IMF study calls into question the whole approach to regulating banks

The Guardian reports that an IMF study has called into question the whole approach to regulating banks by asking if this approach is really addressing the real issue.

The authors of the study point out the simple fact that had all the proposed regulations been enacted prior to the beginning of the financial crisis they would not have prevented the financial crisis from occurring.

This conclusion is worth repeating.  For all the sound and fury, the proposed regulations would not have prevented the financial crisis.

Naturally, the authors call for seeing if there might be an alternative approach.

Regular readers know that there is an alternative to the combination of complex regulations and regulatory oversight.  That alternative is transparency.

Remarkably, transparency happens to be "low cost" and has a track record of success.

Transparency is particularly effective when combined with the principle of caveat emptor (buyer beware).  This combination makes the buyer responsible for all losses on their exposures.  This gives the buyer an incentive to use the disclose data to assess the risk of their exposures and limit the size of their exposures to what they can afford to lose.

By limiting their exposures to what they can afford to lose, buyers build robustness into the financial system.

This is the exact opposite of what we had in the run-up to the financial crisis and the adoption of the bury them in complex regulation approach.

The financial crisis occurred because of the fragility injected into the financial system by its opaque and heavily regulated corners (structured finance securities and banks).   So naturally, the response as pointed out by the IMF is to add even more opacity and, one of its chief sources, complex regulations.

The authors said: "The structural measures to reform banks such as the US Volcker rule, the UK's Vickers ring-fence, and the EU's Liikanen proposal, which would create functional separation of businesses, all reflect a deep sense of unease with the risk culture engendered by the assumption of trading and speculative investments by deposit-taking banks." 

But they added that the proposed reforms would not have prevented the crisis a tLehman Brothers in September 2008, the event that brought the global financial system to the brink of collapse. 

"Looking back, however, restrictions on proprietary trading or investments in private equity alone would not have prevented major bank failures such as Lehman Brothers. Nor would reorganising the bank into separate subsidiaries in each host and home country have facilitated its global, group-wide resolution." 

The study said Britain, the US and the EU were important financial centres and that they could bring benefits to the global economy if the structural reforms led to greater stability.

And the critical structural reform is to bring transparency to all the opaque corners of the financial system.

Big banks demonstrate again why regulations won't restrain their activities

The New York Times carried an interesting article on how the big banks managed to undermine any regulation intended to restrain their risk taking.

This provides further confirmation that the combination of complex regulation and regulatory oversight doesn't work to make the financial system safer.  In fact, relying on complex regulation and regulatory oversight makes the financial system riskier and more prone to crashes.  Our current financial crisis being a case in point.

The only proven method for restraining bank risk taking is requiring the banks to disclose on an ongoing basis their current exposure details.  With access to this information, the market then exerts restraint on the banks.

Under pressure from Wall Street lobbyists, federal regulators have agreed to soften a rule intended to rein in the banking industry’s domination of a risky market. 

The changes to the rule, which will be announced on Thursday, could effectively empower a few big banks to continue controlling the derivatives market, a main culprit in the financial crisis. 

The $700 trillion market for derivatives — contracts that derive their value from an underlying asset like a bond or an interest rate — allow companies to either speculate in the markets or protect against risk. 

It is a lucrative business that, until now, has operated in the shadows of Wall Street rather than in the light of public exchanges. Just five banks hold more than 90 percent of all derivatives contracts....

Here is a prime example of why regulation fails.

Did federal regulators think that the problem posed by derivatives was a lack of price transparency?

Hello, the problem posed by derivatives is that the banks can lose a substantial amount of money on them.  Just look at JP Morgan's losses on the London Whale's CDS trade.

The way to restrain banks from exposing themselves to potentially catastrophic losses on a large derivative portfolio is to require that they disclose their current exposure details, including derivatives.

With this disclosure, banks will dramatically shrink their derivative exposures for fear that the market will trade against them.  Jamie Dimon confirmed this when he tried to hide the CDS trade.

In the aftermath of the crisis, regulators initially planned to force asset managers like Vanguard and Pimco to contact at least five banks when seeking a price for a derivatives contract, a requirement intended to bolster competition among the banks. Now, according to officials briefed on the matter, the Commodity Futures Trading Commission has agreed to lower the standard to two banks. 

About 15 months from now, the officials said, the standard will automatically rise to three banks. And under the trading commission’s new rule, wide swaths of derivatives trading must shift from privately negotiated deals to regulated trading platforms that resemble exchanges. 

But critics worry that the banks gained enough flexibility under the plan that it hews too closely to the “precrisis status.” 

“The rule is really on the edge of returning to the old, opaque way of doing business,” said Marcus Stanley, the policy director of Americans for Financial Reform, a group that supports new rules for Wall Street.

So the CFTC's rule making is all about the idea that buyers of derivatives are too lazy to call multiple banks and compare prices.

If buyers cannot be troubled to get competing quotes, they are agreeing to overpay.

Making such decisions on regulatory standards is a product of the Dodd-Frank Act of 2010, which mandated that federal agencies write hundreds of new rules. ...

It is rules like this that further confirm that Dodd-Frank should be repealed (the only worthwhile parts are the Consumer Financial Protection Bureau and the Volcker Rule).

In an interview on Wednesday, Mr. Gensler said that, even with the compromise, the rule will still push private derivatives trading onto regulated trading platforms, much like stock trading. He also argued that the agency plans to adopt two other rules on Thursday that will subject large swaths of trades to regulatory scrutiny. 

“No longer will this be a closed, dark market,” Mr. Gensler said. “I think what we’re planning to do tomorrow fulfills the Congressional mandate and the president’s commitment.”...

Unless market participants know each bank's exposure details, derivatives are a closed, dark market.

If banks are performing the role that they are suppose to, acting as middlemen as oppose to taking proprietary bets, they should have no problem making this disclosure.

While the regulator defended the derivatives rule, consumer advocates say the agency gave up too much ground. To some, the compromise illustrated the financial industry’s continued influence in Washington. 

“The banks have all these ways to reverse the rules behind the scenes,” Mr. Stanley said.... 

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.

Bank of France turns to "super" transparency to restart securitization in EU

Bloomberg reports that the Bank of France is rolling out what it believes is the model for restarting securitization in the EU.

The distinguishing feature of the Bank of France's model is the reliance on making these deals "super transparent" so that market participants can know what they are buying and know what they own.

This is precisely what your humble blogger has been calling for since the earliest days of the financial crisis.

Why would the Bank of France feel the need to roll out deals that are "super transparent" when the ECB has already endorsed the level of transparency provided by the EU DataWarehouse?

Because the Bank of France sees that the EU DataWarehouse doesn't bring transparency that would allow an investor to know what they own or a buyer to know what they are buying.  Rather, the EU DataWarehouse is the industry's effort to retain opacity at the levels associated with opaque, toxic subprime mortgage-backed securities.

Please note, that the Bank of France recognizes that the only way to reduce, if not totally eliminate, the rating firms' role in securitization is to make the deal "super transparent".  When a deal is "super transparent", reliance on rating firms is greatly reduced as investors can do the analysis for themselves or hire a third party expert.

Regular readers know that your humble blogger has defined what it takes for a structured finance deal to be "super transparent".

First, the deal must provide observable event based reporting under which all activities, like a payment or delinquency, involving the underlying collateral are reported to market participants before the beginning of the next business day.

Second, the deal must make available all data fields tracked by the originator of the underlying collateral and the servicer of this collateral.  These firms are experts and would only track data fields that are relevant for valuing or monitoring the underlying collateral.  There is no legitimate business reason for depriving market participants of the right to piggy-back off this expertise.

The Bank of France wants to help banks package loans to businesses into tradable securities with the creation of a special-purpose vehicles, in what could become a template for the euro area. 

As the European Central Bank looks for ways to improve the flow of credit to small and medium-sized enterprises, or SMEs, the project started by the French central bank in July last year could provide one possible solution, the head of its markets division, Alexandre Gautier, said in a telephone interview. 

He’s in talks with the Frankfurt-based ECB and other national central banks on the initiative, which would ideally create securities that qualify as collateral in ECB refinancing operations. While banks can currently securitize SME loans and use them as collateral at the ECB, the process is complicated and not centralized. 

“We want a vehicle that is super simple and super transparent,” Gautier said. “We’d very much like these securities to be eligible in the euro system, but it’s not a condition. We’ll go ahead on our own if we have to to show that it’s doable.”... 

The aim is to make it easier for banks to re-finance existing loans and incentivize them to extend credit to small businesses. That would especially be the case if the new securities were eligible as collateral with the ECB, said Gautier. 

“The banks were very interested but they said that to make it really attractive, any securities should be eligible as collateral for refinancing within the euro system so that they would be liquid in the event of a crisis,” he said. “That’s now what we’re aiming for.” 

ECB President Mario Draghi said on May 2 that policy makers will start consultations with other European institutions on initiatives to promote lending to SMEs in the euro area using asset-backed securities.

As market for asset-backed securities rebounds, ratings shopping resumes

In yet another sign that zero genuine financial reform has occurred since the beginning of the financial crisis, Bloomberg reports that as the market for asset-backed securities rebounds, credit ratings shopping has returned.

Regular readers will recall that in the run-up to the financial crisis, rating firms were willing to put a AAA-rating on securities that the firms admitted they did not have adequate information monitor prior to issuance of the securities and after the securities traded in the secondary market.

In fact, structured finance securities developed a nickname: opaque, toxic.  Where the opacity of the security hid its toxicity.

Here we are almost 6 years after the financial crisis began and policymakers and financial regulators have done nothing to bring transparency to the structured finance market.

As regular readers know, the only way to bring transparency to structured finance securities is to require that they disclose on an observable event basis all activities like payments or delinquencies that occur with the underlying collateral before the beginning of the next business day.

It is only with observable event based reporting that investors know what they own and potential buyers can know what they are buying.

Here we are almost 6 years later and policymakers and financial regulators have not brought observable event based reporting to structured finance.

In fact, policymakers and financial regulators have gone out of their way to keep these securities opaque.  For example, the ECB puts its blessing on a data warehouse that provides disclosure on the same frequency as opaque, toxic subprime mortgage-backed securities.

Almost six years after the start of the worst financial crisis since the Great Depression, bond issuers are again exploiting credit ratings by seeking firms that will provide high grades on debt backed by assets from auto loans to office buildings considered inappropriate by rivals. 

Fitch Ratings isn’t grading a deal linked to a Manhattan skyscraper after saying investors needed more protection. The securities won top grades from Moody’s Investors Service and Kroll Bond Rating Agency Inc. 

Blackstone Group LP’s Exeter Finance Corp. got top-tier ratings from Standard & Poor’s and DBRS Ltd. in the past 15 months on $629 million of bonds backed by car loans to people with bad credit histories, even as Moody’s and Fitch said they wouldn’t grant such rankings.

Borrowers are finding more options than ever to get the top ratings that many investors require after U.S. regulators doubled the number of companies sanctioned to assess securities to 10 since 2006.... 

Issuance of bonds linked to loans and leases are staging a comeback as the Federal Reserve (FDTR)’s unprecedented stimulus, including a pledge to keep benchmark interest rates close to zero into a fifth year, pushes investors into riskier assets. 

Banks have arranged $31.5 billion of commercial mortgage-backed securities this year with issuance poised to climb 50 percent from 2012 to $70 billion, according to Credit Suisse Group AG. Issuance of bonds tied to subprime auto debt of $7.7 billion this year compares with $5.7 billion in the first four months of 2012, according to Wells Fargo & Co.... 

“Nothing’s really changed” in the ratings business, David Jacob, former head of structured finance at S&P, said in a telephone interview. Regulation “changed some of the processes that they do, but what led to a lot to this bad behavior hasn’t really changed.”

The only way to bring about true change is to require the structured finance securities to provide observable event based reporting.

With this information, market participants can assess for themselves the risk and value of these securities.  Market participants can either do the due diligence themselves or hire third party experts to do the due diligence for them.

This ends any reliance on the rating firms.  With transparency, rating firms become just another third party expert offering an opinion.

Debt graders led by S&P and Moody’s helped ignite the credit seizure that began in August 2007 by lowering their standards to win business before defaults soared on home loans to subprime borrowers, the Federal Crisis Inquiry Commission said in a January 2011 report. 

“My plea today is that you take action,” Franken, a Democrat from Minnesota elected to the Senate in 2008, told participants at the SEC roundtable today. “If we maintain the status quo we are leaving ourselves far too vulnerable to another catastrophe.”...

Where the status quo is opacity.  Bringing transparency to opaque securities like structured finance reduces our vulnerability to another catastrophe.

Simon Johnson asks if the Fed is afraid to regulate banks

In his Bloomberg column, Professor Simon Johnson asks if the Fed is afraid to regulate banks and if it is not afraid, why doesn't it require banks to hold a much higher level of capital.

Professor Johnson observes that

capital regulation needs to be about the true ability to absorb losses relative to total assets. Regulators should focus on this measure -- known as leverage -- and its implications for what happens when a financial company faces failure.

It is interesting that Professor Johnson says this because the adequacy of a bank's capital to absorb expected losses is the principle focus of the Fed's bank examination function.  Bank examiners ask the question of do banks have enough capital to absorb the potential losses on the risks the banks are exposed to.

If yes, then the bank examiners think the bank is adequately capitalized.

If no, then the bank examiners write up the bank and require that it raise additional capital.

Apparently, Professor Johnson doesn't think that the Fed's bank examiners are up to the task of evaluating capital adequacy.  He would like someone else to determine when a bank has enough capital.

There are two potential ways to make this determination:  the market or regulatory fiat.

Regular readers know that your humble blogger favors having the market determine if a bank is adequately capitalized.  What is necessary for the market, which includes the bank examiners, to perform this task is having banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the market can use its valuation expertise to determine if each bank is adequately capitalized or not for the risks that it is taking.

With this information, the market can also exert discipline on the banks so that the banks hold enough capital to absorb their potential losses.  Recall that when banks provided ultra transparency at the beginning of last century, banks maintain a 15+% equity to total asset ratio.

Alternatively, we could have regulators write a regulation requiring banks to hold more capital.  Not only does this involve overcoming the Too Big to Fail bank lobby, but it also means the regulators publicly saying that their bank examiners are not up to the task of evaluating the adequacy of each bank's capitalization.

Ironically, in making the case for the regulators to require the banks to hold more capital, Professor Johnson actually makes the case for doing so by requiring the banks to provide transparency.

Global megabanks are profoundly complex, and intentionally so. Investors and regulators don’t know what risks are being taken. Board members also are usually in the dark. 

Whether top management understands what is happening is an open question: Chief Executive Officer Jamie Dimon is adamant that he had no real knowledge of JPMorgan’s Whale positions, which eventually had a notional value in the trillions of dollars.

Simply requiring banks to hold more capital doesn't address the fact that no one knows what risks are being taken.  Without knowing the level of risk, it is impossible to know if the regulated level of capital is adequate.

The starting point for determining capital adequacy is ultra transparency.  With disclosure comes the ability to assess the level of risk and then exert discipline to ensure there is enough capital to absorb losses.

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.

One of best indicators of genuine reform in financial sector shows no reform

In his Guardian banking blog, Joris Luyendijk interviews an equity sales director who explains how Wall Street profits from both valuation and pricing opacity when it buys or sells derivatives and why it is fighting so hard to retain opacity.

The equity sales director compares his product, which represent an investment in the real economy, with derivatives, which represent a zero-sum bet on the direction of, for example, interest rates.

Which brings me to complex derivatives. The culture of equity is so different from derivatives. We try to build relationships with clients who invest money in real companies, for the long term. Complex derivatives traders work with a far larger and diffuse pool of clients, who could decide at any point to switch from one product to the next.... 

With complex derivatives it's very much about here and now, as you can make money in a market that's going down as well as up. There's no direct relationship with the economic cycle. 

My clients choose to deal with me for the quality of advice, the execution of their trades and the value of our research. With complex derivatives it's mostly driven by price. 

Often complex derivatives are not traded on an open exchange but over the counter [OTC] – in other words, it's an agreement directly between bank and client. One reason is that OTC derivatives are usually custom-made for the client, so there's only of them in the world. 

To illustrate how transparency in equity works, suppose a client places an order to buy a particular stock at careful discretion which is trading at 25. My trader goes into the market and executes it for 25.12. At the end of the day my client sees on his information terminal that the day's average price was 25.10. Did he overpay? He calls me and I go over to our trader. If it's really the trader's fault we might take the loss and give the client a better price. Otherwise we could lose our reputation and he will go elsewhere. 

Now, with OTC derivatives, how does a client find out he was disadvantaged? There's no exchange. Traders and clients base prices for OTC derivatives on a number of 'Greeks' – parameters indicating levels of volatility and other derivative characteristics of the product. 

It all comes down to client's ability to understand these Greeks' their sophistication. There is a huge difference between genuinely sophisticated clients and those eager to be seen as professional who actually don't grasp [all of] it. 

I have heard OTC derivatives traders use the term 'rape and pillage'. That means selling a less sophisticated client a financial product carrying a high likelihood of blowing up and causing that client never to deal with you again. 

"Rape and pillage" was not confined to large investors or corporations.  Regular readers might recall that UK banks were involved in the mis-selling of interest rate derivatives to small companies and individuals.

A lot of regulation has come in to prevent this, but in some non-EU jurisdictions these can still be sold. Again, note the difference with equity. A client can lose money on my recommendations, but it is almost impossible to bring down the client. 

"You could argue that OTC derivatives are among the best indicators of the degree of genuine reform in the financial sector. 

If reform of OTC derivatives is one of the best indicators of genuine reform in the financial sector, what  does reform in this area show?

One reason the crisis of 2008 got so bad was that banks had these totally opaque derivatives on their books, so nobody knew who had what.

Nobody knew which banks were solvent and which were not.  So it is very clear that the reform that is needed is to bring transparency to bank derivatives books.

Since then there's been a fight to improve transparency but banks resist with all their means.  Transparency correlates inversely with profitability; it has always been like that. 

Given that transparency will reduce the profitability of the banks, the banks are fighting to retain opacity in the derivatives and about their exposure details (their books).

So have the banks been successful in retaining their profitability and fending off transparency in derivatives and their exposure details?

Yes.

Since OTC derivatives are one of the best indicators of genuine reform in the financial sector, the lack of transparency shows there has not been genuine reform in the financial sector.

Paul Krugman misses Bernanke's role in disrupting the default/insolvency cycle

In his NY Times blog, Professor Paul Krugman tries to understand the rage directed at Ben Bernanke for lowering interest rates as the economic textbooks say he should be doing during a time of high unemployment and low growth.

Professor Krugman specifically cites Paul Singer's observation that Bernanke's policies are destroying the very fabric of society.

What Professor Krugman misses, and his miss is not at all surprising given that macro economic models do not include the financial sector, is Bernanke's role in disrupting the default/insolvency cycle.

What Mr. Singer and others who have expressed rage at Mr. Bernanke's policies realize is his policies are pushing the cost of the excess debt in the financial system onto savers and through austerity undermining the social contract.

Regular readers know that modern banks are designed to absorb the losses on the excess debt in the financial system and protect the real economy and social contract.  Banks provide this protection because absorbing the losses means that capital that is needed for reinvestment, growth and supporting the social contract is not diverted to making debt service payments on the excess debt.

But wait a second, isn't all Chairman Bernanke doing is lowering rates as the economic textbook suggests?

Chairman Bernanke is doing one more thing.  He is covering up the losses that are currently on and off the bank balance sheets.

Everyone knows that these losses exist, but Chairman Bernanke pretends they don't.

Because he pretends these losses don't exist and signs off on the Fed's bank solvency stress tests, bankers are able to receive enormous cash bonuses that would otherwise be used to rebuild bank book capital levels.

Because he pretends these losses don't exist, firms that should have gone out of business are allowed to continue operating.  This in turn distorts the economic system.

Everyone knows why Chairman Bernanke and the financial regulators wouldn't want the true magnitude of the losses to be known today.  They are fearful of that a second Great Depression could occur.

What Chairman Bernanke and his fellow financial regulators fail to consider is that everyone already knows there are tremendous losses buried in the global financial system.

It did not escape the market's attention that Spain just announced that over 15% of the debt on its banks' balance sheets had to be restructured in the last year.

It did not escape the market's attention that recently Cyprus banks had losses exceeding 20% of their asset value.

What has also not escaped the market's attention is that banks are designed to absorb these losses and rebuild their book capital levels over several years through retention of future earnings.

The source of rage that individuals like Paul Singer feel is that Chairman Bernanke and the financial regulators who did not see the financial crisis coming are now treating someone who did see the financial crisis coming like a child.

I am reminded of that famous movie line: "you couldn't handle the truth".

Hello, the guys who predicted this crisis know that the losses are huge.  They just don't have precise figures for how large the losses are.

They also know something about how the financial system operates.

What their rage is saying is that the financial system is perfectly capable of absorbing the losses that the Chairman and the rest of the financial regulators are hiding.

Who to listen to or is it possible for a non-PhD to penetrate economists' echo chamber

Paul Krugman ran an interesting post on who policymakers and the public should listened to when it comes to a solution for ending our current financial crisis (hat tip Jonathan Portes).

According to Professor Krugman:

Jonathan Portes has a nice little essay, which gets better than I have at the essential issue: it’s not just about the individual track record:

My answer to it is that policymakers and the public should listen to economists

While policymakers listening to economists is definitely an improvement over listening to the bankers who got us into our current difficulties, this is an extraordinarily low bar to get over and doesn't suggest why economists should be listened to rather than some other market participants.

who fulfill two critera: first, they have made empirically testable predictions (conditional or unconditional – see Krugman here) that have proved, by and large, to be broadly consistent with the data; and second, they base those predictions on an analytic framework (not necessarily a formal model) that is persuasive. 

These criteria were the basis for the economics profession to discount the prediction of the financial crisis made by William White and a handful of other economists.  Their predictions were good at using the data.  Their predictions were bad at using an analytical framework.

In other words, getting it right alone is not enough; it should be possible to show your workings – to explain why you got it right. Otherwise, your predictions may be interesting, but they tell you little about how to formulate policy.

Fortunately, your humble blogger has both gotten his predictions right and has been able to show his work using an analytical framework.

Quite. Place not your faith in gurus, even if they got some big stuff right — and that goes for me, too.

Even though it is nice to be a guru, I wouldn't place your faith in me either.

It’s always about the model, not the man....

I would place your faith in the model and the model that did the best job of predicting our current financial crisis and why easy monetary policy combined with austerity or fiscal stimulus has not ended the crisis is the FDR Framework.

This is not surprising as the FDR Framework is the foundation on which our financial system is built.

One side note: One thing that’s striking in Portes’s discussion — and something I very much agree with — is the irrelevance of formal credentials. 

As we’ve debated how to deal with the worst slump since the 1930s, a distressing number of economists have taken to arguing on the basis that they have fancy degrees and you don’t — or in some cases that well, you may have a fancy degree too, and even a prize or two, but in the wrong sub-field, so there. 

But all this counts for very little, especially when macroeconomics itself — or at any rate the kind of macroeconomics that has dominated the journals these past couple of decades — is very much on trial. 

If a PhD in economics counts for so little Professor Krugman, why don't you give me a call so we can discuss the FDR Framework and what it takes to end the bank solvency led financial crisis.

What I can tell you is every economist who thinks they have a solution for the financial crisis or how to fix the banking system I have talked with has been immediately dismissive of the FDR Framework despite its track record at predicting what has actually happened.

You would like to solve the financial crisis and redeem macroeconomics.  Here is your chance.