text as Mr. Halligan has nicely summarized the current global state of the banks.  No one knows whether they are solvent or not.

The only way to know the true condition of a bank is if it provides full disclosure, what I call ultra transparency, and discloses on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the solvency of each bank and its risk.

Please note, as your humble blogger has said repeatedly, banks are designed so they can continue to operate and support the real economy even when they are insolvent.  A bank is insolvent if the market value of its assets is less than the book value of its liabilities.  However, this is not necessarily a permanent condition.

What is important to focus on with a bank is the question of whether the interest income generated by its assets on a fully performing basis (after all losses have been realized) exceeds the interest expense on its liabilities plus operating expenses before banker bonuses.

If the answer is yes, then the bank is capable of generating and retaining earnings so that it can become "solvent" in the future.

If the answer is no, then the bank should be closed.

The UK may avoid a triple-dip recession. But banking sector gridlock is turning our country – once a shining example of industry, ingenuity and enterprise – into a low-investment, low-productivity basket case. Something has to give.

Dean Baker: confusion between saving financial industry and saving financial system

In his post, economist Dean Baker looks at how both the Bush and Obama administrations confused and still confuse saving the financial industry with saving the financial system.

The source of this confusion is the policy of financial failure containment and its corollary, the Geithner Doctrine, that was adopted by the US Treasury and the Federal Reserve.  Under this policy, the Japanese Model for handling a bank solvency led financial crisis and its twin goals of protecting bank book capital levels and banker bonuses at all costs was adopted.

By definition, this policy was designed to protect the status quo including the existing banks and sizable banker bonuses.

In contrast, there is the policy of financial failure prevention on which the global financial system is based.  Under this policy, the Swedish Model for handling a bank solvency led financial crisis is adopted and banks are required to absorb upfront the losses on the excess debt in the financial system.

By definition, this policy is designed to protect the real economy, the taxpayers and the social contract at the cost of greatly reducing banker bonuses.

The Washington Post published excerpts from reporter Neil Irwin's new book,The Alchemists: Three Central Bankers and a World on Fire, under the headline, "three days that saved the world financial system." 

The headline is seriously misleading since it may cause readers to believe the world somehow would have lacked a financial system if the central bankers in Irwin's story had not succeeded in their efforts. 

This is not true. 

Had a financial collapse actually been the outcome, the central banks had the ability to take over failed banks and restart the system. (This is what the FDIC does all the time.)... 

While the immediate hit from the financial collapse would have almost certainly been worse than what Europe and the rest of the world saw in the immediate wake of the initial euro zone crisis, the euro zone and world economy would almost certainly be much better off today if the central bankers had simply allowed the system to collapse. (This assumes that they are as competent as the economic policymakers in Argentina.) 

In this sense, the heroes in Irwin's book can be seen as saving the bankers, who would have been wiped out in a financial collapse, but not really doing much to benefit the rest of society.

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.

Michael Pettis: When do we call it a solvency crisis

In a very interesting column, Michael Pettis looks at how there can be a bank solvency crisis going on for years before the banks and regulators are willing to publicly acknowledge that there is a bank solvency crisis.

The example that Mr. Pettis focuses on is the handling of loans to Less Developed Countries (LDC).

Regular readers know that your humble blogger has written about the LDC experience extensively.  The key takeaways were market participants knew that from a book value perspective the banks were insolvent, this did not matter and banks can operate for years while rebuilding low or negative book capital levels.

Why did market participants know the banks had negative book capital levels as a result of the LDC loans?

Because the banks disclosed the size of their exposures to each Less Developed Country.  By simply taking the price that the loans traded for in the market, market participants had a way of approximating the value of these exposures and what the true book capital level was for each bank.

Compare and contrast this with the current situation where banks do not disclose their exposures.

There is no way for market participants to know just how negative the true book capital levels are for each bank.

To take one possibly illuminating example, I started my trading career during the Latin American debt crisis, which officially began in August 1982. 

I joined the market in 1987, when bankers and policymakers were still assuring everyone that the problem Latin America was facing was a liquidity problem.

Nobody believed them nor because of disclosure of the LDC loans did anyone have to believe them.

I have referred to the handling of the LDC loans and the Savings & Loans as Fed Chairman Paul Volcker's regulatory legacy.  He believed in handling solvency issues behind closed doors.

This philosophy ultimately resulted in what I refer to as the policy of financial failure contagion and its corollary, the Geithner Doctrine (via Yves Smith:  do nothing that will harm the profits or reputations of big and/or politically connected banks).

This policy is built on the notion that financial contagion is minimized by hiding the truth behind closed doors.

As discussed above, this policy was absolutely the wrong conclusion to draw from the LDC loan experience.

The conclusions to have drawn are that markets understand that banks can operate with low or negative book capital levels and that markets can handle the truth.

As long as we could keep rolling loans over, they earnestly explained, the problem would eventually resolve itself at little to no relative cost (well, Latin America was struggling with unemployment, capital flight, hyperinflation and political turmoil, but I guess that doesn’t really count). 

It wasn’t until 1990 that the first formal debt forgiveness took place – known as the Mexican Brady Bond restructuring – and before the end of the decade nearly every country except Chile and Colombia had their own Brady bonds. 

Even those two countries, and all the others, had managed to obtain for themselves a significant amount of informal debt forgiveness through debt-equity swaps and debt repurchases at huge discounts from face value (some legal and some not quite legal). 

Why did it take so long for bankers and policymakers to recognize the truth – that this was not just a liquidity problem? 

Actually it didn’t. Most bankers knew by 1985-86 that the region was actually suffering from a generalized solvency problem, and among the big banks JP Morgan had been taking substantial provisions all along. 

No one could formally acknowledge the possibility of insolvency, however, because to have done so would have required that all of banks take much greater provisions than they already had. 

This would have created a problem. Of the top ten banks in America, only JP Morgan would not have been technically insolvent had the banks been forced to mark their LDC loan portfolios to market.

Mr. Pettis is confusing having negative book capital levels with being technically insolvent.

The banks all were technically insolvent as the book value of their liabilities exceeded the market value of their assets (the definition of technical insolvency).

Recognizing their losses would have had two impacts.  First, it would have in fact made the banks reported book capital levels negative.  Second and far more importantly, it would have hammered banker bonuses.  These bonuses couldn't be paid when banks have low or negative book capital levels.

In May 1987 Citibank, after many years of replenishing its capital, was able to announce suddenly and to the great surprise of the entire market that it had decided to take a huge amount of provisions against dodgy sovereign loans.

When it did so, Security Pacific became the poster bank for everyone knowing that its "true" book capital levels were massively negative.

However, everyone knew it would not be closed as it had a franchise that was capable of generating a significant amount of earnings even with a negative book capital level.

By 1989-90 the rest of the big American banks were also able to accept the write-offs without becoming technically insolvent. That is when everybody formally “discovered” that in fact the LDC debt crisis was a lot more than just a liquidity crisis.

No, this is when the regulators and bankers were willing to formally acknowledge the LDC debt crisis was a solvency crisis. It was well known by the market that it was a solvency crisis since 1982.

This is the key point. The American bankers weren’t stupid. They just could not formally acknowledge reality until they had built up sufficient capital through many years of high earnings – thanks in no small part to the help provided by the Fed in the form of distorted yield curves – to recognize the losses without becoming insolvent.

American bankers were not stupid.  They knew that formally acknowledging reality would end their lucrative bonuses.

This is exactly what has happened globally during our current bank solvency led financial crisis.  

And this matters to Europe. There is simply no way European banks, especially in Germany, can acknowledge the possibility of sovereign insolvency until they, too, have built up enough capital to absorb the losses. 

They have, unfortunately, been painfully slow to do so, even with yield-curve help from the ECB, and so I suspect that this is going to remain a “liquidity” problem for many more years. 

While it does, the debt-burdened countries of peripheral Europe are going to suffer a decade of weak growth, high unemployment, and contentious politics, all the while the debt growing faster than the economy.

Mr. Pettis re-iterates a series of points that your humble blogger has previously made.  These points boil down to two simple observations:

1. when bankers are allowed to pay themselves bonuses, banks cannot rebuild their book capital levels quickly; and
2. when banks are not required to recognize their losses on the excess debt in the financial system, the real economy and the borrowers suffer as a result.

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).

Primary difference between financial repression and deposit confiscation: speed

In an excellent Telegraph column, Ian Cowie looks at the depositor haircut in Cyprus to bailout its banking system as petty theft compared to what savers have been "stealthily robbed" robbed of by financial repression (think zero interest rate policies) to bailout the global financial system.

The primary difference, other than sheer quantity of money pilfered, is speed.

The depositor haircut happened over-night.  Financial repression has been going on since the beginning of the financial crisis.

Your humble blogger uses the word "primary" on purpose.  Both the depositor haircut and financial repression are the result of government policies to bailout the financial system by imposing its losses on savers/taxpayers.

Regular readers know the politicians are making a conscious decision to impose losses on savers/taxpayers and not on the bankers who caused the loss in the first place.  In fact, these bankers continue to be rewarded with nary an interruption in their bonuses.

Politicians are making a conscious decision because the banking system is designed to absorb losses on the excess debt in the financial system and continue operating even though the banks have low or negative book capital levels.

Banks can do this because of the existence of deposit insurance and access to central bank funding.    Deposit insurance effectively makes the taxpayers the banks' silent equity partner when the banks have low or negative book capital levels.  As a result, banks have unlimited capital against which to continue lending.

Every day since the financial crisis began, politicians have made the decision to steal, whether through financial repression or a depositor haircut, from savers/taxpayers and give to the bankers rather than use the banking system as it is designed to be used.

I admit that having the banking system absorb the losses on the excess public and private debt in the financial system would be bad for banker cash bonuses.  However, given the choice between the government stealing from the savers/taxpayers or reducing banker cash bonuses (not necessarily the total size of banker bonuses), I opt for reducing banker cash bonuses.

Outrage about the Cyprus banks euro tax bail-out should not be allowed to obscure the fact that millions of savers in British banks have already lost much more of the real value or purchasing power of their money to prop up financial institutions closer to home. 

Savers in British banks and building societies have been stealthily robbed of more than £43bn of the real value of their savings since the Bank of England froze interest rates at 0.5pc four years ago. 

That's the total shrinkage of bank and building society depositors' purchasing power caused by inflation exceeding frozen interest rates, according to calculations by the pressure group Save Our Savers, following similar calculations by Yorkshire Building Society that the average saver has lost £2,500 in real terms since the credit crisis began. 

Both figures have got much bigger than they were a couple of years ago, as inflation has continued to run ahead of interest paid on deposits.  

Pensioners have suffered even more because higher than average proportions of their fixed incomes are spent on food and fuel. They are the largely silent victims of the Bank of England's policy of running negative real interest rates. 

But this slow-motion bank robbery is more difficult to describe than the short, sharp, smash-and-grab in Cyprus. So, despite the best efforts of this column to blow the whistle, more attention will be given to smaller losses for fewer people in Cyprus than millions of savers and pensioners who have lost much more in British banks and retirement funds. 

Suggested levies of 6.75 per cent of all deposits up to €100,000 (£86,500) and 9.9 per cent for larger deposits caused many savers in Cyprus to withdraw their money from banks over the weekend.... 

Elsewhere, Government sources stressed that deposits held in the London branches of Bank of Cyprus UK and Laiki Bank would not be subject to the new levy. Treasury sources said that “deposits in UK subsidiaries and branches [of Cypriot banks] aren’t affected” by the crisis. 

If only small savers with Britain’s high street banks and building societies could say the same. Nor are they the only victims to pay a high price for quantitative easing and QE’s aim of protecting over-stretched banks and borrowers at the expense of savers. 

Unfortunately, in a vicious seesaw effect, extra demand for gilts created by QE has pushed up the price of bonds, pushing down their yield or the income pensioners can obtain with their savings. Laith Khalaf of wealth managers Hargreaves Lansdown reckons annuity yields have fallen by about a fifth during the last four years. 

So savers of all descriptions are paying a high price for the Bank of England’s strategy of maintaining negative real interest rates. 

Sadly for the millions of victims of this slow-motion bank robbery in Britain, it remains too complex to explain on the front page or in TV bulletins and so much more coverage will be given to a relatively small scale smash and grab with fewer victims in Cyprus.

FSA's Lord Turner: policymakers and regulators inherited "50 year long, large intellectual policy mistake"

In a must read Telegraph column, the FSA's Lord Turner attempts to place the blame for the failure of global policymakers and financial regulators to prevent and adopt a successful policy response to the global financial crisis on an over-reliance on markets.

Five years later, and as Lord Turner prepares to leave the FSA at the end of the month, few would have thought that the unprecedented events of that fateful year [2008] would still be reverberating throughout the developed economies.

For the record, your humble blogger publicly stated in late 2007 and throughout 2008 that without the right policy response, we would be facing a long-term Japan style economic malaise if not outright contraction.  This prediction has been borne out for the last 5 years as clearly, given the economic problems that we face today, the policymakers and financial regulators have not adopted the right policy response.

But, then again, who am I to be listened to on this matter.  After all, my track record includes predicting the financial crisis and subsequently predicting on this blog with the same degree of accuracy which policies were not going to work.

But hey, who cares about a track record when the entire economics profession continues to offer up recommendations despite having not predicted the financial crisis (my apologies to William White and his group at the BIS who did foresee the financial crisis).

In previous recessions, the route back to growth has been quicker. 

This time, a toxic mix of unsustainable levels of public debt and private-sector deleveraging has left the British economy in a long-term funk....

It is not the de-leveraging that has the economy in a funk.  It is the excess debt in the financial system and the policy responses to this excess debt that are causing the financial funk.

Banks are still in the dock. The City still feels friendless.

Oh please.  The City doesn't care about friends.  It is buying and selling policymakers left and right. Witness the UK government dashing off to Brussels to try to head off a regulation limiting banker bonuses.

Remuneration is still headline news.

As it should be given that the policy response that Lord Turner is so proud of was to protect banker bonuses at all costs.

New regulations on financial services are spewing out of Parliament, Europe and the Basel III process....

The number one lesson of the financial crisis is that the combination of complex rules and regulatory oversight does not prevent a financial crisis.

If it did, we would not have had a financial crisis and the banks would have avoided it.

“If you go back to March 2009, which is the point where all of us had gone through the crisis and were coming up for air and saying 'how do we put things right for the future?’ – if you look at all the forecasts, Bank of England, Treasury, the IFS [the Institute for Fiscal Studies], IMF, World Bank, they all suggested a much faster and more robust recovery of the developed-world economies than has actually occurred,” says Lord Turner. 

“I think that’s because we were slow to realise that once an economy has become overleveraged, once either corporates or households are over-leveraged, they will devote whatever disposable income they have to trying to get their balance sheets down, and therefore the demand for credit is depressed.”

Nice example of complete intellectual capture of a regulator by the bankers.  This is not surprising as Lord Turner is trying to defend the indefensible:  protecting banker bonuses and tearing up the social contract to pay for these bonuses.

The demand for credit is not depressed because of repayment of existing debt.

Demand for credit by business is depressed because of a lack of revenue growth.  Businesses simply don't borrow to expand when they don't see revenue growing.

Demand for credit by individuals is depressed because credit is now only provided to individuals who can actually afford the debt service payments.

And until the economy recovers, the financial crisis will cast its shadow over everything that happens....

The financial crisis will continue to make economic recovery impossible so long as policymakers and regulators refuse to require the banks to recognize upfront their losses on the excess public and private debt in the financial system.

Until this is done, the burden of the excess debt falls on the real economy where it diverts capital needed for growth, reinvestment and social programs to debt service and banker bonuses.

“I think we – as the authorities, central banks, regulators, those involved today – are the inheritors of a 50-year-long, large intellectual and policy mistake,” he says. 

“We allowed the banking system to run with much too high levels of leverage, inadequate levels of capital, and we ignored the development of leverage in the financial system and in the real economy. 

“And not only did we ignore it but we had a pretty overt intellectual philosophy that we could ignore it, because we knew the financial system was just a market like any other and whatever it did was bound to be for the good because that’s what markets are. 

“That was a huge mistake. 

“People just fall into the habit of believing that the system is stable. I think, unfortunately, there was the development of a set of intellectual ideas – efficient market hypothesis and rational expectation hypothesis – which provide an apparently sophisticated intellectual argument for why this whole system is safe.

I appreciate the fact that Lord Turner just said the economics profession is worthless and that economists should not be listened to.  It is hard to argue with this given that economists did not see the financial crisis coming and they were the ones promoting the large intellectual mistake.

However, by looking under the surface just a little, one can redeem the economics profession and discover what the real cause of the financial crisis was:  the assumption of transparency in a financial system that became dominated by opacity.

Adam Smith laid out the necessary condition for the invisible hand of the market to work properly:  buyer and seller must have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess and make a fully informed decision.

Without transparency, the rest of economics professions set of intellectual ideas is not just worthless, but downright dangerous.  As shown by the economic crisis.

However, with transparency, the financial system actually works reasonably closely to how the economics profession thinks it should work.

“[But] I think the response to it, the emergency response in Autumn 2008, was very good and I’m proud to have been a part of that process.”

The response in Autumn 2008 and since could not have been worse from the perspective of the real economy, taxpayers and society.

On the other hand, it has been great for the bankers.

When he walked into the FSA, the organisation was already changing, desperately trying to catch up with a financial-services sector that had left it for dead, a sloth trying to catch up with a tiger. 

It wasn’t until the FSA’s own, reluctantly authored, RBS report of 2011 on the collapse of Fred Goodwin’s bank that Lord Turner fully realised how dysfunctional the system had become. 

“I was very surprised that, despite the fact that we had 3,000 people, the allocation on the direct supervision of RBS was five people,” he says. 

“I was more surprised the more I looked at the liquidity standards that we’d been applying and the capital standards we’d been applying. 

“I was surprised at the supervisory approach. I’d been on the board of a bank, I’d been involved in banks, I’d dealt with banks back in the 1980s and 1990s, and I, throughout that, had accepted the existing capital regime as a given, right? 

To his credit, Lord Turner acknowledges why the combination of complex rules and regulatory oversight doesn't work as a substitute for transparency and market discipline.

With transparency, all the market participants, including banking competitors, look at a bank and not just the limited resources available to a regulator.

“I had never gone back to basics and said, 'why do we allow banks to run with 30, 40, 50 times leverage?’. And neither had anybody else, funnily.”

It is not leverage that kills a bank.  It is the risk that a bank takes that kills a bank.

Talk about bank capital ratios misses the important point that the way to prevent a bank from imploding is by restraining its risk taking.

The way to restrain risk taking as JP Morgan's Jamie Dimon has demonstrated is by letting the market see the bank's current global asset, liability and off-balance sheet exposure details.

Why not? critics may scream – or, more precisely, there were some people warning of calamity, why weren’t they listened to? 

“Well, it’s partly the frog in the boiling water, isn’t it?” Lord Turner says. “It slowly happens over time. It doesn’t happen immediately so the frog doesn’t leap out. The frog dies.” And while the frog is slowly dying, everyone is living it up on the debt-fuelled proceeds.

My question is:  why aren't we listening to the people who warned of a calamity now?

As the Bank of England's Robert Jenkins said, it is amazing that policymakers and regulators turned to and still rely on the bankers who brought about the financial crisis.

In 2009, Lord Turner famously said that a lot of banking activity was “socially useless”, a phrase that became the standard around which many critics of the City gathered. Has his opinion changed? 

“Before the crisis, there was too much trading activity in unnecessarily complicated structured credits going on,” says Lord Turner. “We have seen a very significant shrinkage in some of the trading books of our major banks. 

“And I think, when all that deleveraging of trading books is completed, we will find that the real economy never needed this stuff in the first place, and in a sense we’re better off without it. 

“Secondly, I think if you look at Barclays’ decision to radically reduce the size of its tax structuring activity, that is an end of a socially useless activity.”

All of this would permanently go away if banks were required to provide ultra transparency.

Barry Ritholtz: Bankistan vanquishes America (and the EU, Japan and UK too)

From Barry Ritholtz blog, the Big Picture comes a terrific summary of exactly where the global financial system is currently:

Is there a single doubt left in your mind? 

Are you still a believer in Rufus T. Firefly Jamie Dimon as the world’s smartest banker? 

Is there a scintilla of wonder left in your mind that the giant banks are legitimate? 

Have you come around to understanding — finally — what some of us have long understood about banks? 

Are you willing to accept the truth about these corporate behemoths — that they are a horrific combination of economically dangerous, criminally inept, led by pathologically lying CEOs? 

Do you harbor any doubts that the giant banks are anything less than ruthlessly efficient criminal enterprises? 

Can you — finally — admit that our bank-created financial crisis of 2008-09 has led us to where we are today? 

Do you understand the only options presented as a result of that — either corporate bankruptcy and nationalization or a completely artificial Fed driven recovery? (The third option was a Japan-like multi decade recession). 

Do you realize that the feeble recovery, the slow, deleveraging-driven process of gradual economic healing was the result of how our policy makers chose?

Our policy makers chose the Japan-like multi decade recession in which bank bonuses are protected at all costs and society, particularly through cuts in social programs like Medicare and Social Security, pays the cost.

Do you recognize that the world of banking is divided into two camps? 

On one side, there are those who understand that the giant banks must be broken up. They are dismayed at the large banks  under-capitalization, over-leverage and opacity.  

These folks have figured out that these banks are not only too big to fail, but are so large that they are too big to succeed, and that the best route is to let insolvent banks fail. They are unhappy that our finance sector is a trillion dollar black box. 

Insert call for banks to provide ultra transparency here.

They know that the majority of giant banks’ profits come from bailouts, and subsidies. This group is dismayed at the corruption of our political system by financiers.

Insert Jeff Connaughton and the Blob (aka, politicians, regulators, lobbyists and Wall Street) here.

They understands huge banks are anti-competitive, a blaspheme against capitalism.

Insert that we need to adopt the Swedish Model and require the banks to recognize the losses on the excess debt upfront here.

They are shocked about  corruption of even the most fundamental measures of interest rates such as LIBOR.

Insert bankers behaving badly behind a veil of opacity and the need for ultra transparency as sunlight is the best disinfectant and the source of confidence in the financial system.

They are stunned that bankers have overturned a bedrock, fundamental principle of our society — the rule of law rule — with the threat of disrupting the world’s economy if prosecuted for their crimes.

Insert need for requiring ultra transparency as it is only the market that can discipline the banks as they are too big for individual nations to control.

On the other side lay the bank apologists, corrupted politicians, and crony capitalists.  

They advocate the Big Lie of the financial crisis. They choose to ignore the facts and data that disprove their narrative. 

They continue to push the lies that the bailouts were a good investment. (They weren’t). 

They work against the Bipartisan consensus that the giant banks should be broken up.

Insert if banks provided ultra transparency, market discipline in the form of higher cost of funds would force them to reduce their risk and complexity (closing those thousands of subsidiaries that only exist to arbitrage regulations and taxes).

A likely outcome of reducing risk and complexity is that the banks would shrink significantly in size.

They ignore the many former bank CEOs who call for thebreak up of “Too Big to Fail” banks. 

They mandated that GSEs were banned from Lobbying, but they made sure that the big banks retained their influence peddling and hold on Washington DC. 

They no longer represent the voters of their districts, but instead are the elected representatives of Bankistan. 

And unless we do something — and soon — they will vanquish America.

This is also true of the EU and UK.

In the EU, we had the appointment of technocrats to carryout austerity in countries that should have had the banks take losses on their sovereign debt holdings. 

In the UK, we had the chancellor pleading with the EU not to limit bankers' bonuses.

WSJ: misguided faith that rules and regulators can prevent next financial crisis

The Wall Street Journal added its support to your humble blogger's argument that the combination of complex rules and regulations will not prevent the next financial crisis.

The misguided faith that rules and regulators can prevent the next financial crisis is hard to shake, but this week brought a glimmer of hope.

Regular readers know that the combination that will prevent the next financial crisis is transparency and market discipline.

The parts of the financial system that failed in our current financial crisis are those that feature complex rules and regulatory oversight (think banks) and/or opacity (think structured finance securities).

The parts of the financial system that continued to function throughout the financial crisis without government intervention feature transparency and market discipline (think stock or non-financial corporate bond markets).

The chairman of the Basel Committee on Banking Supervision signalled that regulators might be starting to understand how their rules contributed to the 2008 financial crisis—and the damage these rules could do in the future.

It is not the rules that do the damage.

It is the regulators' information monopoly that does the damage.

The regulators' information monopoly prevents market participants from accessing all the useful, relevant information in an appropriate, timely manner when it comes to financial institutions.

As a result, market participants cannot see how the rules are distorting the risk of the banks or, more importantly, how the banks are gaming the rules and adding risk.  Both lead to a financial crisis.

The Basel rules are the global standards that encouraged banks to hold mortgage-backed securities before the crisis and have since been re-written to favor investment in sovereign debt (such as Italian or U.S. bonds). 

Perhaps realizing how terrifying that sounds to taxpayers, Chairman Stefan Ingves said on Tuesday that the committee, whose members include U.S. financial regulators, has created a "high-level task force" to study the issues raised by Basel critics. 

Reformers like Andrew Haldane at the Bank of England and Thomas Hoenig at the U.S. Federal Deposit Insurance Corporation have pointed out that the complex Basel rules have been enormously costly yet were of little use before the crisis in determining which banks would run into trouble....

The failure of the Basel capital requirements in the run up to our current financial crisis should have forever ended the faith that the combination of complex rules and regulatory oversight can prevent a financial crisis.

The failure of the combination of complex rules and regulatory oversight in the run up to our current financial crisis should have caused us to look for an alternative.

The alternative that would have been found is the combination of transparency and market discipline.

Why would the combination of transparency and market discipline have been found?

Because our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Which is simply the combination of transparency and market discipline.

Instead of relying on a straightforward calculation of how much capital banks hold, Basel has embraced complicated methods for assigning "risk-weights" to the various assets held by banks. 

The opportunity for banks is either to lobby regulators to favor particular assets, or to simply wait until regulators bless certain types of investments for political reasons, and then figure out how to construct the most Basel-friendly balance sheet. 

Either way, guess which firms are best at navigating this byzantine regulatory architecture?...

The combination of transparency and market discipline puts an end to banks gaming the rules.

It ends this gaming as the market is only concerned with the risk that banks are taking and not how the banks manipulate some meaningless rules.  If the banks are required to provide ultra transparency, the market will exert discipline based on the actual exposure details of the bank regardless of how the banks game the complex capital rules.

Mr. Ingves and his colleagues have a long way to go. 

Actually, Mr. Ingves and his colleagues will never get to the point where they acknowledge that the combination of complex rules and regulatory oversight will not prevent the next financial crisis.

They are regulators and this would be acknowledging a significant limitation to their capabilities.

What is holding back the global economy in a world awash in money?

In his Guardian column, Michael White tries to answer the question:  what is holding back the global economy in a world awash in money?

Mr. White's response is somewhat tautological: a lack of demand.

So let me re-phrase the question:  what is holding back demand in the global economy in a world awash in money?

Regular readers know that it is the policies adopted at the start of the bank solvency led financial crisis and still being pursued by politicians and central bankers that are holding back demand in the global economy.

It was completely predictable that these policies would result in a lack of demand and a Japan-style economic slump.  I know it was completely predictable because your humble blogger predicted the failure of policies like those that have been adopted and are still being pursued in December 2007.

What is needed to restore demand in the global economy is for politicians and central bankers to stop protecting banker bonuses.

Ok, it is not that simple.

However, stopping protecting banker bonuses is the necessary first step as it implies that politicians and regulators are done listening to the bankers and their lobbyists and are finally serious about protecting the real economy and society.

As for what has to be done to restore demand, .... (hint: look at Iceland and its imperfect implementation of the Swedish Model).

But [Liam] Fox is a mid-Atlantic politician, in impressionable thrall to plausible US Republican ideologues (if you like that sort of thing) as well as to their Ukip fringe, the Tea Party. 

As it shows with every utterance the Tea Party (its foot soldiers as sincere as the average Ukip activist) is busy helping them to become unelectable to the White House, despite their strength in conservative strongholds where folk don't get out much. 

Just look at ex-VP nominee and bogus populist Paul Ryan's latest prescriptions for budget-balancing at the expense of the old and poor. 

So Fox's similar sentiments matter here because a lot of people out there believe his claim that the problem is a supply-side one.... 

No, where Liam Fox goes badly wrong is where he thinks we need to freeze public spending for three or even five years to help cut borrowing and thereby free up scope for tax cuts. 

Our problem, he says, is that we are over-taxed, over-regulated and that we spend and borrow too much. That's true for some people, who are over-taxed (many of them very poor) or over-borrow (those credit cards, eh!), as it is for some firms – small firms, those most likely to create new jobs and wealth. They do carry a big burden of tax and paperwork. 

But overall, it's not true at all. 

Big firms and investors are awash with funds – they don't invest them because they don't see a return.

They also don't pay taxes.  Witness how much money the big firms hold off shore as a result of their efforts to minimize what they pay in taxes.

What is holding us back from a stronger recovery is that there isn't enough demand in the economy. 

Companies and individuals are paying down debt – de-leveraging is the fancy word – yet the government, which has much deeper pockets, is doing the same instead of leaning against the bust (just as Labour failed to lean against the boom)....

It's not that Fox is entirely wrong. There is a case for not ring-fencing certain types of spending, including overseas aid, the NHS and defence equipment, because such exceptions distort spending and distort cuts elsewhere in the system. There a case too for cutting the perks of well-off pensioners – bus passes and winter fuel money – which I have made before on behalf of such people, including myself. 

But the assertion that cutting progressive taxes – abolishing capital gains tax for five years as well – and placing most of the consequent burden on the poorest (who at least spend what they get and thereby put demand into the high street) is both immoral and economically wrong....

But when demand is low and interest rates are exceptionally low, we could spend more money on worthwhile projects – the usual infrastructure stuff, Vince Cable's ideas about investment strategies for productive enterprise, familiar ideas with which the Treasury flirts half-heartedly.

Britain has a more disciplined budget mechanism than the US where the Bush Republicans promised to cut taxes and spending but mostly cut taxes: a supply side remedy that fails and is slowly crippling the federal system.... 

UK austerity might be a more plausible option if everyone else in Europe – and increasingly beyond it – were not playing the same game. Via export drives or currency devaluation we now risk the beggar-my-neighbour tactics which bedevilled the recovery in the 30s. 

Yet the world is awash with capital – try this (subscription) analysis in the FT, which paints a startling contrast between struggling real economies and a mountain of money searching for safe and sensible places to park it.

UK Guardian: Policy response to financial crisis wrong

In a column by its editors discussing why the Funding for Lending Scheme has failed, the Guardian exposes why the entire policy response to the financial crisis has been wrong since the very beginning of the crisis.

The problem with the government's funding for lending scheme – and indeed its entire strategy for growth – can best be expressed in an old cliche: you can lead a horse to water, but you cannot make it drink. 

With its policy of monetary activism, the coalition has concentrated on laying on the H2O of credit.

Please re-read the highlighted text as the justification used by each of the western governments and Japan for bailing out its banks was to preserve their ability to extend credit.

Regular readers know that this justification was built on a number of false assumptions.

One false assumption was that banks had to have capacity on their balance sheets if they were to be able to extend the credit that the real economy needs for growth.  Your humble blogger has documented why this is assumption is wrong.  The simple fact is that lending and funding for loans are completely separate as for at least the last 4 decades banks have had the alternative of selling the loans that it originates to buyers like insurance companies and pension funds.

The Guardian editorial focuses on a different false assumption.  It focuses on the assumption that there is a great unmet need for credit in the presence of an economy facing a major shortfall in demand.

Ministers have exhorted banks to lend, the Treasury has signed up to the Merlin agreement with financiers – as well as encouraging the provision of £375bn of quantitative easing and the £80bn scheme of funding for lending. 

These wheezes have cost hundreds of billions of pounds and taken up months of policymakers' time – and the net result has been sorely disappointing....

They have been good for banker bonuses though as they have enhanced bank profitability.

Faced with a major shortfall in domestic demand, he has depressed demand still further by laying out the biggest programme of spending cuts ever seen in peacetime Britain. 

And to spur growth, he has relied instead on trying to offer as much credit as possible. Put another way, an unthirsty horse has been offered gallons of surplus water.

Please re-read the highlighted text as it nicely summarizes why the response to the financial crisis has not worked to date (even when there was some stimulus as in the US).

Going by reports this week, Mr Osborne will next week announce yet more policies to boost lending to small and medium-sized businesses; perhaps by more closely targeting the funding for lending scheme administered by the Bank of England. 

This could once be chalked up as foolishness, but now it surely goes beyond that – it is wilful, damaging blindness on the chancellor's part....

Willful, damaging blindness about the ineffectiveness of the policy responses to the financial crisis that began on August 9, 2007 are not limited to the UK's chancellor.  This extends across countries and central banks.

As a group, they choose to implement the Japanese Model that Japan deployed for handling its bank solvency led financial crisis.  As a group, they apparently believed they would get a different result than  a Japan-style economic slump.

As a group, they are unwilling to admit that their experience parallels the Japanese experience and they have pushed their economies into a Japan-style economic slump.  A result predicted by your humble blogger.

One of the reasons that your humble blogger has advocated for adopting the Swedish Model for handling a bank solvency led financial crisis is that it avoids the Japan-style economic slump.  It does this by requiring the banks to recognize upfront all the losses on the excess debt in the financial system.

As a result, the burden of servicing the excess debt is not placed on the real economy where it would divert capital needed for growth and reinvestment.

But it must surely be evident by now that the main problem is not the lack of loans available to firms; it is that businesses do not see the growing markets or buoyant economy that would justify them spending and borrowing to invest.

The chief executives and managing directors can hardly be blamed for this: as Tuesday's industrial production figures and bleak forecasts from the National Institute of Economic and Social Research indicate, the economy is still stuck in the doldrums. 

While this remains the case, the government's focus on credit is misplaced.

The Guardian editors have eloquently summarized the current state of the global economy and why the policy response to the bank solvency led financial crisis was and still is wrong.