I am predicting and betting heavily on another large bank failure in the US and the Eurozone. Many on the site have probably already guessed what it is that I do. Well, I may be significantly epanding my job description if the financial system takes the hits that I expect it to.

A Black Swan Swims Across the Pond

European Central Bank’s (ECB) measures to inject necessary liquidity in the financial system had negligible on the interbank liquidity hoarding which led to sharp rise in inter-bank lending rates. Although the liquidity injections by ECB helped restore the expected overnight lending rates (EONIA) to near target level of 4%, there was little impact on the inter-bank borrowing rates for deposits over 3 months (EURIBOR), which stood at 70 basis points against the usual rate of 5-10 basis points over the target rate since banks were unwilling to lend each other. Similar phenomena were observed in US where steps taken by Fed like the Term Auction Facility were proven ineffective in reducing LIBOR-OAS spreads which were more dependent on counterparty risk factors such as asset-backed commercial paper spreads, and credit default swaps. Since term lending does not affect counter party risk Fed should consider other measures that affect LIBOR-OAS spreads. For example, some feel that the ECB’s policy framework for direct open market purchases of marketable assets including high-grade mortgage-backed securities could address the ongoing stress in the market. I personally believe that these securities must be allowed to bottom out. If there is any value in them, speculators such as I will swoop in to purchase them at the right price. The point of consternation is that the right price results in explicit insolvency. The banks are implicitly insolvent now, though, and everyone knows it. I am referring to both commercial banks and the non-bank entitiies that include the investment banks and brokerages - whose fates are heavily intertwined.

Fed rate cutting has also failed to improve margins in many of this nation’s regional banks, as was clearly illustrated in “The Anatomy of a Sick Bank!”. This shows that the problem is getting worse despite rampant rate cuts and the wholesale swallowing of infected assets as collateral. I believe that the banks must be allowed to fail, and it appears as if the Fed and Treasury are coming to that conclusion as well.  Today’s headline on CNBC.com:

Paulson Wants Bank Failure without Fallout – “"In my view, looking beyond the immediate market challenges of today, we need to create a resolution process that ensures the financial system can withstand the failure of a large, complex financial firm," Paulson said in remarks prepared for delivery to the Chatham House think tank in London. "To do this, we will need to give our regulators emergency authority to limit temporary disruptions. These authorities should be flexible and -- to reinforce market discipline -- the trigger for invoking such authority should be very high, such as a bankruptcy filing," he added.

He said the perception should be avoided that an institution is "too interconnected to fail or too big to fail" and added that "we must improve the tools at our disposal for facilitating the orderly failure of a large, complex, financial institution." The United States has procedures for the orderly unwinding of insolvent commercial banks with insured deposits, in which their regulators, including the Fed for smaller state-chartered banks, administer claims and control insolvency proceedings. Paulson on Tuesday said using these procedures for larger, complex institutions such as investment banks could mitigate market disruption but would not impose enough market discipline on the private sector.

And simply subjecting investment banks to normal bankruptcy proceedings "imposes market discipline on creditors, but in a time of crisis could involve undue market disruption," he said.

Knowing that Fed support is readily available could cause institutions to willingly take on too much risk, as they did in the run-up to the subprime mortgage crisis, he said. "For market discipline to constrain risk effectively, financial institutions must be allowed to fail. Under optimal financial regulatory and financial system infrastructures, such a failure would not threaten the overall system."