Current Asset-Level Disclosure: The Solution to Too Big to Fail

To paraphrase Winston Churchill, American regulators always find the right solution, after they try everything else first.

This past week, Kansas City Fed President Thomas Hoenig ruled out higher capital requirements, bail-ins, resolution authority, and better supervision by regulators as solutions that fail to solve the problems of contagion and preventing the next financial crisis.

His proposed solution is to break-up the Too Big to Fail (TBTF) because this will reduce the interconnectedness in the financial system and risk of contagion should one of these institutions fail.   

As a practical matter, the US does not have the political will to break-up the US-based TBTF.  Tim Geithner summed up the Administration's position at the G20 by observing that the US financial system is stronger than it was before the credit crisis.  Without the US pushing to break-up the TBTFA, non-US based TBTF are also highly unlikely to be broken-up.  If any attempt is made to break them up, the non-US TBTF will threaten to leave the country and undermine the economic recovery by taking its lending and tax paying capacity with it.

Your humble blogger has long argued that there is a far better and more effective solution than breaking up the TBTF.  That solution is to require current asset-level disclosure.

The effectiveness of this solution is that it directly addresses the issue of interconnectedness and risk of contagion.  Current asset-level disclosure reveals both the interconnections and the risk of the TBTF to all market participants.  This in turn allows risk to be properly priced throughout the financial system.

Think of current asset-level disclosure as driving contagion in reverse.

Market participants have an incentive to not only avoid the high risk TBTF, but also smaller firms that are heavily exposed to the high risk TBTF.  This drives up the cost of funds and reduces the access to funds for everyone doing business with the TBTF and also the TBTF.  This puts substantial pressure on the TBTF to reduce its risk.

As reported in the Wall Street Journal,

Thomas Hoenig is still a rebel with a cause. 

Although the Federal Reserve Bank of Kansas City president no longer votes on interest-rate policy, and so can't continue his lone dissent to money printing, Mr. Hoenig still is going against the Fed grain. In a speech this week, he said breaking up big banks is the only way to end the threat posed by too-big-to-fail institutions. 

... Mr. Hoenig doesn't buy the idea that better supervision, higher capital levels and powers granted by the Dodd-Frank Act to wind down a tottering institution will take care of the too-big-to-fail problem. The biggest firms, he noted, can't be wound down because "there are too many connections that will bring down other institutions." 

... the systemic risk from too-big-to-fail firms is, if anything, "even worse than before the crisis."

Are Higher Capital Requirements a Substitute for Current Asset-Level Disclosure?

Perhaps the most vocal academic for banks holding more capital is Stanford finance professor Anat Admati.  In a Bloomberg column, while laying out a compelling case for why the Too Big to Fail should not be allowed to begin paying dividends yet, she also makes the case for current asset level disclosure.

She does this when she calls for "better ways to monitor the true leverage and risk of financial institutions".

This is an explicit acknowledgement that higher capital requirements, bail-ins, living wills and hybrid securities are not a substitute for current asset level disclosure.  As regular readers of this blog know, the only way to actually monitor leverage and risk is to have current asset level disclosure.

People become scared when ex- regulators or bankers warn that growth might be hurt or that the recovery would be slowed if we fail to do something. The Federal Reserve seems scared, too, or maybe captured, since it is about to allow increased dividends from banks. 

The Fed should know better. Allowing high payouts to shareholders raises financial institutions’ leverage and that is bad for the economy. 

One of those warning that growth will suffer is William Isaac, head of the Federal Deposit Insurance Corp. from 1981 to 1985 and now chairman of Fifth Third Bancorp. Writing in the Financial Times on Feb. 9, he said that unless banks increase dividends they will have a harder time raising equity in the future, thus hurting the economy. 

This is similar to the flawed assertions made by bankers who are lobbying against increased capital requirements. 

We have seen self-serving statements like this before. ... And the doom and gloom we were promised? There is no evidence ...[of] any negative economic consequences. 

Confusing language often obscures the discussion of capital regulation and makes it more difficult to evaluate such threats. .... Capital is simply equity, the value of shareholders’ ownership claims in banks; and it represents a way for banks to fund their investments without undertaking debt commitments that they might not be able to meet and which add to systemic risk. 

Bankers are fiercely resisting the suggestion that they use more equity and less debt in funding, even though this would reduce their dangerous degree of leverage. 

... when banks are highly leveraged, their equity can be easily wiped out by small declines in asset values. If 95 percent of a bank’s assets are funded with debt, even a 3 percent decline in the asset value raises concerns about solvency and can lead to disruption, the need to “deleverage” by liquidating inefficiently, and possible contagion through the interconnected system. As we have seen, this can have severe consequences for the economy. 

...Isaac is right to point out that the structure of current capital requirements distorts banks’ decisions. The structure, which is focused on the ratio of equity to so-called risk- weighted assets, might induce banks to choose investments in securities over lending, because securities with high credit ratings require less capital and thus allow more debt funding. 

These failures of the system of risk weights, however, have nothing to do with the overall level of capital. Allowing banks to pay dividends and maintain high leverage isn’t the solution to this problem. Instead, better ways to monitor the true leverage and risk of financial institutions should be found. 

Isaac says he favors high capital requirements, but he says that paying dividends now is important for banks’ ability to raise equity later. As prominent academics explained in a letter responding to his column, his arguments for allowing dividends are weak. 

The muddled debate on capital regulation has left us with only minor tweaks to flawed regulations, even after banks’ catastrophic failure in the crisis and the lasting consequences for the economy. The proposed solutions that regulators in the U.S. are focused on, such as resolution mechanisms, bail-ins, contingent capital and living wills, are based on false hopes. They can’t be relied on to prevent a crisis. Increasing equity funding is simpler and better than these pie-in-the-sky ideas. 

Until they build up much greater capital, banks should retain their earnings rather than make payouts to equity. Bank boards, helped by regulators, should make sure that “excess capital” isn’t wasted or cause banks -- as JPMorgan Chief Executive Officer Jamie Dimon said -- to do “stupid things.” And empty, self-interested threats shouldn’t win another round of implicit subsidies if we are to prevent another crisis.

Watson and the Mother of All Databases

Recently, the Financial Times ran on column on how Wall Street views the use of information technology as its savior.  What the author missed is how financial regulators should also be using equally high powered information technology as an integral part of regulating the financial markets.

The critical element to successful information technology is the underlying data.  Without good data, all that can be expected is 'garbage in, garbage out'.

This blog has spent a considerable amount of time talking about both the Mother of All Databases and what would make up the 'good' data is should hold.

This database, which has been championed by the Economist Magazine and Wired, would have current asset-level data for every financial institution, broadly defined, and shadow banking entity, including structured finance securities, on an observable event basis.  The data would be made available to all market participants, including the regulators.

Another critical element is the ability to transform the data into useful information.

This blog has talked about how regulators are going to be able to piggy-back off of Wall Street's ability to transform the data into useful information.  This is a short-term solution.

Recently, IBM demonstrated the future with its 'Watson' information technology.  Suddenly, we can see a future where regulators can ask 'Watson' a question and it will sift through the Mother of All Databases to find the answer.

... Reeling from a crisis that wiped out some of its most lucrative products and a regulatory overhaul that will curb high margin activities, the financial sector sees information technology as its saviour. 

... If, by dint of IT, financial groups can automate functions carried out by error-prone, bonus-guzzling humans, their cost base will shrink, bolstering profits and pleasing investors. 

The Holy Grail in this quest is Ficc – fixed income, currency and commodities trading. Unlike stocks, which have been traded electronically for years, Ficc is still human-based, partly because much of it consists of tailor-made derivatives not quoted on exchanges. 

In the good years, the lack of price transparency for these “over-the-counter” products enabled banks to charge customers high prices. But in an environment where regulators penalise illiquid assets and push more derivatives on to exchanges, the human touch has become a liability to be replaced by cheaper algorithms. 

... Expenditure on IT will be considerable – good news for tech companies but not for banks. 

JPMorgan, for example, puts the cost of its forex integration at half a billion dollars. 

Multiply that by several product lines and countries, and only a handful of financial institutions will be able to take part in the technology revolution without harming short-term profits. 

A widespread use of technology is almost certain to depress margins as customers refuse to pay a premium for trading electronically. 

... The upfront costs of technology have the added advantage of being a barrier to new entrants, enabling five or six large participants to dominate. Call it the Bloombergisation of trading, with banks’ technology firmly embedded in investors’ trading systems. 

German Voters Express Desire for No More Bailouts

In the wake of a recent election in Germany, Bloomberg reported that the results reflect the desire on the part of Germans for no more bailouts.

This raises the interesting question of how are regulators and Euro market officials going to stop the sovereign debt crisis now that additional bailouts have been taken off the table?

Under the FDR Framework, the answer is disclosure of data at the financial institution level.  With this data, the market will determine which financial institutions need capital and how much capital.  At that point, the financial institution can try to raise capital from the private markets.  If not successful, the government has the option of injecting capital or closing the financial institution.

With this strategy, the era of bank bailouts is ended. The focus can then be placed solely on the sovereign issue.  [emphasis added]

Chancellor Angela Merkel’s party suffered its worst defeat since World War II in Germany’s richest state, losing control of Hamburg in the first of seven state elections this year that threaten to limit her scope to tackle Europe’s debt crisis. 

The result in Hamburg, the city-state of Merkel’s birth, underscores the challenge she faces trying to balance public opposition to bailouts for debt-wracked states against pressure from investors and fellow euro countries to lead the way in stemming the debt contagion. She faces three more state ballots next month on either side of a March 24-25 European Union summit called to form a comprehensive plan for the crisis. 

“It’s a warning to Merkel,” said Carsten Brzeski, an economist at ING Groep NV in Brussels. “If she has to draw any lesson, it probably will be to get tougher at the European level to show something to German voters,” he said. “There is no room for Merkel to come home from Brussels on March 25 with anything that could look or smell like a defeat.” 

... “There’s a risk to peripheral bonds if Germany is seen not to be displaying support for the countries that are in trouble,” said Orlando Green, assistant director of capital- markets strategy at Credit Agricole Corporate & Investment bank in London. “The market would have been hoping that a deal would have been struck already” before the elections. 

... Hamburg was the first electoral test of Merkel’s policy since her party lost a state election last May, a result that she blamed on voter anger over bailing out Greece. The defeat cost her control of parliament’s upper house in Berlin, the Bundesrat, where regional administrations are represented. The Hamburg result, if confirmed, would cost the CDU 3 seats in the Bundesrat, further limiting her ability to pass legislation.

... Merkel’s main European policy challenge this year is getting the EU debt-fighting deal through parliament and “for her, Baden-Wuerttemberg is the test,” said Holger Schmieding, chief economist at Joh Berenberg Gossler & Co. in London. 

Germany, Europe’s largest economy, is already the biggest country contributor to last year’s 110 billion-euro bailout of Greece and the rescue fund for debt-stricken states. 

Geithner Effectively Rules Out Need for Banks to Hold More Capital

Tim Geithner offered his assessment on Bloomberg of the US financial system.

In doing so, he effectively ended the international discussion on whether banks need to hold more capital.  It is hard to make a case that US banks need to hold more capital if the US financial system is much stronger than it was before the crisis.  Foreign banks can successfully argue that they too do not need to hold more capital than US banks as this level of capitalization results in a strong financial system.

His comments also confirm that the latest round of stress tests being carried out by US regulators were designed to conclude that the Too Big To Fail banks are adequately capitalized and can be permitted to resume paying dividends.

Given his track record in assessing the condition of the large, global banks being supervised while he was the President of the NY Fed, your humble blogger would prefer that these same banks provide current asset-level data so that market analysts and competitors can confirm his conclusion.

The U.S. financial system is in better shape than it was before the recession and is well placed to provide the funding needed for the economic expansion, Treasury Secretary Timothy F. Geithner said. 

“The core of the American financial system is in a much stronger position than it was before the crisis,” Geithner said today during a Bloomberg Breakfast with reporters in Washington. 

U.S. banks had net income of $87.5 billion in 2010, the highest since 2007, the Federal Deposit Insurance Corp. said today. The Standard & Poor’s 500 index has jumped 64 percent since March 2009, and corporate bond spreads have narrowed. 

“We can say with much more confidence now that the U.S. banking system and the U.S. capital market are much more likely to be in a position to finance the capital needs that come with a recovery,” Geithner said.

Helping Thomas Hoenig and Regulators Deal With Too Big To Fail

The New York Time's Dealbook ran an article discussing the regulation of Too Big to Fail financial institutions.

As the author discusses, regulating TBTF under Dodd-Frank raises a number of important issues such as the mechanism by which regulators decide who is and who is not TBTF.  Perhaps more importantly, the focus of US regulators on TBTF does not mean that the next crisis will not come from the foreign TBTF institutions or other financial players who are not recognized as TBTF.

The Fed's Thomas Hoenig has a different take on TBTF.  He argues for breaking up TBTF firms. [emphasis added]

Large financial institutions continue to pose major risks to the U.S. economy, and must be broken up in order to avoid another meltdown, Kansas City Federal Reserve President Thomas Hoenig said on Wednesday. 

Citing a number of shortcomings in the recently enacted U.S. financial reform legislation, Hoenig argued that many of the firms whose size helped drive the financial system into crisis are now larger than ever. 

He also argued that regulators still lack sufficient powers to rein in financial giants, adding that the unfair advantages they glean from the implicit protection of government are self-reinforcing. 

"We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis," Hoenig told a meeting of the Women in Housing and Finance. 

Hoenig called for "Glass Steagall-type" provisions that would no longer allow commercial banks to engage in the riskier activities normally confined to the investment sector. 

"We must make sure that large financial organizations are not in position to hold the U.S. economy hostage.

In the absence of Glass Steagall-type legislation or an expanded Volcker Rule, this blog has long advocated taking a different approach to handling the TBTF.

This approach has been to require under existing legislation that all financial institutions, like banks and hedge funds and insurance firms, disclose their current asset-level exposures on a global basis.

A key feature of this disclosure requirement is that, unlike the Basel III capital requirements, it directly addresses the issues of risk and solvency.  This disclosure requirement lets both the market and the regulators monitor and constrained risk taking and reduce the potential for contagion.

A key benefit of this disclosure requirement is that it naturally limits the risk any financial institution can take.  Any firm that invests in or relies on a financial institution for credit/interest rate/forex protection has an incentive to adjust their exposure to the financial institution based on the risk of solvency of the financial institution.  This direct feedback into the financial institution's profitability is known as market discipline.


A key benefit of current asset-level disclosure is that it will force the TBTF to shrink without the regulators having to figure out how to break up these firms.

Why?

There are many firms in the global financial markets who offer the same services as the large, global financial institutions but have the advantage that disclosure of their current asset-level data will allow market participants to readily assess their risk.  These firms will attract much more business, because no market participant is compensated for taking on risk from firms that are too complicated to assess.

Current asset-level disclosure gives each global financial institution an incentive to reduce their risk profile in order to maximize their profitability.  How the financial institutions elect to shrink will reflect where they think they can maximize their profitability for a given level of risk.

[emphasis added]

... United States regulators are puzzling through the issue of which financial companies are too big to fail and what kind of heightened regulation will be imposed on them. 

... The Dodd-Frank Act deliberately did not end the era of too-big-to-fail institutions.... Dodd-Frank instead set up a structure that would let the behemoths live, but they would be caged with a monitoring approach. Too-big-to-fail institutions are to be named and subject to extra regulation. 

... The rules are not a bright line and instead assess the label “too big to fail” based on factors including “size,” “leverage” and “interconnectedness.” This is a “you know it when you see it” test. 

... we still don’t know what exactly the regulators think is too big to fail. This is important because there are real consequences to being named to this select group. 

Too-big-to-fail banks may receive important competitive advantages from a lower cost of capital. Their cost to borrow money will be lower because they are perceived to receive an implicit government guarantee. They can also command greater access to regulators. 

... But there will be detriments. Among other things, these institutions will have to hold more capital, be subject to more regulation and, in certain circumstances, can be broken up by the government. 

Depending on whether the costs outweigh the benefits, too-big-to-fail institutions thus may be more or less competitive in the global marketplace. We just don’t know. But this is important, because finance is global. Eight of the 10 largest banks by assets are now outside the United States. 

And this is the biggest quandary about the too-big-to-fail concept. The worry is that the next financial crisis will be different than the last, whether it is a sovereign debt crisis or another currency crisis. Regulator focus on the biggest institutions may lead them to miss the next bubble or even an institution that is not on this list. 

Indeed, the next crisis may come from outside the United States, something Dodd-Frank does not address. 

Spanish Banks Raising Capital Hinges on Loan Transparency

Bloomberg reported on the capital raising activities of the Spanish savings banks. [emphasis added]

Spain’s decision to force lenders to meet stricter capital rules or risk state ownership will provide a boon to bankers and lawyers helping them raise funds with stock market listings and asset sales. 

Only if the investors can be convinced that they are investing in solvent institutions.

Spanish banks may raise as much as 20 billion euros ($27.3 billion) by selling stock in initial public offerings and reducing their stakes in publicly traded companies in the next two years, according to bankers working on the plans. 

The hurdle that must be overcome is the 40+ billion euros gap between what the market thinks it would take to restore solvency and what the Spanish government is requiring the banks to raise.

... Finance Minister Elena Salgado confirmed on Feb. 18 that lenders without a stock exchange listing will have to boost core capital levels as high as 10 percent. She provided some leeway by giving them until the end of the first quarter of 2012 to carry out IPOs, after stating last month that the banks would have to meet the capital rules by “autumn.” The savings bank association pushed for more time. 

Salgado is seeking to convince investors the country’s banking system can absorb losses from the property crash without overburdening public finances. The rules require publicly traded banks to have core capital, a measure of financial strength, of at least 8 percent. 

Transparency on Loans 

“At this point, being transparent about the quality of loans and real estate seems much more important than setting rules on capital that may be difficult to meet from a practical point of view,” said Luis de Guindos, a former deputy finance minister in the government of Jose Maria Aznar and a professor at Instituto de Empresa business school in Madrid. 

Even with the extra time, ... persuade investors they are attractive investments may prove difficult. 

The need to be transparent about the quality of loans is much more practical.  In order to determine if a savings bank is solvent, investors have to be able to analyze its current assets, especially the real estate loans, and see if the value of these assets exceeds its liabilities.  Investors are unlikely to invest if there is a shortfall.

The Wall Street Journal reports that the Spain's central bank said that the savings banks hold 100 billion Euros of 'potentially problematic' real estate and development loans.

Unfortunately, as the Irish central bank can tell them, Spain's central bankers have chosen the wrong way to be more transparent about the quality of the loans.  Like the Irish, the Spanish have chosen to stand between the loan-level data and the market.  Like the Irish, the Spanish have staked their credibility on a number that is highly likely to be wrong.

The reason that disclosure of loan-level data works is that it is not the government telling market participants that there is 100 billion Euros of problematic loans, it is market participants reaching this conclusion on their own.

This difference is huge because the 100 billion Euros number appears to be related to Spain's capacity to recapitalize the savings bank. [emphasis added]

Spain's central bank said the country's ailing savings banks are holding about €100 billion ($136.86 billion) in "potentially problematic" real-estate assets, the first time it has put a number on the extent of those holdings. 

... The figure was disclosed as the head of the Bank of Spain voiced support for the government's plan to boost the solvency levels of those banks, known as cajas. 

... It reiterated its estimate that all the banks will need to raise about €20 billion to meet the new requirements, a figure many analysts describe as too low, and said it will take stakes in lenders that fail to do so by September through its Fund for Orderly Bank Restructuring, also known as FROB. 

The government, however, has offered some flexibility on the September deadline... This flexibility on the deadline, which was announced in January, was viewed as a sign of weakness on the part of many analysts. 

"The initial guidelines have been watered down," Barclays Capital analyst Antonio Garcia said in a report published over the weekend. His own figure for the banking system's capital shortfall is at least €46 billion, or more than double that of the central bank. 

... Monday, the central bank said the cajas have €217 billion in exposure to construction and real-estate companies. It said that €100 billion of that total exposure is "potentially problematic" and that cajas have provisions to cover 38% of it. Many of the loans they hold are backed by assets that ensure the banks will recover at least a portion of their value. [38 billion in reserves and a 50% recovery would imply the need for 12 billion in new capital]

Speaking at the same press conference, the Bank of Spain's deputy governor sought to offer reassurance that the FROB, which has already injected about €11 billion into banks during the crisis, will have sufficient firepower to recapitalize banks that aren't able to raise funds from private sources. 

After a successful €3 billion bond issue last month, the FROB has €4.5 billion on hand plus a €3 billion credit line it can draw on. "The FROB has a comfortable liquidity position," Javier Ariztegui said. The FROB can be expanded to €99 billion through bond issuance.

In a related Bloomberg article, Spain plans to dramatically watered down the definition of capital it applies to its banks.  A move that is likely to convince investors that they are right that the banks require significantly more capital than the government is acknowledging.

Spain’s Finance Minister Elena Salgado will allow Spain’s savings banks to consider generic provisions and preferred shares as core capital, El Confidencial reported. 

The decision, which will be set out ... in a decree outlining capital requirements, will provoke protest from publicly traded banks and other European countries as the instruments have never been classed as core capital, the newspaper said, citing unidentified people with access to the text of the decree. 

Salgado had previously said that new core capital requirements set for Spanish banks this year would use the definition of core capital set out in Basel III.

China Attempts to Get Ahead of the Bank Solvency Problem

Bloomberg reports that China is taking steps to address potential problems in its banking system before they become acute.

Like the US and Europe, the steps focus on a mechanism to alert regulators sooner if there is trouble and requiring banks to hold more capital.

The only proven mechanism for alerting regulators sooner about potential problems and restoring bondholders and equity investors absorbing losses is requiring the banks to disclose their current asset-level data.  With disclosure of this data, then it is not only the regulators who are looking at this data but also credit and equity market analysts and competitors.

Since investors and competitors are at risk of loss from their investment exposure (debt, equity, inter-bank loans), they have an incentive to cap the risk that an individual bank takes.  They can do this by raising the prices they charge the bank for funds or by reducing the bank's access to funds.  Either way, they send a strong message to reduce risk.

By having in place a mechanism for addressing potential problems before they threaten the solvency of a bank, it also makes recapitalizing a bank by conversion of hybrid securities a more attractive proposition.  At the time the securities are converted, the investor knows that the bank is still solvent.

Should it adopt current asset-level disclosure for its financial institutions, China would set a global standard that US and European regulators and financial institutions would have to adopt.  The failure to adopt would be the equivalent of the regulators and financial institutions saying that they have something to hide.  [emphasis added]

China’s banking regulator plans to require lenders to set up procedures to allow them to restore their finances in the event of a crisis, a person with knowledge of the matter said. 

Banks considered systemically important may have to adopt safeguards including selling debt that can be converted into equity, the person said, declining to be identified because the watchdog’s deliberations are confidential. 

Regulators will also be given broader powers to supervise those lenders’ decision- making and operations to help discover potential risks early, the person said. 

China is seeking to avoid a repeat of its last banking crisis, when the government spent more than $650 billion over a decade to bail out banks after years of state-directed lending. 

Concerns about lenders’ asset quality resurfaced after credit expansion surged to 96 percent in 2009, prompting the banking regulator to push through more stringent capital requirements. 

China’s major banks cut their combined bad-loan ratio to 1.15 percent as of Dec. 31 from 17.2 percent in 2003, when the China Banking Regulatory Commission was created, official data show. 

Setting up “self-rescue” mechanisms is part of efforts to make sure equity and bond holders take greater responsibility for salvaging a bank should it encounter financial difficulties, the person said. One possible measure is selling “bail-in” debt, the person said without elaborating. 

A CBRC official, who declined to be identified citing agency policy, said in a text message response to questions that the regulator is studying the issue of self-rescue mechanisms. 

... Regulators will have the power to decide when a bank in trouble must activate its self-rescue mechanisms, the person said. The government may seek revisions to China’s Commercial Bank Law to accommodate the new requirements, according to the person. 

Global regulators spent the past two years devising ways to ensure taxpayers won’t be on the hook in the event of another banking crisis. 

The Basel Committee on Banking Supervision announced last month that hybrid debt securities need to include triggers that force banks to convert them into common stock or write them off, averting government bailouts by providing capital buffers that can fund a “bail-in” by stakeholders if a bank gets into trouble. Hybrid securities blend characteristics of equity and debt. 

China’s systemically important banks may also be subject to higher liquidity standards than domestic competitors, and may be required to have lower concentration of loans to a single borrower, the person said. 

Should a troubled lender’s own measures fail to revive it, the government would seek to broker an acquisition by a healthy bank to avoid the consequences of a closure, providing support with favorable tax and credit policies if needed, the person said. When public funds become necessary to rescue a bank, management will be held accountable, according to the person. 

The CBRC may raise the five biggest state-controlled lenders’ capital adequacy requirement to as high as 14 percent, from 11.5 percent currently, if credit growth is deemed excessive, a person familiar with the matter said last month. That includes an additional 1 percent of capital charged on them to reflect their systemic importance, the person then said. 

Andrew Haldane: Controlling Financial Contagion

The Bank of England's Andrew Haldane co-authored an op-ed in the Financial Times focused on the need to minimize the possibility of contagion by requiring large, interconnected banks to hold more capital.

He compares contagion to a disease and looks to the study of infectious disease for a solution.  The solution he finds to stop the spread of a disease is to target the most likely spreaders of the disease.  In this case, large, interconnected banks.

The preventative solution that he recommends is to inoculate these large banks against spreading contagion by requiring them to hold more capital.

Unfortunately, more capital has never been shown to prevent contagion!

Moving the capital ratio from 5 to 10% would not have stopped the credit markets from freezing in 2008. Every financial institution was concerned with the solvency of every other financial institution and, as discussed in the Financial Crisis Inquiry Commission report, lacked the information to know who was and who was not solvent.

Capital is at best a one-off solution.  Even worse, it is a one-off solution that can lead to the preverse outcome of actually increasing the risk of the large, interconnected banks.  As discussed in a previous post, management has an incentive to maximize its compensation even if this means increasing the risk of the large, interconnected bank to overcome the drag of higher capital ratios.

There is a better way to inoculate large, interconnected banks and protect the rest of the financial system from contagion!

The direct solution is to make the large, interconnected banks disclose their current asset-level data.  With this data, credit and equity market analysts and competitors can analyze the risk and solvency of each large, interconnected bank.

Based on the risk of the large, interconnected bank, market participants can adjust their exposure to the institution.  If the large, interconnected bank adopts a riskier strategy, then its cost of funds will increase and its access to funds and interconnectedness will decrease.  This will naturally cause the large, interconnected bank to cut back on its risk.  Exactly the outcome needed to reduce the probability of contagion.

Unlike disease, where it might be impossible to identify if the carrier is infected, risk held by the large, interconnected banks can be identify if these banks are required to disclose their current asset-level data.

Why gamble on higher capital ratios, which might not halt transmission of a bank's solvency problems through contagion, when there is the alternative of requiring current asset-level disclosure that will halt transmission of a bank's solvency problems before they get started?  [emphasis added]

Regulators want big, complex banks to hold larger buffers of capital to protect the financial system. Big banks argue this is unnecessary because risk is diversified across their larger balance sheets. 

Who is right? 

Natural sciences – especially epidemiology, ecology and genetics – provide clues. 

... There is no evidence that failure probabilities are lower among big, complex banks than smaller ones. 

But even if there were, the case for big banks holding higher levels of loss-absorbing capital would not be weakened. That case rests not on the probability of large banks failing, but on their system-wide impact. What matters is not a bank’s closeness to the edge of the cliff; it is the extent of the fall. And this will depend on a bank’s size, complexity and numbers of market counterparties. 

These basic principles have long been known in the study of infectious diseases. Optimal strategies for preventing disease spread focus on “super spreaders”: not those most likely to die, but those with the greatest capacity to infect counterparties. The same calculus applies to big, complex banks.  

These super-spreaders of the financial world have huge balance sheets and often comprise
thousands of distinct legal entities. Their numbers of counterparties are often mind-boggling. When Lehman Brothers failed, it had more than 1m such relationships. These spread financial infection on a global scale. 

Fortunately, epidemiologists provide us with a simple preventative solution: target the
super-spreader. For banks, this means the largest, most complex and most interconnected banks should hold higher amounts of loss-absorbing capital. This lowers the chances of them contracting disease, thus heading off its contagious consequences. Rather than seeking to equalise the probability of failure across institutions (irrespective of size), regulation would seek to equalise each bank’s contribution to systemic risk. 

Higher Capital Ratios Do Not Guarantee Lower Risk In Banking System

Bloomberg reported that Paul Tucker, the Deputy Governor of the Bank of England, and Adair Turner, the Chairman of the Financial Services Authority, are hoping that new regulations requiring banks to hold higher capital ratios will reduce both risk in the banking system and executive pay.

By themselves, higher capital ratios do not guarantee a reduction in risk in the banking system or a reduction in executive pay.

In fact, higher capital ratios will most likely lead to the preverse outcome of actually increasing the amount of risk in the banking system.  Compensation driven by either gross net income or return on equity directly drives the bank executive's choice of both assets to put on the balance sheet and how to fund them.

For example, in the US, in the mid-1980s, a large regional bank suffered hundreds of millions in losses because bank executives had a sizable amount of their compensation tied to return on equity.  Prior to the loss, the bank had the highest capital ratio of any major bank in the world.  This high level of capital necessitated the bank purchasing $3 billion of 30 year Treasuries in order to generate the interest income needed to achieve the return on equity target.  Naturally, interest rates moved up and the bank lost roughly half its capital.

What does guarantee a reduction of risk in the banking system, both traditional and shadow, is fully implementing the FDR Framework by requiring the disclosure of all useful, relevant information in an appropriate, timely manner to all market participants.

This information can be used by credit and equity market analysts, as well as competitors, to analyze the risk of a financial institution and price investments in the financial institution.  If a financial institution takes on more risk, it can be expected that its cost of funds will increase to reflect this risk.  [emphasis added]

Bank of England Deputy Governor Paul Tucker said ... that lower returns on equity for banks would give shareholders a greater incentive to cap executive pay. Credit Suisse Group AG cut its profitability goal this month after concluding stricter capital rules will constrain earnings. The Zurich-based bank will aim for a return on equity of more than 15 percent over three to five years, down from a previous target of more than 18 percent. 

“By reducing their return on equity, I think myself that that will eventually have an impact on compensation too,” Tucker said. “As that return on equity comes down, I think they will start to put pressure on the returns that go to managers.” 

Tucker said that policy makers had made some progress in the area of financial reform.
“Basel III is cooked,” he said. “We got many other countries to agree to a higher capital ratio than they wanted to agree to.” 

Financial Services Authority Chairman Adair Turner, speaking at the same event, said that if regulators were “benevolent dictators” working in an “ideal world,” bank capital ratios would be as high as 20 percent. 

The Basel Committee on Banking Supervision said last year it will require lenders to have common equity equal to at least 7 percent of assets weighted according to riskiness, an increase from the current 2 percent standard, including a 2.5 percent buffer to withstand future shocks. 

“When you’ve ended up with too high a leverage, if you try and move out of that too quickly you will slow down the real economy,” Turner said.

Violating FDR Framework Will Not Work for IMF and European Regulators

At the conclusion of the G-20 meeting, the IMF and European regulators reiterated their intent to continue violating the recommendations offered by the FDR Framework.

The FDR Framework specifies what governments should and should not do with regards to the financial markets.  Governments should insure that all useful, relevant information is made available in an appropriate, timely manner to all market participants.  Governments should not endorse specific investments.

According to a Bloomberg article, the IMF and European regulators find themselves chasing the market and trying to make a convincing case that they have their arms around the sovereign debt crisis.

Their solution, which they have already unsuccessfully tried variations of before, is the exact opposite of what the FDR Framework would advise.

First, the IMF and the European regulators violate the guideline of not endorsing specific investments by trying to convince the market of something.  This strategy is doomed from the beginning as it puts the market analysts in a position to say why what the IMF and European regulators propose as a solution will not work.  Given that the market analysts have been right for the last year, more of the same does not sound promising.

Second, the IMF and the European regulators violate the guideline of insuring that all useful, relevant information is made available in an appropriate, timely manner to all market participants.  Instead, the IMF and European regulators limit access to this data.  This strategy is doomed from the beginning because it is only when the market has and can analyze the data that the market can decide if the IMF and European regulators' solution works.

A much better strategy would be for the IMF and European regulators to announce that all the useful, relevant information will be made available in an appropriate, timely manner to all market participants.  They should encourage the market to analyze this data and confirm that their solution will work to address the sovereign debt crisis.  They should also promise to do more if needed.

Then, they should make the financial institution current asset-level data available and see what the market concludes is needed in the way of additional capital at the financial institution and sovereign level.  [emphasis added]

International Monetary Fund Managing Director Dominique Strauss-Kahn said European Union leaders must convince investors that they can fix the region’s debt crisis and he’s “confident” they will do so by the end of next month. 

“Markets aren’t everything, but markets are important,” Strauss-Kahn said in a Bloomberg Television interview with David Tweed in Paris. “You have to do something that will be seen, not only by markets, to work.” 

After rescuing Greece and Ireland, EU leaders are now seeking to overhaul the governance of the 17-nation euro area and create a permanent system to offer members financial support. While talks continue as governments prepare for two summits in Brussels next month, the EU’s decision-making process has sometimes slowed a resolution to the crisis that began more than a year ago. 

If a solution “comes too late, you’re always behind the curve,” Strauss-Kahn said in an interview after meeting with Group of 20 officials in Paris. “Talking with the most important leaders in Europe, I think they understand well the need to have a comprehensive approach” and “I’m rather confident they’ll come up with something rather comprehensive by the end of March.” 

... Euro-region finance ministers shifted the focus away from the near-term crisis management with a decision last week that the permanent said mechanism to be set up in 2013 will be able to lend 500 billion euros ($675 billion), twice the amount of the fund set up in the wake of Greece’s near-default last year. As with the current mechanism, the IMF will contribute 50 cents for every euro from European governments. 

Strauss-Kahn wasn’t alone today in stepping up pressure on EU governments. European Central Bank President Jean-Claude Trichet told the region’s leaders that it’s up to them to retain the confidence of bond investors. 

“We call all governments in Europe without any exception” to “apply the plan they have as rigorously and as convincingly” as possible, Trichet said at a press conference in Paris after the G-20 meeting. “We have a very strong message for Portugal as well as for others. It’s up to countries to be convincing” and make their case to the markets.

Regulators felt a 'sense of shame' over taxpayer bailouts

Bloomberg reported that according to Paul Tucker, the Deputy Governor of the Bank of England, central bankers and regulators felt a 'sense of shame' because their failure led to taxpayers having to bailout the global banking system.

In response, they are proposing new rules that hopefully will allow banks to fail without requiring another taxpayer funded bailout.

The preference here is that instead of focusing on how to unwind a bank after it fails, much greater attention be spent addressing the issue of preventing the failure in the first place.

As has been discussed repeatedly on this blog, preventing failure can be achieved by fully implementing the FDR Framework and making sure that all useful, relevant information is made available in an appropriate, timely manner to all market participants.  This information can be used by the credit and equity market analysts, as well as competitors, to analyze the risk of a financial institution and price any investment in the financial institution.

When the market has the necessary information to correctly price the risk of a financial institution, it also has the ability to exert market discipline.  For example, the cost of funds to the bank will increase as the risk of the bank increases.  This in turn will serve to restrain the risk a bank takes.  [emphasis added]

Bank of England Deputy Governor Paul Tucker said regulators felt a “sense of shame” that taxpayers had to bail out banks after the collapse of Lehman Brothers Holdings Inc., as they devise rules to prevent a repeat of the financial crisis. 

“This is the worst moment in the working lives of anybody who was in office in central banking or in regulation,” Tucker said at an event at Clare College, Cambridge University, England late yesterday. Regulators are working on new rules that will allow banks to fail “partly because of the sense of shame that we all have that we brought this cost to the taxpayer.” 

Bank regulators and policy makers including finance ministers attending this week’s G-20 meeting in Paris are trying to devise new rules that will allow banks to fail without requiring taxpayer bailouts or damaging economic growth. 

Geithner, like Haldane, thinks bank supervision needs improvement

In his interview with the Financial Crisis Inquiry Commission, Tim Geithner seconded the observation made by the Bank of England's Andy Haldane about the need to improve the basic craft of supervision.

As regular readers of this blog know, the only way to meaningfully improve the basic craft of supervision is to follow the FDR Framework and insure that all useful, relevant information is made available in an appropriate, timely manner to all market participants.

Disclosure of this information allows the banking supervisors to benefit from the financial markets' ability to understand what this information means and take action based on this understanding.

For example, for all structured finance securities and financial institutions, current asset-level data reported on an observable event basis would be disclosed.  With this data, the credit and equity market analysts, as well as competitors, could independently analyze the risk of and value each security and financial institution.  This would lead to liquid trading markets for the securities and market discipline for the financial institutions.

In addition, this would free the banking supervisors from reliance on asking the firms they regulate for a sophisticated understanding of the regulated firms and the markets.  The banking supervisors could now ask a significant number of fully informed, independent experts. [emphasis added]

Geithner told the panel that supervision of U.S. financial institutions eroded during years of stability and needs to be improved. 

Supervisors aren’t “paid very much, they don’t get much training,” he said. “They don’t spend any time in the market. They’ve got a much less sophisticated understanding of the institutions they’re supposed to supervise than they would need to do it effectively.” 

Geithner said “nothing would make me happier than to have a bunch of generals come in and figure out how to improve the basic craft of supervision and make it tougher again.”

Providing all the useful, relevant information in an appropriate, timely manner to all market participants would create the necessary condition for a bunch of generals to come in and improve and toughen supervision. 

Lehman Teaches JP Morgan Lesson on Need for Current Asset-Level Disclosure

Bloomberg reported on how even a global, financial institution like JP Morgan could not value the opaque toxic structured finance securities.  In this particular case, had current asset-level data on the underlying collateral been available, JP Morgan would not have accepted the securities as collateral. [emphasis added]

Lehman Brothers Holdings Inc. tricked JPMorgan Chase & Co. into holding onto collateral that the bankrupt investment firm internally described as “goat poo,” according to a court filing by JPMorgan. 

JPMorgan was stuck with Lehman’s worst securities backing $25 billion of loans as Lehman was sold to Barclays Plc in September 2008, JPMorgan said in its filing yesterday in U.S. Bankruptcy Court in Manhattan. Lehman described the collateral as “toxic crap” and “goat poo” to be scattered “in other people’s backyards,” JPMorgan said. 

“Only later was JPMorgan able to determine that the position in which it unexpectedly found itself was the result of collusion and deception” by Lehman and Barclays, JPMorgan said. 

The accusations appeared in amended counterclaims against Lehman in its lawsuit against JPMorgan. Both companies are based in New York. 

Lehman accuses JPMorgan of siphoning billions of dollars from Lehman, leading to it collapse in September 2008. London- based Barclays bought Lehman’s broker-dealer unit after Lehman’s bankruptcy filing. 

Kimberly Macleod, a spokeswoman for Lehman, and Mark Lane, a spokesman for Barclays, both declined to comment. 

The case is Lehman Brothers Holdings Inc. v. JPMorgan Chase Bank NA, 10-03266, U.S. Bankruptcy Court, Southern District of New York (Manhattan).

Ben Bernanke Is Still Looking For Cause of the Credit Crisis

Dear Chairman Bernanke,

Please allow me to explain the cause of the credit crisis.  The reason that I am volunteering to do this is I just finished reading your paper, "International Capital Flows and the Return to Safe Assets in the United States, 2003-2007", and I can see that you are still looking for the explanation.

As regular readers of this blog know, the cause of the credit crisis was the failure of the US government to fully implement the FDR Framework.  This framework was developed during the Great Depression and has served as the bedrock for the global financial system since that time.

Under the FDR Framework, there are strict guidelines for what governments should and should not do in dealing with the financial markets.

• Government should ensure that all useful, relevant information is made available in an appropriate, timely manner to all market participants.

• Government should not recommend specific investments.

In your paper, you identify a host of factors that contributed to the credit crisis. [emphasis added]

A broad array of domestic institutional factors--including problems with the originate-to-distribute model for mortgage loans, deteriorating lending standards, deficiencies in risk management, conflicting incentives for the GSEs, and shortcomings of supervision and regulation--were the primary sources of the U.S. housing boom and bust and the associated financial crisis.

In addition, the extended rise in U.S. house prices was likely also supported by long-term interest rates (including mortgage rates) that were surprisingly low, given the level of short-term rates and other macro fundamentals--a development that Greenspan (2005) dubbed a "conundrum." The "global saving glut" (GSG) hypothesis (Bernanke, 2005 and 2007) argues that increased capital inflows to the United States from countries in which desired saving greatly exceeded desired investment--including Asian emerging markets and commodity exporters--were an important reason that U.S. longer-term interest rates during this period were lower than expected.

All of these factors contributed to the credit crisis.  However, if one of these factors had not been present, its absence would not have prevented the credit crisis.

The absence of the factor that would have prevented the credit crisis was left off the list.  The factor left off was the failure of government to ensure that all the useful, relevant information was available in an appropriate, timely manner to all market participants.

Had all the useful, relevant information been available in an appropriate, timely manner to all market participants, the credit crisis would not have happened.

That is a bold statement, what is the evidence to back it up?

The Financial Crisis Inquiry Commission found and reported a considerable amount of evidence showing the critical role the lack of access to all useful, relevant information played in the crisis: [emphasis added]

Furthermore, when the crisis began, uncertainty (suggested by the sizable revisions in the IMF estimates) and leverage would promote contagion. Investors would realize they did not know as much as they wanted to know about the mortgage assets that banks, investment banks, and other firms held or to which they were exposed. To an extent not understood by many before the crisis, financial institutions had leveraged themselves with commercial paper, with derivatives, and in the short-term repo markets, in part by using mortgage-backed securities and CDOs as collateral. Lenders would question the value of the assets that those companies had posted as collateral at the same time that they were questioning the value of those companies’ balance sheets. [ pdf page 256] 

“In a context of opacity about where risk resides, . . . a general distrust has contaminated many asset classes. What had once been liquid is now illiquid. Good collateral cannot be sold or financed at anything approaching its true value,” Moody’s wrote on September.  [pdf page 281] 

The key concern for markets and regulators was that they weren’t sure they understood the extent of toxic assets on the balance sheets of financial institutions—so they couldn’t be sure which banks were really solvent. [page 373] 

Had all the useful, relevant information been available in an appropriate, timely manner, market participants would have purchased far less "toxic" securities in the first place.  They would have seen the deteriorating underwriting standards and that the quality of the mortgages did not match the representations in the prospectus.

Had all the useful, relevant information been available in an appropriate, timely manner, market participants would also have known the extent of each bank's exposure to "toxic" assets and therefore which banks were solvent and which were not.

The issue of "toxic" assets causing solvency concerns would not have occurred because market participants would also have been able to exert discipline on the banks.  As the exposure to "toxic" assets went up, the bank's share price would have decline and the bank's cost of funds would have increased to reflect the increase in risk the bank was taking on.  A decline in share price and an increase in the cost of doing business is an unambiguous and easily understood message to bank management to cease and desist.

I look forward to meeting with you and your staff to discuss how the application of the FDR Framework going forward would restore financial markets where investors bear the risk of loss and governments are not required to bailout financial institutions.

Sincerely,

Your Humble Blogger

Future ECB head Mario Draghi Worries About Shadow Banking System

Reuters reports that Mario Draghi is concerned that increasing regulation on the traditional banking system will drive risk to the unregulated shadow banking system. [emphasis added]

The head of the Swiss-based Financial Stability Board, Mario Draghi, said on Thursday that regulators must turn their attention to the lightly regulated shadow banking sector, according to a source at a closed-door meeting where he spoke. 

Draghi, also the governor of the Bank of Italy, told a conference in Paris that increased regulation on the traditional banking system increased incentives to use other less regulated areas of the financial system. 

He also said that the FSB was looking at areas of the shadow banking sector that remain largely uncovered by oversight, citing in particular credit intermediation, using financial instruments to create new products with different maturities and leverage. 

In the financial markets, regulation and oversight is frequently an inadequate, expensive substitute for the combination of genuine transparency and market discipline.

The US Savings & Loan crisis and the Less Developed Country Debt crisis discredit the notion that heavy regulation and oversight on the traditional banking system is superior to light regulation in maintaining financial stability.

As Alan Greenspan discovered with the recent credit crisis,  market discipline without genuine transparency is not a substitute for oversight and enforcing existing regulations.

Given what has been tried to date, is financial stability, light regulation, oversight and equal treatment to both the traditional and shadow banking systems possible?

Yes, as frequent readers of this blog know.  The solution is to fully implement the FDR Framework globally across both the traditional and shadow banking systems.  This would require that all useful, relevant information is made available in an appropriate, timely manner to all market participants.

Whether it is a bank or a structured finance security or a covered bond, it should disclose current asset-level data on an observable event basis.  With this data, market participants could independently analyze the risk and value of the bank or security.

Disclosure has many benefits.

• It is flexible enough to apply to both the traditional and shadow banking systems.  

• It provides market participants with the information they need to properly assess the risk and reward of a bank or security.  

• It increases oversight from just regulators to all market participants and this in turn improves the stability of the whole financial system.  

• It is inexpensive and, thanks to 21st century information technology, easy to comply with.

The Problem with Bank Stress Tests: Regulators

Bloomberg reported on the stress tests currently being conducted by the Fed.  As readers of this blog know, although the stress tests have not been completed, the results of these stress tests are already known.   Most, if not all, of the 19 Too Big to Fail US banks will be allowed to resume paying dividends and the global standard for acceptable capital levels will have been set.

But knowing the results gets us ahead of the story.  [emphasis added]

The banks stress-tested the performance of their loans, securities, earnings, and capital against at least three possible economic outcomes as part of a broader capital-planning exercise.

Since the banks ran the tests, why would any market participant trust the results?

... The Federal Reserve ordered the 19 largest U.S. banks to test their capital levels against a scenario of renewed recession ... “They’re essentially saying, ‘Before you start returning capital to shareholders, let’s make sure banks’ capital bases are strong enough to withstand a double-dip scenario,’ ” said Jonathan Hatcher, a credit strategist specializing in banks at New York-based Jefferies Group Inc. Regulators don’t want to see banks “come crawling back for help later,” he said.

....The Fed has told banks that it expects dividends and share buybacks to be “conservative” and allow for “significant accretion of capital,” according to a November notice. Some capital payout plans may be rejected as “inappropriate,” the notice said. 

Before capital is returned to investors wouldn't it be a good time to let the market determine if these banks are solvent (the value of their assets exceeds their liabilities)?

The review “allows our supervisors to compare the progress made by each firm in developing a rigorous internal analysis of its capital needs, with its own idiosyncratic characteristics and risks, as well as to see how the firms would fare under a standardized adverse scenario developed by our economists,” Fed Governor Daniel Tarullo said in an e-mail.

Maybe Fed Governor Tarullo forgot that the market does not care what the Fed supervisors and economists think.  They had their chance before the credit crisis to show they knew what they were doing.  They were not up to the task.

One of the lessons of the credit crisis is that investors have to do their own homework and not rely on third parties like Rating Agencies or the Fed to do their homework for them.

.... Banks will also have to consider how many faulty mortgages investors may ask them to take back into their portfolios. Standard & Poor’s Corp. estimates mortgage buybacks could cost the industry as much as $60 billion.

Can you say $1 trillion?

After all, every deal that did not have the mortgages transferred to the trustee as described in the pooling and servicing agreement is subject to being repurchased.  While the failure to convey the mortgages to the trusts might not be fraud, it looks like it violates the representation that the mortgages would be put into a trust for the investors.

In addition, as Allstate shows in its lawsuit with JP Morgan, there are also representation and warranty claims based on the difference between what the prospectus claimed was the quality of the underlying collateral and what the quality actually was.

As part of the most recent capital exam, regulators have made one of the largest data requests in Fed history, outside of normal regulatory reporting, asking banks for information about their securities, loans and other holdings. This will give the Fed the ability to check and even challenge the assumptions banks make about their portfolios.

Is it possible that the Fed has listened to your humble blogger?  Or is it just so fundamentally necessary for independently judging the results that the Fed requested asset-level data that was current at the time of the stress tests.

Of course this raises the interesting question of why does the Fed rely on the banks to run the stress tests?  Given that the Fed has the data, they could have made it available to all market participants and let all the analysts and competitors run their own stress tests.  Then, the Fed could have found out what the market's view of the solvency and capitalization of the banks is.

The tests are being overseen by a new financial-risk unit assembled by Chairman Ben S. Bernanke and Tarullo. Known as the Large Institution Supervision Coordinating Committee, or LISCC, the unit draws on the Fed’s deep bench of economists, quantitative researchers, regulatory experts and forecasters and looks at risks across the financial system.

... “The current review of firms’ capital plans is another step forward in our approach to supervision of the largest banking organizations,” Tarullo said. “It has also served as an occasion for discussion in the LISCC of the overall state of the industry and key issues faced by banking organizations.”

... The dividend increases, if they happen, will be one of the most carefully screened payouts in U.S. regulatory history, with more than 100 Fed staff working on the capital analysis of the banks.

And there is the problem with U.S. or any regulators conducting stress tests.  The Fed throws 100+ staff at bank capital analysis.  This is a fraction of what the financial markets would assign to the task.

If the current asset-level data was made available to all market participants, the number of analysts would be an order of magnitude greater.  Think of the resources that competitors would deploy in analyzing each other.

Congress is also watching. The Fed should be cautious about allowing banks to reduce their capital through dividends or stock repurchases, House Democrats, including Representative Brad Miller of North Carolina, said in a Feb. 15 letter to Bernanke. 

“We applaud your undertaking new stress tests on the banks,” the lawmakers said. “It appears doubtful, however, that the stress tests alone can resolve the uncertainty facing those banks to justify reducing their capital.”

Is it possible that Congress has also been listening to your humble blogger?  Or is it just so fundamentally necessary that Congress realizes that unless the market has current asset-level data to confirm bank solvency, there are always going to be significant doubts about the solvency of the banks.

The Fed’s involvement in decisions normally reserved for boards shows how far the Dodd-Frank Act has pushed regulators into corporate governance. 

“It is an uneasy balance between regulating an institution and running it,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics in Washington, a research firm whose clients include the nations’ biggest banks. The Fed is moving “far more assertively” on bank oversight, she said.

Actually, it is the Fed's choice not to have the banks disclose current asset-level data.  If the Fed elected to have this data disclosed, it would be regulating an institution under the FDR framework and not running it.

By keeping the data to itself, the Fed violates the FDR framework.  It is recommending a specific investment when it says that a bank is adequately capitalized.

Current Asset-Level Disclosure Succeeds Where Capital and Liquidity Standards Fail

Why have efforts to significantly increase bank capital and liquidity standards failed?  Because they are easily undermined by the 'least common denominator problem'.

What is the least common denominator problem?

In the world of large, global financial institutions, the least common denominator is that regulator with the easiest compliance standards.

For example, take capital at banks.  At the beginning of the credit crisis, Tim Geithner frequently commented on the need for the G-20 regulators to maintain a united front and require banks to hold much more capital.  Next month, Tim is going to set the lowest  capital standard among the global regulators.

How is he going to do this?  Currently, the Fed and the Treasury are stress testing the 19 Too Big to Fail banks.  At the end of the stress test, those banks that pass will be allowed to pay dividends because they are deemed to be adequately capitalized.  The bank with the lowest capital ratio that is deemed to be adequately capitalized sets the global standard.

None of the banks would pass if Tim were adopting the Swiss capital standards.  The Swiss capital standards are essentially the capital standards proposed in Basel III multiplied by 2.

Few of the banks would pass if Tim were adopting the Spanish capital standards.  The Spanish capital standards are essentially a ratio of 8% equity to assets.

How are Tim's easiest capital standards transmitted around the world?

Financial institutions are very good at pointing out that they would be at a competitive disadvantage if they were subjected to higher standards.  They simply have to lobby for a "Level Playing Field".

What they get in return for a level playing field is a race to the bottom in standards.

Long time readers of this blog know that your humble blogger has been pushing for disclosure of current asset-level data.  One of the reasons for this is that disclosure of current asset-level data is immune to the level playing field argument and the race to the bottom.

In fact, if one regulator embraced disclosure of current asset-level data it would create a race to the top as it would become the global standard!!!

Why would there be a global race to adopt current asset-level data?

It is only with disclosure of current asset-level data that the market can determine which banks are solvent and which are not.  As used here, solvent means that the market value of the bank's assets exceeds the bank's liabilities.

Obviously, if a bank discloses its current asset-level data and the market determines that it is solvent, it is also adequately capitalized.  It is also at a competitive advantage over its peers who do not disclose current asset-level data, because it is perceived as less risky.

In the absence of disclosure of current asset-level data, market participants will always question whether a bank is solvent or not.

So long as there are questions about whether a bank is solvent, there will also always be the companion problem of liquidity because of the potential for a 'run' on the bank.  Please recall that runs on a bank occur because of the "perception" of insolvency.  In the absence of current asset-level data, there is no actual information to disprove this perception.

Finally, unlike higher capital ratios or forcing banks to hold more liquid assets, current asset-level disclosure does not interfere in the ability of a bank to generate credit for the economy so long as the pricing of the credit properly reflects the risk of the credit.

Does the Banking Industry Have Too Much Capital?

In a recent investor presentation, Jamie Dimon of JP Morgan argued that inside of twelve months the US banking system will have too much capital.

Prove it!

By the end of the year, it should be possible to make available to all market participants on a current basis all the assets held by JP Morgan.  Then credit and equity market analysts, as well as competitors, can analyze these assets and determine if the value of JP Morgan's assets exceeds its liabilities.

With this data also being made available by all of JP Morgan's competitors, JP Morgan can identify and avoid the dumb competitors who, despite having lots of capital, take on too much risk.

As MarketWatch reported: [emphasis added]

By early next year, the U.S. banking industry will have too much capital, rather than too little, J.P. Morgan Chase & Co. Chief Executive Jamie Dimon said Tuesday during an investor presentation. 

“I’m worried about how much capital is going to build up in the system in the U.S.,” Dimon said. “In 12 months we’re looking at a lot of capital we can’t use. That may make people do stupid things.” 

A lack of capital and liquidity in the industry turned a housing market slump into a global financial crisis in which hundreds of banks failed and governments committed hundreds of billions of dollars to save some of the largest financial institutions in the world.

According to the Financial Crisis Inquiry Commission report, the issue that triggered the freezing of the capital markets was that neither market participants like banks or regulators knew which financial institutions were solvent and which were not.

As this blog has long maintained, the only way to know if a financial institution is solvent is to be able to analyze and value the assets the financial institution currently has and see if this exceeds its liabilities.

Since then, regulators have pushed banks to increase capital so that the industry has more of a cushion for future crises. Basel III is the latest effort, although some of the details have still to be finalized. 

To paraphrase the Bard, Basel III is a lot of sound and fury signifying nothing.

In the absence of marking all of the assets to market, what exactly is the value of reporting a high level of book capital?  Lehman Brothers showed this does not prevent bankruptcy.

Citigroup Inc. (NYSE:C)   Chief Executive Vikram Pandit said Tuesday that the minimum Basel III requirement is for a core tier one capital ratio of 7%. Citi plans to operate with a ratio of 8% to 9% and aims to comply by 2012, the CEO added. 

In contrast, J.P. Morgan’s Dimon said a Basel III ratio of 7% is “completely sufficient.”
“We agree with higher capital and higher liquidity. We just don’t think it should go any further,” Dimon added. “Most of all I want it to be finished.” 

... If J.P. Morgan can’t find good ways to use excess capital, it may hold on to it, Dimon added. 

Update
This is also the end of the ability of regulators to require higher capital levels.

Sometime next month, the US Treasury and Federal Reserve are going to announce the results of the latest stress tests of the Too Big to Fail Banks.  The results are already known.  The banks are going to be found to be adequately capitalized and therefore they can begin paying dividends again.

For banks in the UK or elsewhere, this is great news.  They can make the argument that there needs to be a level playing field and they should not be required to hold more capital than US banks.  If the regulators, like Mervyn King and David Miles disagree, too bad.  The banks now have much more leverage behind their threat to leave to force the regulators to back down.

As this blog has repeatedly said, focusing on the issue of bank capital is a mistake.

Regulators need to fulfill their obligation under the FDR Framework and focus on and assure that market participants have access to all the useful, relevant information in an appropriate, timely manner.