DON'T PANIC ABOUT BANKING SYSTEM INSOLVENCY

The International Monetary Fund has estimated total credit write-downs of $4.1tn, with $2.7tn in U.S. institutions. McKinsey Consultancy says there are still $2tn of toxic assets sitting on the books of U.S. banks. Nouriel Roubini estimates total losses on loans made by U.S. financial firms and the fall in the market value of their assets will reach $3.6tn ($1.6tn loans and $2tn for securities). The U.S. banks and broker dealers are exposed to half of this figure, or $1.8tn; the rest is borne by other financials in the US and abroad. With $2tn of write-offs to go, how could Treasury Secretary Timothy Geithner say to a Congressional panel last week, “Currently, the vast majority of banks have more capital than they need to be considered well capitalized by their regulators.”? Is he being economical with the truth? Does it matter if he is? The question and argument applies proportionately equally to the UK as to the US and to many otjher countries. The US banks balance sheet is given below: I've been saying publicly in FT and elsewhere, including saying that Nouriel Roubini is under-estimating, for over a year that the US banking system will have its capital wiped out twice over. I've also in the FT and to himself direct told Roubini that despite this 200% wipeout he is exaggerating the insolvency of the banks!
The US and UK governments and central banks, and others, are doing exactly the right things however they zigzag to get there. The story is capable of being simply told. The credit crunch is wiping out bank capital once and the recession once more. A 70-100% capital wipeout is normal in a recession, and that much banks should know how to recover from given the time to do so.
Governments and central banks are refinancing capital reserves and 'funding gaps' (difference between customer deposits and customer assets) by swapping bank assets for T-bills (subject to fees and large 25-30% haircuts i.e. plenty of headroom for taxpayr profit), but doing so whereby taxpayers money is not employed (bailout financing and guarantees are off-budget).
All writedowns and losses are generally capable of 40-50% debt-recovery over 3 years. Bank assets have roughly 50% collateral cover, but debt recovery is not limited to collateral, and of course some collateral such as property and land may take a few years before it is profitably worth selling on, but meanhile may be converted into various asset types and sometimes worked for development and cash-flow. That takes care of repaying government support.
The other half, also one times capital, has to be found by selling off non-core businesses, capital raising (internally and externally) and by cost-cutting, again over 1-3 years. That banks capital gets eaten into by losses and witedowns is what it is for. To be below recommended capital reserves (say 12% ratio to risk-weighted assets or 6% ratio to gross assets, including economic capital buffers) is not insolvency except temporarily. We do not actually have a strict measure of absolute bank insolvency except an irrecoverable cash-flow insolvency after full resort to central bank liquidity window and other measures. There is a kind of insolvency if a bank loses its unsecured borrowing credit rating, when in effect it has to be taken over or broken up.
Recessions and credit crunch are serious shocks to the system. We have to accept that they mean capital wipeouts. But the banking system, and all or nearly all important banks retain viable book value. If one or two fail they may drag down several others and as with lehman Brothers example the knock-on costs are excessive. Therefore, it is not an option to let a dominant bank fail in this way.
No banks are too big not to be temporarily insolvent, but they can be too big to allow to fail. So let's get real and take it in the shorts that we have to navigate through the capital wipeouts and accept that the Fed, FDIC, US Treasury etc. plus the banks own efforts if given sufficient time will keep going and recover as the economy as a whole recovers.
If banks and the banking system is deemed irrecoverably and disasterously insolvent, this means the same for the whole economy including all us. Insofar as we are not bankrupt insolvent neither are the banks.
The above issues should be mapped out by the banks scenario stress-tests modeled over the whole economic and credit cycle. But, serious problems exist in the technical difficulties banks find in correlating their balance sheets to the general economy. In a single jump that is in fact impossible. It is only possible by correlating the whole banking sector to the economy and then each bank to its banking sector including country by country and assessing the risk diversity and liquidity risk and reserve capital hits arrival rates.
I agree with William Black, former senior bank regulator, currently Assoc. Prof. of Economics and Law at University of Missouri. He says the stress tests conducted on the 19 US biggest banks a sham. In his own words:
If you did a real stress test, as Geithner explained them, you wouldn't just have a $2 trillion hole -- you'd impose regulatory capital requirements of 50%. (That I don't agree with since the deleveraging it would enforce would damage economic recovery fatally.) You can't conduct a meaningful stress test without reviewing (sampling) the underlying loan files and it seems likely that the purchasers of securitized instruments (not just mortgages) do not even have the loan file data. Moreover, loss ratios vary enormously depending on the issuer, so even a bank that originates (or has purchased a bank that originates) similar product cannot simply take its own loss rate and extrapolate it to the measure the risk on the value of securitized credit instruments. (This is true for complete accuracy, but the uncertainties involved are also managed by credit enhancements to the securitisations and it can suffice to have a rough accuracy since there is considerable scope for managing the outfall once the scale of the problems and forecast arrival rates of losses and recoveries are known. But, yes, this is not a spreadsheet game; it requires serious full-scale models and super-computing power.))
It is vastly more difficult to examine a bank that is engaged in accounting control fraud. You can't rely on the bank's books and records. It doesn't simply take more, far more, FTEs -- it takes examiners with experience, care, courage, and investigative instincts and abilities. Very few folks earning $60K are willing to get in the face of the CEO and CFO making $25 million annually and tell them that they are running a fraudulent bank and they are liars. FYI, this is one of the reasons, why having "resident examiners" never works. The examiners don't even get to marry the natives. They get to worship God's anointed. Effective examination is good for you, but it is very unpleasant, ala a doctor's finger up your rectum. It requires total independence. So, the examination force doesn't have remotely the numbers or the relevant experience and mindset to examine the largest banks with the greatest problems.
Examiners certainly can't do the stress testing that Geithner describes or evaluate the reliability of a large bank's proprietary stress test. If they were serious about constructing reliable stress tests, which they aren't, you'd require their analytics to be made public. You'd have the industry fund independent investigations by rocket scientists chosen by a committee selected by the regulators of the soundness of the analytics. You'd also have the industry fund competitions to rip them apart (a bit like we hire legit hackers to test security by trying to defeat it) and show where they produce absurd results. The geeks would have a field day (that would probably last a decade). There are probably zero examiners that have the modeling skills required to evaluate the most sophisticated stress test models. The concept that there are 100 examiners with these skills, suddenly freed up from all other duties, assigned to conduct stress tests is a lie.
I agree about the lack of skilled examiners. It follows from the failure in Basel II to provide a blueprint for its Pillar II scenario stress-tests even though this is central to the whole Basel II scheme = to make banks more aware and sensitive to the underlying economy. I disagree with Black insofar as I believe the authorities should be able to stress-test whole banking sectors. Central banks should have this capability. Their shared problem is that government and central bank macro-economic models lack a sufficiently detailed disaggregatd financial sector. This is a solvable problem, but there is little sign yhet that this is being addressed even though the problem is becoming recognised.
On Monday we will see how much transparency and disclosure the Treasury and Federal Reserve will provide regarding the not so stressful tests. The runours are that six banks have failed their tests. Sheila Bair, Chair of the FDIC, says that the $110bn left in the TARP kitty is enough to cover capital shortfalls. This is more hope than reality, but TARP is not the only capital resource. The U.S. banking system will need close to $1tn more capital infusion, but this can be recovered. Some commentators ask if the Federal Reserve was so keen on disclosure and transparency, why haven’t they released the names of the banks that have borrowed from them, and the collateral provided for the loans? The obvious and sensible answer is the need to maintain confidence and this confidence is justified by the US government, like other governments do, standing behind the banks.
Some critics go back to the question of hy was all this allowed to happen and choose to blame governments and especially Alan Greenspan’s part. On his speaking tours he gets paid $100,000 to tel us: The presumption that you could incrementally defuse a bubble was a fantasy. Clearly, you cannot defuse these things, unless you hit them right on the head and break the economy. Essentially, break the potential profitability that is engendering that sort of stuff. We could have basically clamped down on the American economy, generated a 10 percent unemployment rate. And I will guarantee we would not have had a housing boom, stock market boom or indeed a particularly good economy either.
From an economics viewpoint he is right; bubbles are inevitable. But, they can be defused as they have been many times in the past. What happens then however is that government actions such as choking off credit expansion by raising interest rates or variously slowing growth and seeking to rebalance external trade and defend currencies are blamed for economic slowdowns and recessions. Now we know what happens when government refrain from doing this on the basis of wanting never again to be blamed for economic cycles. To repeat myself: economic cycles are good and necessary. They just need more anticipatory management. They cannot be banned, nor should they be.