Post financial crisis policies promise chronic stagnation

In his Financial Times column, Satyajit Das observes about the policies adopted to deal with the financial crisis:

These policies will engineer a chronic stagnation, requiring continuous intervention to prevent rapid deterioration.

Mr. Das uses arguments that should be very familiar to readers to support this conclusion.

The arguments should be familiar because your humble blogger has been using them under the description of the Japanese Model for handling a bank solvency led financial crisis since the beginning of the current crisis.

The collapse of Lehman Brothers and the ensuing financial seizure was symptomatic of high debt levels, global imbalances, excessive financialisation and unfinanced social entitlements, which underpinned an economic model reliant on credit-driven consumption.

What made all of these conditions possible was opacity in the financial markets.

As a result of opacity, market participants were not able to independently assess risk.  Specifically, market participants could not independently assess the risk of banks, both commercial and investment, and structured finance securities.

Without an ability to independently assess risk, market participants relied on organizations, regulators and rating firms, that represented they had transparency and the ability to independently assess risk.

Unfortunately, even if these organizations were capable of accurately assessing risk, there were institutional reasons why they would not accurately communicate their assessment to the market.

Regulators do not accurately communicate risk because of fear of damaging the safety and soundness of their financial system.  Rating firms do not accurately communicate risk because they compete to be paid by the issuers for their ratings.

Regardless, the reliance on faulty risk assessments led to too much debt in the global financial system.

Surprisingly, little has changed. Unsurprisingly, activity has not equated to achievement. Since 2007, total public and private debt in major economies has increased not decreased, with higher public borrowing offsetting debt reductions by businesses and households. 

Debt levels have also risen in emerging countries from before the crisis....

The financial sector exists to support the real economy. Financial instruments, such as shares, bonds and their derivatives, are claims on real businesses. But over time, trading in the claims themselves has become more rewarding, leading to a disproportionate increase in the level of financial rather than real business activity. 

Regular readers will recall that modern banks are designed to protect the real economy from excess debt in the financial system.

Banks can protect the real economy because they have an ability to absorb upfront the losses on this excess debt and continue to operate.

Banks can continue to operate with low or negative book capital levels because of the combination of deposit insurance and access to central bank funding.  When banks have low or negative book capital, deposit insurance effectively makes the taxpayers the banks' silent equity partner.  As a result, so long as a bank can generate earnings, it can continue operating while it rebuilds its book capital level.

The financial sector needs to be pared back to its utility function: making payments, matching savers and borrowers, and providing simple risk management tools.

Your humble blogger has repeatedly said that paring back the financial sector requires bringing transparency to all the opaque corners of the financial system.

JP Morgan has shown that I am right about this benefit of transparency.  JP Morgan showed this in its handling of the London "Whale" trade.  As soon as the market found out what JP Morgan's position was, it closed the position.

If banks were required to disclose their current global asset, liability and off-balance sheet exposure details, there are a significant number of "positions" that they would quickly exit.  This includes proprietary trades as well as regulatory and tax arbitrages.

Instead of fundamental reform, policy makers are introducing complex capital, liquidity and trading controls of dubious efficacy that invite regulatory arbitrage.

Fundamental reform would have been bringing transparency to all the opaque corners of the financial system.

Instead, we have what your humble blogger refers to as the substitution of technocratic financial regulation involving complex rules and regulatory oversight for transparency and market discipline.

As Christopher Whalen said of this substitution of technocratic financial regulation for transparency and market discipline,

The moral of the story of Lehman Brothers is that no amount of regulation can prevent acts of wanton stupidity, fraud, and greed in a free society. Expecting regulators to proactively prevent a financial crisis is at best wishful thinking.

Returning to Mr. Das.

Too-big-to-fail banks have become larger. Initiatives such as the central counterparty for derivatives have introduced complex interconnections and new systemic risks. ...

The real solution always required reducing debt, reversing imbalances, decreasing financialisation and modifying behaviours....

Transparency is the real solution.

By requiring banks to disclose their exposure details, markets would have been able to exert discipline on the banks so that they recognized their losses on the excess debt in the financial system.

With transparency, financialization would have been decreased as market participants would then be in a position where they could independently assess the risk of the various products Wall Street and the City sell.  Many fewer of these products would be sold as market participants would see that the potential rewards from ownership did not compensate for the risk being taken.

Finally, transparency brings about behavior modification.  Sunlight is the best disinfectant of bad behavior by bankers.

Der Spiegel: Bank reform still needed 5 years after crisis began

A must read Der Spiegel article makes the important point that five years after the beginning of the efforts to reform the international banking system the addition of complex rules and regulatory oversight has achieved nothing.

Regular readers know that the only way to fix the financial system is to require the banks to provide transparency.  Specifically, they need to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the risk of each bank and limit their exposure to each bank to what the market participant can afford to lose given the risk of each bank.

When market participants limit their exposure based on the risk of each bank, contagion or the domino effect is ended.  Contagion is ended because each market participant has set their level of exposure to each bank to what they can afford to lose.  This means there is no reason to ever bailout a bank for fear of contagion.

At the same time, the bank's management becomes subject to market discipline.

Management knows if it increases the bank's risk passed a certain level, it will increase the cost of funds to the bank at the same time as it reduces the bank's access to funds.  This is bad for the bank's net income and share price.

Management also knows that if it reduces the bank's risk it will be rewarded.  Lower risk leads to a lower cost of funds.  A lower cost of funds tends to be good for a bank's net income and its share price.

This is how market discipline works.

Market discipline is something that the banks have not been subjected to for over forty years.  Instead, banks have been subjected to complex rules and regulatory oversight replacing transparency and market discipline.

The results have been predictable.  The banks have gamed the system and taken on far greater levels of risk than the markets would have permitted.

Banks were able to do this because regulators do not approve or disapprove of any exposure a bank takes on (they don't do this as it would mean the regulator was allocating capital across the economy).

Instead, the regulators try to estimate the probability of loss if there is a problem with an exposure and the amount of loss should the problem occur.  Regulators then compare this loss to the bank's book capital level to see if it can absorb the loss.

It is not surprising that Der Spiegel sees a need for bank reform.  Adding more complex rules and regulatory oversight does nothing to change the fundamental reason regulators were incapable of preventing the current financial crisis.

It is only when there is transparency that the next financial crisis can be prevented.

When asked whether he believes that the industry and lawmakers learned the right lessons from that tumultuous weekend in September 2008, he concludes soberly: "We would hardly be more effectively protected against a chain reaction today than we were five years ago.".... 

While it is certainly true that bank bailouts no longer have to be ironed out in hectic, nighttime crisis meetings, it is also true that large banks, especially in the United States, are raking in billions once again. 

But the new sheen is deceptive, because banks owe much of their comeback to ongoing support from governments and central banks. Instead of having to launch bailout operations worth billions, they have simply turned to a policy of slowly feeding the financial industry with cheap money.

Please re-read the previous paragraph as it confirms the adoption of the Japanese Model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels and banker bonuses are protected at all costs.

As a result, governments feed money into the banks.  Some of this money is used to absorb losses and some is used to pay bonuses.

"In the euro zone, many banks would have trouble refinancing themselves without the help of the European Central Bank (ECB)," says Christoph Kaserer, a financial expert at the Technical University of Munich. 

According to Kaserer, a number of institutions are not sufficiently profitable to survive on their own in the long term.

Under the Swedish Model, banks are required to recognize upfront their losses on the excess debt in the financial system.

Banks which are capable of generating earnings after recognition of their losses are allowed to continue operating.  Earnings are used to rebuild book capital levels.

Banks which are not able to generate earnings after recognition of their losses are closed.

The euro-zone countries, fearing the potentially uncontrollable consequences of liquidating ailing financial groups, have helped create so-called zombie banks. 

European banks are still burdened with massive bad loans left over from the financial crisis -- amounting to €136 billion ($180 billion) at Germany's Commerzbank alone. 

Analysts with the Royal Bank of Scotland estimate that the banks need to shed about €3.2 trillion in assets in the next three to five years, while at the same time generating €47 billion in fresh capital to be considered stable.

Please note that financial authorities cite fear of uncontrollable consequences, i.e. contagion, as the reason for adopting the Japanese Model and creating zombie banks.

This fear is entirely misplaced as market participants already have some idea of the size of the losses at each bank and which banks do and don't have the ability to generate earnings.

Rather than continue to feed money into banker bonuses, governments should be requiring each bank to provide transparency into their exposure details.  As discussed above, market participants could then assess the risk of each bank and adjust their exposures accordingly.

With the risk of financial contagion removed, regulators could then require the banks to take their losses and clean up the banking system.

If one of these shaky financial giants were to fall, it would likely spell the end of the banking sector's tentative recovery.... 

The banking sector's recovery is all smoke and mirrors.

In the last five years, there have in fact been a significant number of new guidelines, laws, drafts and recommendations. 

The banks were forced to increase the size of their financial cushions, for example, but they still aren't large enough. 

Regulators devised split banking systems designed to shield customer deposits from risky trading activities, but the concepts are half-baked and have yet to be fully implemented.... 

Bankers' bonuses were capped, but then their fixed salaries were increased dramatically. 

Regulators had vowed to rein in the rampant trade in derivatives among banks by requiring it to be conducted on supervised exchanges. Instead, the over-the-counter derivatives market has grown by 20 percent since 2009.

In short, complex regulations and regulatory oversight don't work.

Over the years, lawmakers have lost sight of the most important objectives of regulation. 

Secure savings deposits, a continuous supply of credit and a functioning payment transaction system are as important to an economy as intact water pipes or power grids. 

The point is to ensure that this supply functions properly. 

At the same time, governments and taxpayers cannot allow themselves to be held hostage by the banks, merely because they can guarantee a basic supply of capital. 

"What is needed is fundamental structural change, which, as in other industries, costs money. Lawmakers shy away from that," says Clemens Fuest, President of the Center for European Economic Research (ZEW).

The fundamental structural change needed is to bring transparency to the banks and the rest of the opaque corners of the financial system.

With transparency, banks are subject to market discipline and governments and taxpayers are no longer held hostage by the banks.

Financial industry executives take every opportunity to warn that if regulators take aim at financial groups, then businesses, savers and investors will ultimately suffer.... 

The beauty of requiring banks to provide transparency is it doesn't reduce their ability to provide loans, take deposits or support a functioning payment system.

Transparency addresses the issue of how much risk banks take by using market discipline to restrain risk taking.

At the same time, Jain sends out a warning to lawmakers not to overdo it with new legislation. "If all measures are implemented as planned, it could spell the end of 100 years of universal banking in Europe," Jain said in Frankfurt. His message seems to strike a chord.

Capital rules are a case in point. "Contrary to their political rhetoric, Germany, France and even Japan have blocked the acceptance of tougher requirements in international negotiations," says financial expert Harald Hau of the University of Geneva. Their goal, he adds, is to avoid putting their own, undercapitalized banks under pressure....

Please note that after 2+ decades, Japan is blocking capital rules because of its zombie banks.

This is a clear indicator that the Japanese Model is the wrong policy for handling a bank solvency led financial crisis.  It is also a clear indicator that the EU, UK and US that also adopted the Japanese Model will not do any better.

"So far, this central problem has been neglected in the reform plans," says Jan-Pieter Krahnen of Frankfurt's Goethe University....

The bigger and less transparent the banks, the more reliable their guarantee that the government will bail them out if necessary. "The banks know that if they're complex enough, they'll be bailed out," says ZEW President Fuest.

That is why the solution is to require the banks to provide transparency.

ECB says Europe faces Japanese style lost decade if banks not fixed

Reuters reports that according to the ECB, Europe faces a Japanese style lost decade if banks not fixed.

Regular readers know that your humble blogger said this almost six years ago when the EU, UK and US adopted the Japanese Model for handling a bank solvency led financial crisis.

It is nice to see with four years left to go in the decade, the ECB agrees and has produced a study the confirms all of observations about the failings of the Japanese Model that I have made.

Decision makers should move quickly to repair the euro zone's ailing banking system to avert a Japanese-style lost decade of minimal growth and inflation, a European Central Bank study said on Thursday. 

"The risk is the emergence of a situation of the type experienced in Japan during its 'lost decade'," the study said. 

"Fragile banks have an incentive to continue financing troubled and inefficient firms, so as to avoid recognising further losses." 

The unwinding process can become a long-lasting drag on the economy, the research paper said. 

"In this constant balancing act, policy interventions should, therefore, avoid delaying the necessary adjustment process." 

Once banks' balance sheets have been cleaned, corporate defaults might have a much smaller impact on the economy, it said.

BIS blames creditors and bank regulators for current eternal financial crisis

As reported by the Telegraph, the BIS laid the blame for the current ongoing global financial crisis on the creditors (banks) and their regulators.

Specifically, the BIS said the mechanism for dealing with the excess debt in the global financial system is jammed because bank regulators refuse to require banks to recognize upfront the losses on their debt.

By design, banks are suppose to absorb upfront the losses on the excess debt so as to protect the real economy.  If they do not do so, the burden of the excess debt is place on the real economy.

This burden takes two forms: debt service and misallocation of capital.  Together these forms of burden result in the real economy not having the capital it needs for reinvestment and growth as well as not properly allocating the capital it does have.

A clear recipe for economic stagnation.

Your humble blogger predicted this economic outcome at the beginning of the financial crisis when global policymakers and bank regulators adopted the Japanese Model for handling a bank solvency led financial crisis.

Under this model, the mechanism for dealing with losses on excess debt is intentionally jammed as bank book capital levels and banker bonuses are protected at all costs.

Regular readers know that your humble blogger also pointed out that with adoption of the Swedish Model under which banks recognize upfront the losses on the excess debt the real economy is protected.

It is nice to have the BIS agree with my analysis.

The Switzerland-based watchdog said unprecedented imbalances have built up in the global system and these are failing to self-correct because the mechanism is jammed.... 

The BIS said European banks played a huge role in stoking the pre-Lehman credit bubble. They rotated $1.25 trillion into US debt alone between 2003 and 2007, greater than the combined purchases of Asia and OPEC. It said banks funnelled money into southern Europe regardless of risk in "expectations of a bail-out" if any country got into trouble. 

"European banks were negligent in assuming – and their regulators in allowing – such exposures. Overlending was as responsible for the ensuing crisis as over-borrowing."... 

The watchdog called for "symmetry in adjustment between creditors and debtors" to avoid repeating the 1930s, warning that global recovery will remain stunted until the creditors chip in.

Swallowing the bankers' line

Earlier this month, Robert Jenkins, former external member of the Bank of England's financial policy committee, observed:

I fear that the banks have bamboozled government into believing that society must choose between safety and growth, between safer banks and bank shareholder value, and between a safer financial framework and a competitive City of London. These are all false choices.

Please re-read the highlighted text and ask the question of how could this have come to pass.

In his Project Syndicate commentary, Professor Simon Johnson offers a series of potential explanations for how banks have bamboozled government.

There are three possible explanations for what has gone wrong. 

One is that financial reform is inherently complicated. But, though many technical details need to be fleshed out, some of the world’s smartest people work in the relevant regulatory agencies. They are more than capable of writing and enforcing rules – that is, when this is what they are really asked to do. 

Your humble blogger wonders when the regulators within the SEC decided that they were not really being asked to ensure transparency in the financial system?

Regular readers know the SEC was ground zero for the financial crisis and it was the failure of the SEC to ensure transparency that created the conditions for the financial crisis.  Specifically, the SEC allowed opacity for both banks and structured finance securities.

For banks to be transparent, they must disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This was the law in the UK since the 1870s and the standard in the US in the 1930s when the SEC was created.  Clearly, by the start of the financial crisis in 2007, this was no longer true.

For structured finance securities to be transparent, they must disclose on an observable event based basis.  Every observable event like a payment or delinquency involving the underlying assets must be reported to all market participants before the beginning of the next business day.  Clearly by the start of the financial crisis in 2007, this was not true as opaque, toxic sub-prime RMBS deals report on a once per month basis.

The second explanation focuses on conflict among agencies with overlapping jurisdictions, both within and across countries. Again, there is an element of truth to this; but we have also seen a great deal of coordination even on the most complex topics – such as how much equity big banks should have, or how the potential failure of such a firm should be handled. 

Another source of conflict is the regulatory race to the bottom.

That leaves the final explanation: those in charge of financial reform really did not want to make rapid progress.  

In both the US and Europe, government leaders are gripped by one overriding fear: that their economies will slip back into recession – or worse.  

The big banks play on this fear, arguing that financial reform will cause them to become unprofitable and make them unable to lend, or that there will be some other dire unintended consequence. There has been a veritable avalanche of lobbying on this point, which has resulted in top officials moving slowly, for fear of damaging the economy.

Professor Johnson has nicely explained that fear is why the banks were successful in bamboozling government leaders.

But did the government leaders actually have anything to fear?  After all, the first response to the financial crisis was to put the banking system on life support.

Regular readers know that the answer has always been no  There was nothing to fear, but fear itself.

Our financial system was designed to survive even the failure of the SEC to ensure transparency.  Our financial system was designed to survive a massive credit bubble with the creation of excess debt that was well beyond the borrowers' capacity to repay.

Our financial system was designed to survive because it has a safety valve to release its excesses while protecting the real economy.

This safety valve is the ability of banks to absorb upfront the losses on the excess debt in the financial system and continue to operate and service the real economy.

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

Of course, because government leaders swallowed the bankers' line, we have never used the safety valve.

Instead, we have protected bank book capital levels and banker bonuses while at the same time burdening the real economy with servicing the excess debt.  The result has been economic stagnation, an unwinding of the social contract and an increase in inequality.

Bernanke's epitaph: "We had to do something"

In his testimony before the US House of Representatives, Fed Chairman Ben Bernanke provided his own epitaph when he observe "we had to do something" in response to the financial crisis.

Remarkably, since the moment he appeared in panic before Congress to testify on the need for TARP, the self-described Great Depression expert hasn't been unable to come up with a better thought through strategy for ending the financial crisis than "we had to do something".

Actually, as Mark Twain would say, you only have to pay taxes and die.  Everything else you do is optional.

Mr. Bernanke's testimony confirmed that either he a) didn't understand that he was dealing with a bank solvency led financial crisis and the solution is adoption of the Swedish Model or b) he understood that pursuing the Japanese Model would not work and he is trying to defend his legacy.

Bernanke's defensiveness can probably be chalked up to the one thing he could plausibly be afraid of: watching his legacy go the same way as that of former Treasury Secretary Tim Geithner, who left while excoriated for his seeming friendliness toward big banks.

The Geithner Doctrine doesn't "seem" friendly to big banks.  It is designed to be friendly to big banks.

The Geithner Doctrine is don't do anything that will harm the profitability or reputation of big and/or politically connected banks (hat tip Yves Smith).

Bernanke has done more than Geithner did, and took on the economic job left undone by a dysfunctional Congress and a distracted president as well. He became a one-man economic Mr Fix-it, not by choice but by necessity.

Mr. Bernanke told everyone who would listen that he is an expert on the Great Depression.  Hence, he was a logical person to lead the response to our current financial crisis.

The one problem as pointed out by Anna Schwartz, Milton Friedman's co-author and a noted expert on the Great Depression too, is that Mr. Bernanke learned the wrong lessons (see here and here) about the Great Depression.

When faced with a bank solvency led financial crisis, ending the crisis requires having the banks recognize upfront their losses on the excess public and private debt in the financial system.

Until banks recognize the losses, monetary policy is not going to end the crisis.

A fact that should be apparent to all as we approach the six year mark on August 9, 2013 of the beginning of the financial crisis.

Now, facing the end of his term, he is fighting an uphill battle to get the credit for the work laid at his door. 

He wasn't often right – in fact, in forecasting, often wrong – but his Fed did more than any other government or private entity to tackle the country's economic problems. 

That's something.

Your humble blogger would give Mr. Bernanke a significant amount of credit for trying and doing something were it not for one small fact: he didn't use all the tools at the Fed's disposal from the beginning of the financial crisis.

As he testified before Congress, he talked about not being successful at ending the crisis and the need for the Fed to have additional tools if it were to successfully end the crisis.  However, he completely ignores the fact that the Fed has an entire toolkit from its role as lender of last resort and responsibility for bank supervision that he chose not to use.

The Fed could have used both of these tools to end the financial crisis by requiring the banks to recognize their losses upfront on the excess public and private debt in the financial system and protect the real economy and the social contract.

Mr. Bernanke elected not to do so.

He chose to pursue zero interest rate and quantitative easing policies that Walter Bagehot, who invented the modern central bank in the 1870s, said would create economic headwinds that render these policies ineffective.  Turns out Bagehot was right. The economic headwinds existed in the form of the Retirement Plan Death Spiral as both individuals and companies cut back current consumption to fund the shortfall in earnings on retirement assets.

He chose to allow bankers to continue to pay themselves large cash bonuses at the same time the Fed engaged in regulatory forbearance and let the banks transform their non-performing loans through 'extend and pretend' into 'zombie' loans.

He chose to put the real economy into a downward spiral by placing the burden of the excess debt on the real economy where it diverted capital needed for reinvestment, growth and supporting the social contract to debt service.

Update:
In his testimony, Bernanke also observed that

Fed didn't have a way to oversee the shadow banking system.

As regular readers know, the inability to see what is going on in shadow banking should have been a less than subtle hint that there was a need for transparency.

Economist magazine discovers we still have zombie banks throughout global financial system

The Economist magazine captures the state of the global financial system when it observed

[it] is in a terrible state, and nothing much is being done about it.

But the problem doesn't end with the global financial system.  It extends to the global economy.

Regular readers know that policymakers and financial regulators chose to pursue the Japanese Model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels and banker bonuses are protected at all costs.

The costs of this protection include transferring the burden of the excess debt in the financial system onto the real economy where it diverts capital needed for reinvestment, growth and supporting the social programs to debt service.

The result is economic malaise and re-writing the social contract.

Regular readers also know that there is a proven solution for handling and ending a bank solvency led financial crisis:  the Swedish Model.  Under the Swedish Model, banks are required to recognize upfront their losses on the excess debt in the financial system.  This protects the real economy and the social contract.

Our modern banking system is designed to support adoption of the Swedish Models.  Specifically, banks are capable of continuing to support the real economy even when they have low or negative book capital levels.

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

The zombie banks and economic destruction caused by these banks that the Economist finds are the result of pursuing the Japanese Model.

Banks are central to Europe’s prospects.

Since banks are central to Europe's prospects, it is important to understand how they are designed and to realize that the designers understood that there would be a time when excess debt once again existed in the financial system.

So the choice to have zombie banks is entirely the policymakers and financial regulators.

The fear, especially in peripheral economies, is a repeat of Japan’s experience in the 1990s, when “zombie” banks staggered along for years, neither healthy enough to lend to firms nor weak enough to collapse.

Given that global policymakers and financial regulators chose to pursue the Japanese Model, it is guaranteed that Japan's experience with zombie banks would occur in the EU, UK and US.

There are the same unvital signs in Europe. The average price-to-book ratio for European banks remains below one, suggesting that investors think lenders are worth more dead than alive.... 

Weren’t the Europeans supposed to be cleaning up their balance-sheets?...

Regulators worry that banks, rather than writing off or selling bad loans, have been fiddling with the models that dictate how much capital they need to hold. Danske Bank, a big Danish lender, was abruptly ordered by its supervisor to change its calculations last month, lowering its capital ratio. Denmark is outside the euro, but even German politicians joke about the nasty surprises in their banks’ balance-sheets.

None of this presages a full-scale collapse: European banks have more capital than they did before the start of the crisis. But lending is being throttled....

All of this applies in the UK. In the US, price to book is slightly higher, but these banks aren't lending either.

Please note that while lending is being throttled, banker pay has not been.

The second cure involves lifting the cloud of suspicion over European banks. 

The ECB will undertake an “asset-quality review” before it takes up the role of euro-zone banking supervisor next year. 

Previous stress tests by national supervisors were not tough enough—and convinced nobody. 

The asset-quality review is the ECB’s first and best chance to establish its credibility. 

Banks that fall short must be recapitalised—by raising fresh equity from private investors, by bailing in creditors and, in some cases, by bringing in public money. 

An asset-quality review suffers from the same problem as a stress-test.  Nobody believes the results.

Ireland did both with its banks and nobody believes the banks are solvent.  Greece and Spain have also done asset-quality reviews and stress-tests.

The reason that asset-quality reviews and stress-tests are not believable is that they are not accompanied by the requirement that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is needed so that market participants can independently confirm the results of the asset-quality review and stress-test.

Without the ability to independently review the results, a big red flag is waved in front of the market participants that says don't trust the results.

ECB's Coeure: 'Zombie-banks' pose Japan-like threat

After almost six years of pretending that banks are not insolvent, the ECB executive board member Benoit Coeure tears down the facade and observes that the 'zombie-banks' pose a Japan-like threat to the real economy.

Specifically, Coeure focuses on the economic distortions that are brought about by these banks continuing to lend against and transform non-performing loans to 'zombie-loans'.

Policymakers and financial regulators in the EU, UK and US adopted the Japanese Model for handling a bank solvency led financial crisis at the beginning of the crisis.  So it is not at all surprising to see these economies going through Japan's experience.

Under this model, bank book capital levels and banker bonuses are protected at all costs.

The major cost of protecting bank book capital levels is that it transfers the burden of the excess debt onto the real economy.  Not only does this divert capital needed for reinvestment, growth and supporting the real economy to debt service, but it creates economic distortions in market competition (aka, pricing).

Regular readers know that there is only one way to end 'zombie banks' and the distortions they create.  Adopt the Swedish Model and require the banks to recognize upfront the losses on the excess public and private debt in the financial system.

The Swedish Model puts the burden of the excess debt on the banks where it belongs and frees the real economy to return to normal functioning.

Your humble blogger says the burden of the excess debt belongs on banks because they are designed to absorb the losses on this debt and protect the real economy.  Banks can absorb losses because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, when banks have low or negative book capital levels, taxpayers effectively become their silent equity partners.

European Central Bank Executive Board member Benoit Coeure warned Friday that the region's "Zombie Banks" could pose a danger to the Eurozone recovery and said lessons needed to be learned from Japan's so-called "lost decade" in order to prevent it from happening here. 

In prepared remarks for a speech at an investment conference in Paris, Coeure said banks that are reluctant to call in bad loans for fear of writing off existing capital were a real threat to the region's banking system if left unchecked. 

He also noted the regulatory capital requirements could give some banks the "perverse incentive" to extend credit to insolvent borrowers. 

"[Zombie bank] are a problem for regulators, because they have an incentive to take excessive risks, for example, by extending loans to ex-ante risky new customers," Coeure said. "A deeper concern, however, is that zombie banks may pose risks for medium to long-term growth if they engage in so-called "evergreening" of loans, which is often discussed with reference to Japan."... 

the Japanese government's strategy of guaranteeing the liabilities of struggling lenders "effectively kept wages high and prices low, reducing the profits that new productive firms generated and distorting market competition. As a result, even solvent banks had very few good lending opportunities and the economy remained stagnant throughout the 1990s."...

A major issue for Coeure, however, is the reliance many euro area banks have on the purchase of government debt. 

"Banks in countries under stress have, in particular, been investing in relatively risky government bonds, using cheap short-term funding, hoping to pocket the spread between the bond return and the cost of funding on the upside," he said. "This phenomenon shares unsavoury features with the behaviour of banks during Japan's lost decade."...

"This sovereign-bank nexus, whereby domestic banks become the main creditor to national governments, in return increasing the government's incentive to intervene in its banking sector, can become a threat to long-term economic recovery in the euro area. 

Unless both bank balance sheets and public finances are sanitised, and the link between the banks and sovereigns is broken, the euro area may indeed have a long recovery ahead of it, with insufficient loan supply to creditworthy enterprises, depressed productivity and high unemployment rates."

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

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

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

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

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

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

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

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

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

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

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

And what is financial contagion?

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

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

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

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

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

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

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

No.  There are two types of core depositors.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

IMF to admit mistakes with Greece, but what about Ireland, Portugal, Cyprus and Spain?

The Guardian, following on the initial report in the Wall Street Journal, says that the IMF is going to admit to numerous mistakes that it made and contributed to in the handling of Greece's financial crisis.

The IMF will disclose that its biggest mistake was not requiring the original creditors (also known as the banks) to absorb losses at the beginning of the debt crisis.

The IMF is going to say that the primary beneficiaries of the mistaken strategy pursued in Greece were the creditor banks.

Imagine that.

Who could have guessed that the creditor banks would have been the beneficiary of Greece destroying its social contract?


Regular readers will recall that following the advice of the bankers, global policymakers and financial regulators adopted the Japanese Model under which bank book capital levels and banker bonuses were protected at all costs.  Not having the banks take losses at the beginning of the financial crisis was the direct result of this policy.

As predicted by your humble blogger, the result of protecting the banks and banker bonuses was to put the burden of the excess debt on the real economy with the result being a downward spiraling economy and an end to the social contract.

As the IMF is admitting to mistakes in handling Greece, will it also admit that the same fundamentally flawed strategy was used in Ireland, Portugal and Spain to the detriment of these countries' real economies and social contracts?

The authoritative Kathimerini newspaper said the report identified a number of "mistakes" including the failure of creditors to agree to a restructuring of Greece's debt burden earlier – a failure that had had a disastrous effect on its macro-economic assumptions. 

"From what we understand the IMF singles out the EU for criticism in its handling of the problem more than anything else," said one well-placed official at the Greek finance ministry. 

"But acknowledgement of these mistakes will help us. It has already helped cut some slack and it will help us get what we really need which is a haircut on our debt next year."

Please re-read the highlighted text as it is an explicit statement that the problem of excess debt in the financial system did not go away as a result of pursuing the Japanese Model for the last 5 years.  There are still losses to be taken.

One of the reasons that the IMF is apologizing is it realizes that it will have to absorb the losses and it gets its funding from taxpayers.  Effectively, the IMF oversaw a program that transferred losses from private balance sheets, the banks, to the taxpayers.

Please note that before the IMF engaged in the program it is now apologizing for, individuals, like your humble blogger, were saying that the program would not work and the only beneficiaries would be the banks.

For this reason, a simple apology is not enough.

At a minimum, 100% of the IMF's pension assets should be given to the poor in Greece with recognition by the IMF that giving up its retirement assets and the right to replace them is the least the IMF can do for the pain and suffering it has caused.

Paul Krugman on "Japan the Model"

In his New York Times' column, Professor Paul Krugman looks at Japan's pursuit of aggressive monetary policy combined with a dose of fiscal stimulus as the model for ending what he sees as the lack of effort by policymakers to fix the global economy.

So the overall verdict on Japan’s effort to turn its economy around is so far, so good. And let’s hope that this verdict both stands and strengthens over time. 

For if Abenomics works, it will serve a dual purpose, giving Japan itself a much-needed boost and the rest of us an even more-needed antidote to policy lethargy. 

As I said at the beginning, at this point the Western world has seemingly succumbed to a severe case of economic defeatism; we’re not even trying to solve our problems. That needs to change — and maybe, just maybe, Japan can be the instrument of that change.

Please re-read Professor Krugman's comments as he has identified a critical problem:  "we're not even trying to solve our problems."

The reason that we are no longer trying to solve our problems is that it means acknowledging what has been done so far did not fix the economic problems.

And this opens up Pandora's Box for policymakers who have adopted the Japanese Model and chosen to protect bank book capital levels and banker bonuses at all costs.

It opens up Pandora's Box because it is clear that the combinations of austerity/monetary stimulus and fiscal stimulus/monetary stimulus have both failed.  As Professor Joseph Stiglitz said in a Bloomberg article,

“Clearly the economy is not back to normal, and to accept this as the new normal would be really wrong.”

Regular readers know that there is a proven solution for ending a bank solvency led financial crisis like the crisis we are currently experiencing.  That solution is the Swedish Model.

Under the Swedish Model, banks are required to recognize upfront their losses on the excess public and private debt in the financial system.  This removes from the real economy the burden of servicing the excess debt and ends the diversion of capital that is needed for reinvestment, growth and to support the social programs.

Since the 1930s when the US first implemented the Swedish Model, banks have been designed to absorb the losses on the excess debt and continue to operate and support the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers are effectively the banks silent equity partner when the banks have low or negative book capital levels.  Capital levels that can be rebuilt over several years through retention of 100% of pre-banker bonus earnings.

As Professor Krugman rightly points out, we are not trying to solve our economic problem.  In fact, this is a choice of the policymakers under advice from the bankers.

After all, the bankers stand to lose their cash bonuses if we fix the excess debt problem with the economy.

So long as policymakers don't try to solve our economic problems, the bankers benefit and it is society that bears the costs.

As your humble blogger has said since the beginning of the financial crisis, the question is "When" will policymakers put their countrymen ahead of the bankers?

Who prevented the second Great Depression?

Since the beginning of our current financial crisis, policy makers and central bankers have continually used as justification for their policies the claim that no matter how distasteful their policies are necessary to prevent a second Great Depression.

This raises an interesting question.  In response to the Great Depression, did the policy makers in the 1930s put in place a financial system to prevent another Great Depression or not?

Current policy makers would like to claim that the Dodd-Frank Act is all about preventing another Great Depression.  If current policy makers were focused on preventing another Great Depression, there is no reason to assume that policy makers in the 1930s did not have the same agenda.  Particularly because the policy makers in the 1930s were living through and had first hand experience with the Great Depression.

Furthermore, if policy maker in the 1930s did have the agenda of preventing another Great Depression, is it possible that their policy prescriptions alone were adequate to have prevented our current financial crisis from becoming the second Great Depression?

Regular readers know that the 1930s policy makers did in fact put in place all the elements that were necessary for dealing with our current financial crisis and avoiding a second Great Depression.  These policy makers assumed that the lessons of the Great Depression would be forgotten (after all, bankers are very good salespeople) and that another period of excess credit creation could occur.

The 1930s policy makers put in place the elements necessary for dealing with the excess credit in the financial system.  Specifically, they understood that the Swedish Model is the way to deal with a bank solvency led financial crisis.  Under the Swedish Model, banks are required to absorb the losses on the excess debt in the financial system and protect the real economy and the social contract.

The 1930s policy makers designed banks to be able to absorb losses should there ever be a credit bubble and still continue to support the real economy.

Banks can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, taxpayers effectively become the banks' silent equity partners during the years the banks are retaining pre-banker bonus earnings and rebuilding their book capital levels after absorbing the losses on the excess debt.

The 1930s policy makers also put in place the concept of automatic economic stabilizer programs.

So what did our current policy makers contribute to handling our current financial crisis and preventing a second Great Depression?

First, they adopted of the Japanese Model.  Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  As a result, the burden of the excess debt is put on the real economy where it diverts capital needed for reinvestment, growth and the social contract to debt service.

So rather than use the financial system as it is designed and bringing an end to our current financial crisis, our current policy makers chose to maximize both the length of our financial crisis and the damage the financial crisis does to the real economy and the social contract.

Of course, the choices made by our current policy makers haven't hurt everyone.  For bankers and their bonuses, it is close to if not the best of times.

Second, despite our current policy makers' claim to have prevented a second Great Depression, this claim is premature until such time as the excess debt has been purged from the financial system and all programs adopted to deal with our current financial crisis are ended.

An example of the programs that must be ended are monetary policies like zero interest rate and quantitative easing.  What will happen to the real economy and the financial markets when central banks try to unwind these policies?  Will unwinding these policies precipitate the second Great Depression our current policy makers claim to have prevented?

Almost 6 years after financial crisis began, consensus emerging there is no sovereign debt crisis in EU

In his Reuters Macroscope post, Pedro da Costa explains how a consensus is emerging that the EU is not facing a sovereign debt crisis, but rather a bank solvency led financial crisis.

This is very important because the cure for a bank solvency led financial crisis is well known: adopt the Swedish Model and require the banks to recognize upfront all their losses on the excess private and public debt in the financial system.

Modern banks are designed to absorb these losses and continue operating and supporting the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.  When banks have low or negative book capital levels, deposit insurance effectively makes the taxpayers the banks' silent equity partner.

Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.

In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.

Taxpayers have been forced to shoulder the burden because they are being called on to bailout the banks when the banks are perfectly capable of rebuilding their book capital levels through retention of future earnings.

Taxpayers have also been forced to shoulder the burden because the banks have not been required to recognize the losses on the excess debt in the financial system.  As a result, the taxpayers and the real economy are called on to make the debt service payments on this excess debt.  This diverts capital that is needed for reinvestment, growth and support of the social contract.

"The way austerity is being represented by both politicians and the media – as the payback for something called the ‘sovereign debt crisis,’ supposedly brought on by states that apparently ‘spent too much’ – is a quite fundamental misrepresentation of the facts.  

These problems, including the crisis in the bond markets, started with the banks and will end with the banks. 

The current mess is not a sovereign debt crisis generated by excessive spending for anyone except the Greeks. For everyone else, the problem is the banks that sovereigns have to take responsibility for, especially in the euro zone. That we call it a ‘sovereign debt crisis’ suggests a very interesting politics of ’bait and switch’ at play."

No surprise that bankers and politicians would engage in 'bait and switch'.  After all, the policies that have been adopted were designed to protect bank book capital levels and banker bonuses at all costs.

This has meant putting the bankers ahead of honoring the social contract or serving the best interests of the taxpayers.

So why all the misunderstanding? Why has the crisis become conflated with a government debt problem in the public imagination? 

According to Blythe, this is a convenient way for Wall Street to again saddle the state with massive banking sector losses.

Please re-read the highlighted text as Blythe it is simply marketing by Wall Street to avoid the consequences of its losses and to keep its bonuses flowing in an uninterrupted fashion.

The cost of bailing, recapitalizing, and otherwise saving the global banking system has been, depending on how you count it, between 3 and 13 trillion dollars. 

Most of that ended up on the balance sheets of governments as they absorb the costs of the bust, which is why we mistakenly call this a sovereign debt crisis when in fact it is a transmuted and well-camouflaged banking crisis.

Please re-read the highlighted text as Blythe provides an estimate of how much money the bankers should be reimbursing governments and taxpayers for as a result of their management of the banking system.

Spanish prelate sides with Elliott's Paul Singer to tell Paul Krugman that response to financial crisis destroying society

As reported by the Telegraph's Ambrose Evans-Pritchard, the Spanish prelate has weighed in on the side of Elliott's Paul Singer against Paul Krugman and called for a change in the policies adopted to deal with the bank solvency led financial crisis so that society does not collapse.

Professor Krugman wrote a post in his NY Times blog in which he defended the policies run by Ben Bernanke, the Fed and other central banks as

just what the textbook says you should be doing.

As regular readers know, the economic textbooks are wrong.

This fact is not surprising because leading up to our current financial crisis the models used by economists did not include the banking sector.

This fact is not surprising because even though the global central bankers claim to have read Walter Bagehot's Lombard Street, in which he "invented" the modern central bank, their response to the financial crisis has broken a number of the rules he laid out.  For example,

• Central banks are suppose to lend freely at high rates of interest against good collateral; or
• Central banks are suppose to keep interest rates at or above 2% as rates below 2% bring about a change in the behavior of savers.

Regular readers know that there is one response that works every time when dealing with a bank solvency led financial crisis.  That response is to adopt the Swedish Model and require the banks to recognize upfront their losses on the excess debt in the financial system.

The Swedish Model protects society as the banks absorbing the losses spares the real economy from diverting capital needed for reinvestment, growth and the social contract to debt service on the excess debt.

Regular readers know that under the FDR Framework, banks are designed to absorb these losses and continue to support the real economy.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

Unfortunately, the Swedish Model has not yet been adopted to deal with our current financial crisis.  Instead, policymakers and central bankers have 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 and the burden of servicing the excess debt in the financial system is placed on the real economy.

The results have been predictable (I know, I predicted them).  The global economy is in a Japan-style economic slump and the social contract is being rewritten to the benefit of the rich at the expense of the poor.

As the Spanish prelate said,

"We have to change direction, otherwise this is going to bring down whole political systems," said Braulio Rodriguez, the Archbishop of Toledo. 

"It is very dangerous. Unemployment has reached tremendous levels and austerity cuts don't seem to be producing results," he told The Telegraph.

Austerity will never produce a positive result when facing a bank solvency led financial crisis.  I have been making this point since the beginning of the crisis.

"There is deep unease across the whole society, and it is not just in Spain. We have to give people some hope or this is going to foment conflict and mutual hatred." 

Europe's Catholic bishops have been careful not to stray into the political debate or criticise EU economic strategy but the Archbishop said the current course is untenable.

There are two reasons that the current course is untenable.

First, it is not fixing the underlying problems.

Second, it is causing untold damage to society.

"The Vatican has always been an enthusiast for Europe, but a Europe of solidarity where we help each other, not a Europe of coal and steel. Whether this is possible depends on Germany and Chancellor Angela Merkel," he said. 

Unemployment in Spain has reached 6.2m, or 27pc, despite a growing diaspora of young Spaniards seeking work in Britain, Germany, Brazil, or the Gulf, and an exodus of immigrants returning home. Spain's population fell by 0.7pc last year. 

The jobless rate in the Toledo region of Castilla-La Mancha is 31pc. The rate for youth has jumped to 64pc from 14pc at the peak of the credit bubble. 

Spain has largely avoided the sort of street clashes seen in Greece. People have coped with stoicism, drawing on the deep strengths of Spanish family support. Yet the authority of the state is eroding. A new Metroscopia poll shows that 87pc of voters have lost confidence in premier Mariano Rajoy.

Confidence in the state should erode because it is being run for the benefit of the bankers and not for the benefit of its citizens.

El Mundo fears a slow-fermenting 'crisis of the regime', with almost every institution -- including the monarchy -- in disrepute. It likens the mood to "pre-revolutionary" France in the late 1780s. 

The Archbishop, speaking in the austere episcopal palace of Spain's ancient capital, said the current crisis is doing far more damage than the recession in the mid-1990s when unemployment briefly spiked above 24pc. On that occasion peseta devaluations let Spain regain competitiveness and recover gradually despite austerity cuts. 

This time the country seems trapped in slump. The long-term jobless rate is much higher. 

Unemployment benefits taper off after six months, and stop after two years. There are almost two million households where no family member has a job. 

Europe's Catholic bishops know first-hand from their Cor Unum charitable network just how desperate it has become. "We can try to mitigate the effects by giving basic help to people left totally unprotected, but we can't create jobs," said the Archbishop. 

"We are seeing families who used to middle class needing help. This is totally new. As a matter of honour, they won't come to us until they have exhausted everything,"

As we approach the sixth anniversary of the beginning of our current financial crisis, it is time to acknowledge that the response to the financial crisis has been a failure.  If it were a success, policies like zero interest rates and quantitative easing would no longer be pursued.

The time has come to adopt the Swedish Model.  

History shows that within a year of adopting the Swedish Model the bank solvency led financial crisis is over and growth has returned to the real economy.

Collapse in trust that politicians and their experts can restore economy and living standards

It has taken almost 6 years, but we have finally arrived at the point where there has been a collapse in trust that the politicians and their experts can restore the economy and return people's living standards to  before the financial crisis.

This is a watershed moment as it sends the unambiguous message that the vast majority of people recognize the response to the financial crisis is a complete failure.

It is not surprising that the vast majority of people would feel this way as the response was designed to protect bank book capital levels and banker bonuses and shift the damage from excess debt in the financial system onto them.

As reported by the Guardian,

Most voters, but especially coalition supporters, have lost faith in the ability of swift government action to restore living standards to the levels seen before the banking crash. 

A belief in whether government has the power, let alone the policies, to restore living standards also appears to be one of the issues that most determines which party voters will back....

Such is the pessimism among poorer voters that one in three earning less than £20,000 a year do not believe a recovery would help their living standards, although that figure falls to a fifth among only a fifth of richer voters.... 

Gavin Kelly, chief executive of the Resolution Foundation, said: "Despite the stagnation of recent years, including in the period prior to the recession, the majority of people still think that with the right policies growth will translate into steadily rising living standards. 

"They want their share of the future gains from growth. However, a large minority appear to have lost faith in this belief, which is concerning, given that the legitimacy of our economy rests on it."

IMF confirms solvency problem not fixed by response to financial crisis

According to a Guardian article, the IMF warns that the global economy still faces chronic risk until the excess debt in the global financial system is dealt with.

The International Monetary Fund has warned that the repair job on the world's battered financial system is only partly completed and said failure to finish the job risks propelling the crisis into a chronic new phase....

But with only a modest recovery in the global economy since the deep slump of 2008-09, the report said the improvement in financial market conditions could only be sustained through measures to address issues that posed risks both to financial stability and growth. 

"Continued improvements will require further balance sheet repair in the financial sector and a smooth unwinding of public and private debt overhangs. If progress in addressing these medium-term challenges falters, risks could reappear. The global financial crisis could morph into a more chronic phase marked by a deterioration of financial conditions and recurring bouts of financial stability."

A Bloomberg article gave an explicit example of the excess debt that needs to be dealt with.

As much as 20 percent of non-bank corporate debt in the weakest euro-area economies is unsustainable and may force companies to cut dividends and sell assets, dealing further blows to investor confidence, the International Monetary Fund said. 

Businesses (SXXP) in Italy, Spain and Portugal have the largest “debt overhang,” according to the IMF’s Global Financial Stability Report released today, which analyzed 1,500 publicly traded non-financial European firms. 

Strains in the corporate sector may in turn hurt banks’ asset quality, the report showed. 

“Firms in the euro-area periphery have built a sizable debt overhang during the credit boom, on the back of high profit expectations and easy credit conditions,” the IMF said. Now they “face the challenge of reducing the debt overhang in an environment of lower growth and higher interest rates, in part related to financial fragmentation in the euro area.”

The IMF's findings are not a surprise as the global policymakers and financial regulators response to a bank solvency led financial crisis was not to address this excess debt.

Instead, they adopted the Japanese Model under which bank book capital levels and banker bonuses are protect at all costs.  By doing this, the burden of the excess debt in the financial system has been placed on the real economy where it is diverting capital needed for growth and reinvestment to debt service.

As predicted by your humble blogger, the result has been a global Japanese-style economic slump.

Fortunately, the excess debt in the global financial system can still be dealt with.  This requires the global policymakers and financial regulators to abandon the failed Japanese Model and adopt the proven Swedish Model.

Under the Swedish Model, banks recognize upfront their losses on the excess debt in the financial system.  This protects the real economy and allows it to resume growing.  

Adopting the Swedish Model ends the diversion of capital from the real economy to cover the debt service on the excess debt.  Instead, under the Swedish Model, all of the capital that the real economy generates for growth and reinvestment is retained for use by the real economy.

One of the many benefits of adopting the Swedish Model is that it ends the need for austerity and rewriting the social contract.

Update
From the Guardian, the IMF recommended that as part of cleaning up the banks, they adopt enhanced disclosure.

Enhanced disclosure for banks and conducting selective asset quality reviews will help restore confidence in bank balance sheets and improve market discipline

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.