The law of unintended consequences: Why European banks are sacrificing growth

In an interesting article, Bloomberg confirms that to achieve a meaningless 9% Tier I capital ratio not only are European banks shrinking by selling their best assets, but their risk is going up at the same time because they continue to hold their problem debt exposures.

Under pressure from regulators to bolster capital, European banks are selling some of their fastest-growing businesses to competitors from outside the region. The sales may leave them better able to withstand financial stress—and less able to boost future profits....

The inability to boost future profits of course makes the banks less attractive as an investment which in turn limits their ability to tap the capital markets for equity - a decidedly negative unintended consequence of the current push for higher capital ratios.

Such sales are an unintended consequence of the decision by European regulators to make banks increase capital—a buffer that protects against credit losses—to help them survive the worsening sovereign-debt crisis.... 

To reduce their reliance on the markets for funding, banks across Europe have pledged to cut assets by more than €950 billion over the next two years, according to data compiled by Bloomberg. 

About two-thirds of that will come from sales of profitable units and performing loans, says Huw van Steenis, aMorgan Stanley (MS) analyst in London. 

While it may be hard to get premium prices for those businesses in a crisis, other options for raising money are even less appealing. 

Lenders don’t want to issue additional shares because their stock prices are too low: The Bloomberg Europe Banks and Financial Services Index is down 33.5 percent this year. 

Exactly who would want to buy these shares given the current lack of disclosure?  Banks are a black box.

Selling troubled loans is also problematic. If the banks accept the low prices investors are willing to pay, the lenders would have to record losses on the loans, and those losses would erode their capital. As a result, distressed assets and souring loans will account for just 4 percent of asset reductions over the next two years, according to van Steenis. 

That leaves selling entire business units outside of their domestic markets. These are the most profitable parts of their business,” says Azad Zangana, European economist at London-based Schroders (SHNWF), citing Spanish and Portuguese banks selling assets in Latin America. 

“You begin to become a less profitable organization. Your business model stops working if you’re being forced to lend only to an economy that’s going through a very deep recession.” 

By shedding some of their best assets, the sales may make banks less stable. “Lenders are selling more liquid assets so they can get a price that avoids additional capital losses,” says Joseph Swanson, co-head of restructuring at Houlihan Lokey in London. “Unfortunately, this strategy can result in lower asset quality and increased earnings volatility.”... 

“When you sell an asset, there are always two sides of the coin,” says Stephane Leunens, a spokesman for KBC. “We focus on de-risking the company while trying to generate sufficient growth in our core markets.”...

Analysts say the banks are in a bind. “If they raise capital by selling crown jewels, the market will reward them in the short term because they’ll meet the regulator’s time frame,” says Will James, who runs the SLI European Equity Income Fund at Standard Life (SLFPF) in Edinburgh. The longer-term question, he adds, is “How do you grow in an environment where customers are unwilling to borrow? That’s the missing piece from the puzzle. In a low-growth or no-growth environment, banks that have sold good assets will continue to struggle.”

Response to 'Bring Back Boring Banks' [update]

The NY Times published an interesting editorial by AMAR BHIDÉ in which he makes the case for why, despite the Dodd-Frank Act and a blizzard of new regulations, major financial reform is still needed.

He sees a global financial system that is on life support needing frequent rescues by the central banks.  He also sees a lack of confidence in the financial system.

To address these problems, he calls for a return to boring banks.  This call has two major elements.  First, the government should guarantee all bank deposits.  Second, banks should face much tighter restrictions on risk taking including being restricted to easily understood businesses.

While I agree with his analysis of the problem, I disagree with his proposed solution.

The primary source of my disagreement is that regulated banks are fully capable of blowing themselves up even when they are restricted to easily understood businesses.  Examples of this include the US Savings & Loans that became virtually extinct because of losses on mortgages and the current Eurozone banking crisis triggered by losses on Eurozone sovereign debt.

CENTRAL bankers barely averted a financial panic before Christmas by replacing hundreds of billions of dollars of deposits fleeing European banks. But confidence in the global banking system remains dangerously low. To prevent the next panic, it’s not enough to rely on emergency actions by the Federal Reserve and the European Central Bank. 

Instead, governments should fully guarantee all bank deposits — and impose much tighter restrictions on risk-taking by banks.

Regular readers know that my blueprint for saving the financial system calls for governments to fully guarantee all bank deposits.  This guarantee of all bank deposits is needed to prevent bank runs while the banks are recapitalizing after recognizing all of their losses.

Where I disagree with Amar is over how to impose much tighter restrictions on risk-taking by banks.  I think much tighter restrictions should be the result of market discipline.  Market discipline has many sources including investors, competitors and regulators.

My mechanism for bringing market discipline to the financial sector is to require all financial institutions to have to provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure detail.  Market participants can use this data as the basis for exerting their respective form of market discipline.

Banks should be forced to shed activities like derivatives trading that regulators cannot easily examine.

With ultra transparency, market discipline would create incentives for banks to reduce their derivative trading.  These incentives include the possibility of predatory trading against the banks given their positions are known.

The Dodd-Frank financial reform act of 2010 did nothing to secure large deposits and very little to curtail risk-taking by banks. It was a missed opportunity to fix a regulatory effort [to prevent financial panics] that goes back nearly 150 years.... 

In fact, an overwhelming proportion of the “quick cash” in the global financial system is uninsured and prone to manic-depressive behavior, swinging unpredictably from thoughtless yield-chasing to extreme risk aversion.

Much of this flighty cash finds its way into banks through lightly regulated vehicles like certificates of deposits or repurchase agreements. Money market funds, like banks, are a repository for cash, but are uninsured and largely unexamined.

The reason that this "quick cash" exhibits manic-depressive behavior has to do with the fact that banks are 'black boxes'.  Currently, banks do not provide adequate disclosure so that the individuals who control the quick cash can assess the risk of each bank.  As a result, these individuals tend to extreme risk aversion and shift their investments should there be any hint of trouble.

Relying on the Fed and other central banks to counter panics is dangerous brinkmanship. A lender of last resort ought not to be a first line of defense.

Rather, we need to take away the reason for any depositor to fear losing money through an explicit, comprehensive government guarantee. The government stands behind all paper currency regardless of whose wallet, till or safe it sits in.

The government effectively did this in 2009.

Why not also make all short-term deposits, which function much like currency, the explicit liability of the government?

Guaranteeing all bank accounts would pave the way for reinstating interest-rate caps, ending the competition for fickle yield-chasers that helps set off credit booms and busts. (Banks vie with one another to attract wholesale depositors by paying higher rates, and are then impelled to take greater risks to be able to pay the higher rates.) 

Stringent limits on the activities of banks would be even more crucial. If people thought that losses were likely to be unbearable, guarantees would be useless.

Regardless of the size of the losses, guarantees are useful.  So long as depositors believe that they could withdraw all their funds, they will continue to use a bank even if it has a large, negative book equity value.

I agree that guaranteeing all the deposits requires stringent limits to be place on bank activities.  My preference is to put these limits on by requiring ultra transparency.  That way, if the bank's risk increases, everyone can see it and market discipline exerted.

Without ultra transparency, bank managers are likely to gamble on redemption like the managers of the US Savings & Loans did.

Banks must therefore be restricted to those activities, like making traditional loans and simple hedging operations, that a regulator of average education and intelligence can monitor. If the average examiner can’t understand it, it shouldn’t be allowed. 

Giant banks that are mega-receptacles for hot deposits would have to cease opaque activities that regulators cannot realistically examine and that top executives cannot control.... 

Amar's solution still leaves the financial markets dependent on a single point of failure:  the regulators.

By providing ultra transparency, the regulator can tap the market for understanding and monitoring the risks that banks are taking.

These radical, 1930s-style measures may seem a pipe dream. 

But we now have the worst of all worlds: panics, followed by emergency interventions by central banks, and vague but implicit guarantees to lure back deposits. 

Since the 2008 financial crisis, governments and central bankers have been seriously overstretched. The next time a panic starts, markets may just not believe that the Treasury and Fed have the resources to stop it.

Update

I would like to thank SW for calling my attention to the fact that savings and loans didn't just get wiped out by mortgages.  Given the opportunity by regulators to gamble on redemption, many of these also managed to lose a considerable amount of money in junk bonds.

Ultimately, the problem faced with a 100% deposit guarantee is the asset side of the balance sheet.  The question becomes how to eliminate all the ways that banks can fail.  Ironically, when we eliminate all the ways a bank can fail, we end up with a money market mutual fund that invests in short term government securities.

I like the 100% deposit guarantee only for the period during which banks recognize all the losses currently hidden in the financial system.  After these losses have been recognized, I think that deposit guarantees should be reduced.  The reduction in the deposit guarantee forces the banks to raise funds from the market.

When the market has ultra transparency, the cost of the non-guaranteed funds will reflect the risk the bank is taking.  Hence, market discipline is applied to the banks.

To raise capital, Unicredit proposes selling stock at 43% discount

Italy's Unicredit is the first Eurozone bank to test the equity markets to try to raise capital to meet the 9% Tier I capital ratio.  To attract buyers, Unicredit is offering current shareholders the opportunity to buy more shares at a 43% discount to yesterday's closing stock price.

If the offering is going to be successful, Unicredit is going to have to provide significantly more disclosure on its exposures.

Investors have learned not to buy financial 'black boxes', and Unicredit is a giant black box loaded with unknown exposures, as a result of their experience buying sub-prime mortgage backed structured finance securities.

According to a Guardian article,

Stephen Hester, the chief executive of Royal Bank of Scotland, remarked last year that investors thought it was "dumb" to invest in banks.  

Over the next few months, it will become clearer if his remarks are correct as banks across Europe race to plug the €106bn (£88.2bn) shortfall that regulators believe they need to survive the eurozone crisis. 

UniCredit is the first big test. 

Embarking upon its third capital hike since the 2008 banking crisis, the Italian bank is currently enduring significant pain on the markets. Its shares have fallen 10%, and been suspended, after it priced its €7.5bn cash call at a 43% discount – larger than expected – to Tuesday night's share price.... 

Not all of the banks across Europe deemed to have shortfalls (all UK banks were given a clean bill of health) will embark on such cash calls. Others are selling off businesses and reducing their risky loans, but the plight of UniCredit is regarded as important. 

Louise Cooper, markets analyst at BGC Capital, said. "This will be a key test for investors' appetite for bank share offerings and will be closely watched by corporate brokers whose banking clients desperately need to raise new equity."

Ireland house prices continue their collapse, lowest level since 2000

The Guardian reports that house prices in Ireland continue collapsing and have now lost more than the maximum assumed by BlackRock in the April 2011 government sponsored bank stress test.

One of the reasons that this is important is that it once again calls into doubt the solvency of the two pillar banks in Ireland.

Compounding matters is the simple fact that everyone knows the Irish banks have not been aggressive about dealing with the 20% of the mortgages that have or are experiencing performance problems.

Last year at this time, I urged the Irish government to require its banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Had this been done, a bottom would have been put in place under the housing market as banks would have an incentive to resume mortgage lending while working through the troubled mortgages as quickly as possible.

Property prices in Ireland are in freefall, according to housing analysts, whose latest figures show that prices in Dublin have collapsed by 65% in five years and by 60% across the country. 

A house price index released by the largest residential sales group – the Sherry FitzGerald Group – found that the pace of deflation has sped up in Dublin, while prices across the country are now at levels last seen 11 years ago. 

The group, which has been surveying a weighted basket of 1,500 properties since 1999, said residential property in Dublin was now worth 64.2% less than at the 2006 peak, with a national fall of 58.8%. 

Separate surveys by two property websites also found large declines in 2011's asking prices: myhome.ie said sale prices were down 50% since 2006, while its rival website daft.ie reported an 8% drop in the last quarter alone, calling it the largest ever quarterly fall in house prices in Ireland....

In 2011, just €2.3bn (£1.9bn) was available in mortgage finance, according to the Irish Banking Federation, compared with €40bn at the peak of the property market in 2006. With no signs of mortgage credit returning to the market soon, and unemployment expected to rise in 2012, there are fears that property prices will continue to decline this year....

If Sherry FitzGerald's figures are borne out by other data and the decline continues this year, the crash will exceed the worst-case scenario outlined by the US asset management firm BlackRock Solutions, which conducted the stress tests for the Central Bank of Ireland that led to the fifth bailout of Irish banks in April 2011. 

BlackRock's tests were the most severe ever applied to banks, and were the first to price in the cost of a new toxic wave of mortgage debt from the residential and buy-to-let markets. It predicted that, at best, house prices in Ireland would drop 55% before recovering and at worst 60%. 

Ronan Lyons, daft.ie economist, said the crash was no surprise, as just 13,000 mortgages were issued in 2011 compared with 200,000 in 2006. "Given that the property market in any developed economy is inextricably linked to the mortgage market, it's no surprise that prices are down 50% or more, if lending is down by over 90%." 

He is one of the few who thinks there is a positive aspect to the latest figures: "If you think of the fall in house prices as a necessary correction, whose size is determined by fundamental factors, then it is better for the prices to race to the finishing line than to crawl there."

To remove credit ratings, regulators embrace zero-risk Greek bonds

A Bloomberg article reports on how regulators, in response to the the Dodd-Frank Act prohibition on using credit ratings in regulations, have turned to another risk ranking system that assigns Greek bonds a zero risk weight.

A classic case of "jumping from the frying pan of the ridiculous into the fire of the absurd".

The reason that regulators are going through this exercise is bank capital requirements.  Specifically, the idea embedded in the Basel capital requirements of risk-weighting assets based on the credit rating of the borrower.

Dodd-Frank puts the US bank regulators in an awkward position.  How to find a substitute for credit ratings that produces the same outcome under the Basel capital requirements.

Fortunately, Dodd-Frank does not tell the US bank regulators how to find this substitute.

My preference is to substitute the market for the credit ratings.

This can be achieved by requiring that all banks provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  The market will value each exposure.

Specifically, market participants including other banks, rating agencies and independent pricing services, will value each exposure.  Regulators can then use the credit spreads implied by these valuations to risk-weight each bank's assets.

U.S. regulators, required by Congress to remove credit ratings from banking rules, have devised a plan anchored in a Paris-based group’s rankings that assign zero risk to most European government debt. 

The Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency proposed rules last month to set bank capital levels using classifications made by the Organisation for Economic Co-operation and Development. The intergovernmental group, two-thirds of whose members are European Union countries, considers most EU sovereign bonds risk-free, including those of Greece and Portugal. 

The proposal undermines the intent of the 2010 Dodd-Frank Act, which sought to eliminate the use of ratings ...

“The OECD represents the member governments, so there’s an inherent conflict of interest there, too,” said De Ghenghi, a member of the firm’s financial-institutions group. “The regulators were dealt bad cards when they were asked to come up with alternatives to credit ratings. It’s almost impossible to find something where there are no conflicts of any kind.” 

The Dec. 7 proposal is part of a U.S. effort to implement global capital rules revised in 2009 by the Basel Committee on Banking Supervision, which coordinates global regulation. The revisions would increase the amount of capital banks are required to have to back mortgage-linked securities and other complicated products at the heart of the 2008 financial crisis... 

The U.S. proposal, which includes alternatives for rating securitizations as well as government bonds, allows regulators to increase risk weightings for nations that have defaulted on their debt within the past five years. Voluntary restructurings, such as the one Greece is negotiating with its creditors, would be considered a default, resulting in a jump in risk weighting. Until then, it would stay at zero. 

“At least with this, they veer off the OECD straitjacket a bit, but it’s still backward-looking,” said Karen Shaw Petrou, managing partner at Washington-based research firm Federal Financial Analytics.

Recognizing the weakness of OECD ratings, U.S. regulators added the debt-restructuring provision and suggested using market indicators to complement them, said Bobby Bean, the FDIC’s associate director of policy, who helped draft the proposal. 

Among the indicators mentioned in the proposed rule are bond yields and credit-default swap spreads, which could measure investors’ perceptions of default risks. 

“When is the appropriate time to trigger the debt- restructuring charge?” Bean said in an interview. “Do you do it when there are discussions going on, like in the case of Greece now? These will be part of the ongoing supervisory conversation with the bank.” 

While the suggested use of market indicators was intended to make ratings more up-to-date, Bean said, the proposal calls for stripping out short-term volatility by using one-year averages of yields or CDS spreads. 

That also would be backward-looking, Petrou said. The CDS spread of Lehman Brothers Holdings Inc. widened only a few weeks before the firm went bankrupt, so a one-year average wouldn’t capture increasing risk until it was too late, she said....

“Broadly speaking, any credit-risk system will end up somewhat emulating credit ratings done by the rating firms,” said Richard Spillenkothen, a former director of banking supervision at the Fed. “Hopefully, the parts of the rating firms’ flawed methodologies are fixed in these formulas.” 

Since the crisis, rating companies also have revised the way they evaluate securitizations in an effort to fix such defects. For example, S&P now requires that loan pools have a larger proportion of subordinated debt so the risk of the top- rated tranches defaulting is lower.

New rules approved by the Basel committee last year and known as Basel III also rely on credit ratings for calculating how much capital banks need to protect against losses on securities and bonds on their banking books, the part of the balance sheet where they keep assets held to maturity. 

The Fed, FDIC and OCC, which are trying to devise a proposal by the end of March for how to implement Basel III, will have to come up with another approach to avoid relying on credit firms. The alternatives proposed Dec. 7 probably will be repeated in the Basel III implementation plan, Spillenkothen said. Bean declined to say whether that would be the case since regulators haven’t completed their work yet. 

The new Basel rules, like the current ones, will allow the largest banks to use internal models to assign risk to assets, including Greek bonds, unless regulators object. The U.S. never implemented the earlier Basel framework, known as Basel II, which was adopted by the EU in 2006. Basel III rules are supposed to go into effect globally starting in 2013.

“Banks have been doing their own analysis on their sovereign exposures and don’t rely on the rating firms’ ratings,” said Sabeth Siddique, a director at Deloitte & Touche LLP in Washington and a former assistant director of bank supervision and regulation at the Fed. “The largest banks are more nimble than the ratings firms. So their analysis could be better than what the regulators came up with, too.” 

Allowing banks to use internal models to determine risk enabled European lenders to reduce the amount of capital they held before the financial crisis, which led to government bailouts. The biggest U.S. banks will start using internal models when Basel III is implemented. 

“If you let banks determine their own risk weighting, then you open it up to possible gaming of the results, as European banks have done for a while,” said Petrou of Federal Financial Analytics. “A strong bank might choose to use higher risk in its model, but why should the weak bank do that when it can hold less capital?”

Hostage to mountains of debt, economies and banks become zombies

The Wall Street Journal talked with Bridgewater Associates Robert Prince about his views on where the economy is headed.  His focus was on how working through the mountains of debt is effectively turning the economies and banks of the US, UK and Europe into zombies.

Despite the fact that Japan is already in its third lost decade from its credit bubble, Mr. Prince thinks that the western economies have only 10 to 15 more lost years to work through their credit bubble.

As ZeroHedge likes to phrase the problem of the mountain of debt

the greatest threat to the modern financial system: a debt overhang so large, at roughly $21 trillion, that one of 3 things will have to happen: a global debt restructuring/repudiation; global hyperinflation to inflate away this debt, or a one-time financial tax on all individuals amounting to roughly 30% of all wealth. That's pretty much it, at least according to mathematics.

Regular reader know that your humble blogger thinks that the best and fastest way to fix the financial system and work through the debt bubble is ultra transparency.

Specifically, by requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, the distortion in asset prices caused by regulatory forbearance is eliminated.

With this information, market participants will value every exposure for each bank.

As a result, the focus of banks changes from hiding losses (think extend and pretend) to addressing their bad debt and minimizing their losses.

The alternative to ultra transparency that has been tried unsuccessfully in Japan, the US, UK and Europe is to continue hiding the debt in the financial system and try to inflate it away.  This alternative has numerous problems, not the least of which is that it results in both the economies and banks being zombies.

Bridgewater Associates has made big money for investors in recent years by staying bearish on much of the global economy. As the new year rings in, the hedge fund firm has no plans to change that gloomy view. 

Robert Prince, co-chief investment officer at Bridgewater, and his managers at the world's biggest hedge fund firm are preparing for at least a decade of slow growth and high unemployment for the big developed economies. Mr. Prince describes those economies—the U.S. and Europe, in particular—as "zombies" and says they will remain that way until they work through their mountains of debt. 

"What you have is a picture of broken economic systems that are operating on life support," Mr. Prince says. "We're in a secular deleveraging that will probably take 15 to 20 years to work through and we're just four years in." 

In Europe, "the debt crisis is [a] long ways from over," he says. The economic and financial morass will mean interest rates in the U.S. and Europe will essentially be locked at zero for years....

In a conference room at Bridgewater's headquarters, where the water from the Saugatuck appeared to almost lap at the glass walls, Mr. Prince paints a grim picture of the challenges facing the U.S. and European economies. 

Recent better-than-expected news on the U.S. economy is unlikely to be the start of a healthy expansion, he says. The uptick in economic growth has been fueled by a decline in the savings rate, which, without material income and employment gains, is unlikely to be sustainable as long-term credit growth also remains weak, he says. 

The problem for the U.S, says Mr. Prince, is that it is on the wrong side of a long-term debt cycle. 

"We were in a leveraging-up period for 60 years, from the early 1950s to 2008," he says. This debt bubble was self-reinforcing on the way up, and "when it tipped over, it set about a self-reinforcing process on the way down." 

As evidence for the long slog facing the U.S economy, he notes that the level of leverage, as measured by comparing household income to net worth, is still higher than it was before 2008.
"The most likely environment is moderate growth with wiggles up and down and this is one of those wiggles up," he says.... 

Europe, meanwhile, is headed into a potentially deep recession, with policy makers boxed in by an interconnected banking and sovereign-debt crisis. 

"You've got insolvent banks supporting insolvent sovereigns and insolvent sovereigns supporting insolvent banks," he says.

This is where ultra transparency and a credible deposit guarantor come in.  With ultra transparency, the banks can absorb the losses on the insolvent sovereign debt.  With the deposit guarantor, the banks can continue in operation while they rebuild their book capital.

Germany looking at 75% writedown on Greek debts

A Bloomberg article reports that Germany is looking at making private sector investors in Greek sovereign debt take a 75% haircut.

Clearly, this will be the first of many forced haircuts as it will be impossible for politicians in Ireland, Portugal, Spain and Italy to suggest to their voters that they should endure significant amounts of austerity rather than have the private sector (aka, banks) absorb the losses.

This is particularly true given that banks have a special role as the safety valve circuit breaker between the excesses of the financial markets and the real economy.  In a world where bank deposits are guaranteed, banks can absorb the losses from debt write-downs and still continue to operate despite massive amount of negative book equity.

Germany’s government declined to comment on a report that it may push for creditors to accept bigger losses on Greek debt than previously agreed upon, saying only that talks on lowering Greece’s debt level may end soon. 

Germany is studying a proposal to write down 75 percent of Greek government bonds held by private creditors as part of a planned debt swap to ensure greater debt sustainability, Greek news website Euro2day.gr reported today, without citing anyone. 

Under the terms of Greece’s 130 billion-euro ($168 billion) second bailout backed by European leaders in October, investors would take a 50 percent hit on the nominal value of 206 billion euros of privately owned debt. 

Talks are ongoing about the specifics of the role of the private sector and Germany assumes that the negotiations will end soon, the Finance Ministry in Berlin said in an e-mailed response to the Greek report, without elaborating.... 

Greece’s creditors are resisting pressure from the International Monetary Fund to accept bigger losses on holdings of the nation’s government bonds, three people with direct knowledge of the discussions said last month.

Of course the banks are resisting, because once everyone realizes that banks can in fact take write-downs and still keep operating, write-downs will become the solution du jour.

Greece’s debt will balloon to almost twice the size of its economy this year without a write-off accord with investors, the IMF said Dec. 13. 

At a Dec. 9 European summit, German Chancellor Angela Merkel backed away from a prior demand that bondholders shoulder losses in any future euro-area rescue, saying that Greece was a “special case.”

An interesting interview with Standard Chartered chief Peter Sands

The Telegraph published an interesting interview with Standard Chartered chief Peter Sands.

Just before Christmas, Standard Chartered's highly respected economics unit led by Gerard Lyons published its forecasts for 2012. For those in the West it made for pretty miserable reading – recession in the eurozone economies (GDP -1.5pc), recession in the UK (GDP -1.3pc), low growth in the US (GDP +1.7pc) and European sovereigns facing further downgrades as the single currency crisis shows little sign of resolution. 

Entitled Fragile West, Resilient East, the report said ...

"In the West, the fundamentals are poor, the policy cupboard is almost empty and confidence has been shot to pieces. In contrast, across the emerging world, the fundamentals are good, the policy cupboard is almost full and confidence is likely to prove resilient."... 

Sitting in his office on the corner of Basinghall Street in the City, Peter Sands, the chief executive of Standard Chartered, could be forgiven a small smile. His bank is almost wholly focused on the emerging markets of Asia and Africa, with little exposure to the eurozone. But such is the fear of eurozone failure that it is concentrating all minds. 

"Obviously we close 2011 with a huge amount of focus on the trials and tribulations of the eurozone and I actually think the big news of last month's summit [in Brussels] was that unfortunately, once again, the eurozone's political leadership didn't really produce something that was compelling or credible as a plan to deal with the problems and to re-energise growth
in the eurozone," he said. 

"So we enter 2012 with a very difficult outlook for the eurozone [and] with an increasing possibility of countries actually leaving the eurozone. Nobody should underestimate what a big deal that would be, because it would be very difficult to manage the contagion risk, even if it was only Greece."

Regular readers know that "contagion risk" is a direct result of the opacity of the 'black box' banks.  Nobody knows where the losses are.

Requiring the banks to provide ultra transparency by disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details eliminates contagion risk.  It does this because every market participant can adjust their exposure based on the risk of each bank to what they can afford to lose.

"The disruption from [a country leaving] would really be significant. It will have ramifications all over the world – both directly, because the simple maths is that the eurozone is a very large part of the global economy and if it is going slower then economic trade will be slower around the world. But there is also the confidence perspective." 

Rather than become more optimistic as European summit after European summit attempted to knit together a deal to solve the sovereign debt crisis during 2011, Sands has looked on with increasing pessimism. I ask him if his position has hardened on the issue of whether the eurozone could really break apart. "Yes," he answers simply. 

"I think the probability of countries leaving the eurozone has increased," he continues. "We have had several successive plans announced to solve the problem of the eurozone which simply haven't convinced the market and ultimately the current structure, shape and scope of the eurozone only works if the market believes it's worth supporting. 

"We are in a path-dependent problem, where the solutions available at any one time are not necessarily available at the next step and so I think the solutions base has narrowed because we have missed opportunities."

Previously, your humble blogger had also noted how the number of available, untried solutions was declining.  For example, regulators had tried the combination of stress tests and bailouts and this had failed as the European banking system is seen by the market as being on the verge of collapse.

My conclusion was that Eurozone policymakers would turn to the solution that FDR and his administration used successfully to break the back of the Great Depression:  ultra transparency.  FDR and his administration were able to provide ultra transparency by offering an implied 100% guarantee of bank deposits.

With eurozone break-up would come lower growth and, as The Telegraph reported last week, the possible use of emergency measures such as capital controls to protect nations' economies. The economic dislocation which has brought demonstrations to the streets across the eurozone would pale by comparison with what might be unleashed. 

"I think there is a real risk because these economic problems bring real social consequences - cuts in social provisions, higher rates of unemployment, very high rates of youth unemployment. There is a real risk of all this translating into greater calls for protectionism, more populist policies. I think it is quite easy to tell a story of 2012 that is quite depressing."...

This is the reason that banks need to perform their safety valve function and act as a circuit breaker between the excesses of the financial markets and the real economy.  Banks do this by recognizing their losses even if it means they have large, negative book equity values.

"One thing I am concerned about is that there is a degree of inward-looking insularity to much of the debate about regulatory policy that is on one level understandable, given what we've been through, but is potentially very damaging to the vibrancy and the ability of the City to compete and London-based institutions to compete in international markets." 

Despite the threat from fresh waves of banking regulation from the implementation of the Independent Commission on Banking (ICB) reforms and the Government's announcement that the UK-only banking levy will increase from Sunday, Sands has always made it clear that the preferred option for Standard Chartered is retaining its London HQ. But, as a bank with most of its business focused in Asia and Africa and with investors constantly asking the question, analysts say it would be foolish to rule out other options. 

"Our deposits in Bangladesh attract the UK bank levy," Sands says. "Nobody else's deposits in Bangladesh attract the UK bank levy apart from HSBC and they are much smaller than us [there]. So, none of our major competitors [faces the bank levy]. The whole issue of FSA super-equivalence, the FSA front-running what has been agreed on the international agenda, [means] we operate at a degree of competitive disadvantage." 

One of the ICB's proposals is to impose higher levels of loss-absorbing capital on UK banks before the globally agreed Financial Stability Board and Basel rules come into force. It is not a matter of whether you agree with higher levels of such capital (as a matter of fact, Sands does), it is why, as Sands puts it, the UK "isn't moving with the [global] regulatory agenda"?

However, higher capital without ultra transparency is meaningless.

Just look at what is happening in the Eurozone as banks are reducing their leverage to meet the regulators 9% Tier I capital ratio target.  No one thinks the banks are any safer.  Instead, they see the banks as riskier as they are selling off their performing assets to reach the capital ratio.

 All the changes should be seen in the context of the huge global forces pushing the next phase of development from West to East. As the Government and the Financial Services Authority plan their latest assault on UK banking, the critics argue, the East looks at how it will promote its financial sector to support growth. The UK and Europe, many argue, are too busy looking back at 2007 and 2008 to see what is coming over the horizon. 

"If you are too focused on driving looking in the rear-view mirror, you can either miss the tree in front of you or you simply don't know where you are going," Sands says. 

The tree this time has proved to be the eurozone ....

Some say Standard Chartered is a "flight-to-quality" institution and that it is well placed – and resourced – to take advantage as eurozone-exposed banks rapidly deliver. 

"The rougher the markets get, the more we attract liquidity," Sands says. "We have just been upgraded by S&P at a time when most other banks are getting cut. And I think we are the only bank that has been upgraded by all three rating agencies since the beginning of the crisis. So we are in a very strong position." 

If the eurozone does collapse, of course, then few will be able to tell where the chips will fall.

Actually, as far as the financial system is concerned, we should be able to tell where the chips will fall if the eurozone does collapse.  The only reason the market cannot tell is because banks and structured finance securities are allowed to remain opaque.

Saving the Eurozone means no more socializing the losses and privatizing the gains

Ultimately, saving the Eurozone will require ending the policy of socializing the losses and privatizing the gains.  This policy has to end because the market does not believe that together the Eurozone countries have the ability to absorb the losses that are currently hidden in the financial system.

An example of the market expressing its loss of confidence is the freezing of the interbank lending market in the Eurozone.

Why would Eurozone banks stop lending to each other?

Because each Eurozone banks knows what losses it is hiding and they are worried about getting repaid because they cannot determine the size of the losses that banks they might lend to are hiding.  Furthermore, the banks are nervous about the capacity of the host country to bail out its banks.

This is a problem that existed when the financial crisis began on August 9, 2007.  This symptoms associated with this problem were temporarily relieved by adoption of socializing the losses.  Unfortunately, it is now clear that the losses are bigger than the Eurozone can support.

Since the beginning of the financial crisis, your humble blogger has said there is an alternative to socializing the losses.  That alternative is to have banks perform their safety valve function and act as a circuit breaker between the excesses of the financial markets and the real economy.

I understand why regulators are reluctant to adopt this policy:  financial institutions are going to show massive negative book capital when they are required to recognize their losses and the regulators are afraid this will trigger a run on the financial system.

This assumption is fundamentally wrong.

First, there is deposit insurance.  What holds the deposits in place is the perceived solvency of the government and not whether a bank has a positive or negative book capital account.

Second, the market knows that there are significant losses hidden in the banking system.  It has already adjusted to this fact (for proof, just look at how in the late 1980s bank stock prices rose dramatically after banks came clean about their losses on loans to less developed countries).

One of the reasons that financial institutions should be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details is it ends hiding losses.

All market participants, including other banks, can see what the true condition of each bank is.  It is only when market participants can independently assess the true condition of each bank that trust in the financial system is restored.

Happy New Year!