As Predicted, Without Transparency No Trust in Irish Banks

As predicted previously on this blog, without disclosure of the Irish banks current asset and liability level data, investor trust in these banks will not be restored.

The Irish Times reported that March was another big month for the withdrawal of deposits from the Irish banking system.  This occurred despite all the publicity surrounding the release of the latest round of stress tests augmented by BlackRock's analysis of the loan books of the Irish banks.

One of the interesting findings in the article is that after months of foreign investors leading the rush out of the Irish banks, Irish companies are now leading the way in withdrawing deposits.

This is not surprising.  Since retail investors are mostly covered by the deposit insurance, they are not sensitive to bank solvency.

On the other hand, companies that carry deposits in excess of the insurance limit are.  The withdrawals reflect their decision to minimize their exposure to potential losses in the banking system.

The individuals in charge of managing investments for companies are sophisticated enough to know that if all the useful, relevant information is not disclosed in an appropriate timely manner and there is doubt about a bank's solvency, then do not keep more money in a bank than is covered by a government deposit guarantee.

BANKS IN Ireland continued to record a fall in deposits in March, according to figures published by the Central Bank yesterday, while bank lending also declined. 

By the widest measure, there was an outflow of money on deposit of €16.7 billion last month when compared to February (see chart). The total deposit base stood at €630.7 billion last month. 

That is a significant decline on the middle of last year. A loss of international investor faith in Ireland from September has resulted in the large withdrawals. 

Cumulatively in the seven months from September of last year to March of this year, almost 30 per cent of deposits have been withdrawn. 

The figures are broken down into three residency groupings – Ireland, the euro area and the rest of the world. 

Residents in the rest of the world category have pulled deposits from banks in Ireland at the fastest rate over the past half year, with Irish residents making the smallest withdrawals. 

However, in March the trend reversed. Of the total €16.7 billion withdrawn, Irish residents accounted for almost €9 billion of the overall fall in money lodged in banks here. 

The figures for Irish resident deposits are disaggregated further. Irish banks’ deposits with their rivals – a normal practice – fell by more than €12 billion month-on-month in March. 

The effect of this on the total deposit base was partly offset by a €5 billion increase in the amount placed on deposit by the Government. 

Retail depositors’ faith in the banking system has been least affected by the banking crisis over the past half year. This was also the case in March. 

Household deposits fell by just €438 million, the smallest decline since December. In total, they stood at just below €93 billion in March, down just €4 billion since the middle of last year. 

Irish companies, in contrast to households, accelerated the pace of their withdrawals in March.  Collectively, they pulled almost €1 billion from accounts in March. Their total deposits stood at just over €32 billion. 

Covered Bonds and the Need for Disclosure

The Financial Times published an article on covered bonds and the need for disclosure.  Since covered bonds are a structured finance product, the disclosure requirements should be exactly the same as for multi-tranche structured finance products.

As has been discussed many times on this blog, the useful, relevant information for a structured finance products, including covered bonds, includes the terms of the deal and the current performance of the underlying assets.  This asset-level data can be easily accessed from the issuer's loan database.

Covered bond experts have been called to Frankfurt to discuss the health of their market with the European Central Bank. 

The ECB bought €60bn of the bonds, an ultra-safe form of securitisation, during the financial crisis and has since taken a strong line on improving the transparency and investor-friendliness of the products. 

This parallels the ECB's efforts on ABS deals where the ECB has required that data on the underlying collateral performance be made available if the deals are to be eligible for being pledged to the ECB.

Banks have been selling covered bonds at a record pace, with nearly €120bn sold in the first quarter of this year, as investors plumped for the safest forms of bank debt. 

Unlike regular securitisations, which transfer packages of loans off lenders’ balance sheets – and which are still tainted by the “toxic” label of the subprime crisis – covered bonds are backed by loans that remain on bank books. 

The issuing bank also has to replace dud loans and the pool is ringfenced for the bondholders in a bankruptcy. 

... The ECB meeting, scheduled to take place on Friday, will focus on how to produce a system for labelling, or kitemarking, covered bonds to reassure investors about the quality of their holdings. 

It will also consider increasing the amount of information buyers are given about the assets that make up the underlying cover pool.

If the ECB would like, your humble blogger has an information system that would provide current information on the assets making up the underlying cover pool and would let market participants determine for themselves the quality of their holdings.

It is the second such “round table” discussion the central bank has held since it completed its buying programme last June and is intended to check up on the industry’s progress in meeting the ECB’s demands. 

... However, the calls for greater transparency are increasing tensions between investors and issuers as bondholders back policymakers’ calls for more data, but issuers push back against what they consider to be impractical proposals. 

“They’re asking for a Christmas list, frankly. They’ve cherry-picked the highest and toughest standards in the market without perhaps thinking about whether this can actually be done,” said one banker. 

As stated above, it can be done.

As other countries have adapted the German covered bond model to their own culture and legal systems, each market has developed slightly different habits and characteristics. 

“The problem is, some guys can produce the numbers with their eyes closed, but a lot of people just can’t provide this data,” the banker added. 

Actually, all of the issuers should be able to produce the data with their eyes closed.  It comes straight from their lending systems.

But supporters of the CBIC plans said the aim was to give issuers the space to explain their models, not to shoehorn lenders into providing numbers without considering whether they enhanced the information available.

Nassim Taleb Wants Regulatory Black Swans Eliminated

I thought that readers of this blog would find the following cross-post interesting.  It was written on April 15, 2009 and is being reposted with the permission of the author.

Nassim Taleb got me musing a little today...

In a Bloomberg television interview (reported in Bloomberg News), Nassim Nicolas Taleb argued for the simplification of the financial system.

“Regulators are fundamentally dumb,” he said. “Traders will go around them. I want the system where regulators can be stupid without you and I being harmed by it.” [A very straightforward statement by Mr. Black Swan.]

Regular readers of this blog know that the FDR Framework defines the very simple system that Mr. Taleb would like.  All market participants would have access to all the useful, relevant information in an appropriate, timely manner.

By breaking the regulators' monopoly on all the current asset and liability-level information for financial institutions, the FDR Framework ends the creation of financial black swans caused by this monopoly.

There is little question that regulators have been blind to many of the abuses unleashed by the financial elite in the past fifteen years. However prosaic it may be to term them "fundamentally dumb," it is not particularly helpful in describing the problem or fashioning a solution. By focusing on the inability of regulators to prevent the crisis and attributing it to their being "fundamentally dumb," Taleb fails to focus on the role political power and the ability to influence legislation played in the formation of the crisis.

It is true that regulators lost sight of their need for useful data on a timely basis. They also succumbed to the political power and lobbying of the financial elite and eviscerated the stringent disclosure provisions in the final language of Reg AB.

However, not all blame can be placed with the regulatory system. Congress, in its infinite wisdom, buckled to the lobbying of the financial services oligarchy and passed legislation that overturned the almost century old bucket shop rules, thereby unleashing the Credit Default Swap doomsday machine. The rolling back of the "bucket shop" laws through the passage of the Commodity Futures Modernization Act of 2000 was chronicled in a 60 Minutes broadcast, "The Bet That Blew Up Wall Street."

As discussed previously on this blog, the issue has nothing to do with the intelligence of regulators (which your humble blogger thinks is uniformly very high), but that there is a very strong bias in the regulatory and political system to dismiss evidence of the financial black swans before it is too late (see earlier posts on the Nyberg Report on Ireland).

It is the combination of the regulatory information monopoly and the regulators' relationship to the political system that guarantee that evidence of financial black swans will have to be overwhelming to all market participants before regulators will take any action. Unfortunately, by then it is too late.

The easy solution to prevent future regulatory black swans and their related financial instability is to eliminate the regulators' information monopoly.  With this information now available to all market participants, the market participants can do a better of assessing risk and properly pricing and limiting their investment exposures.

While it is now a given that re-regulation of the financial services industry will be the price to be paid by the bankers and traders for blowing up the economy and unleashing massive economic ruin and untold hardship across the world, the battle is by no means ended.

Regulators are not fundamentally stupid. There is little doubt though that the denizens of Wall Street are exceptionally bright and ethically challenged, as Prof Stiglitz has stated. They seek out areas of opacity to ply their trades, areas where they believe that with the benefit of asymmetrical information, they will earn outrageous profits.

Because those profits are often outrageous, they will continue to fight attempts at imposing substantive and substantial transparency. No level playing fields permitted.
Restoring financial stability will not be easy, pleasant or cheap.

First, we need better trained and better informed regulators with less inherent conflicts of interest (e.g., the regulator should not be referring to the regulated as "customers") and a better environment for regulation. Wall Street has proven incapable of policing itself for the public good, but more than capable of availing itself of the public weal.

We also need regulators across the world looking at the same information. In this exceedingly complex, globally connected system, the more regulatory eyeballs looking at a complete set of data, the better for the world to prevent a future financial crisis. No longer can a single country's regulator hope to be able to process, free of political interference, all of the data. Moreover, by decentralizing the "eyeball" process, it becomes more difficult for the financial elite to advance its regulatory agenda.

Second, we need a financial system with an extremely high level of disclosure. No longer can we afford to buckle to the lobbying by the bankers that compliance is too "expensive." We've seen costs this time that make the costs of compliance a mere pittance.

Andy Haldane of the Bank of England placed the cost of the crisis at $4+ trillion.

Third, we need to articulate an exit strategy from the plethora of government guarantees that have our financial system on government life support. That will require filling the capital hole and a functioning secondary market.

Will China Avoid a Banking Crisis?

Bloomberg ran an interesting article which described how China is trying to handle its banks and prevent a banking crisis similar to the recent credit crisis in the US and Europe.

To date, China has been copying all of the regulatory responses of its G-20 counterparts.  Since none of these responses worked or involved actually disclosing the current asset and liability-level data, we can be sure that the banking crisis in China is unlikely to be avoided.

Why the confidence.  Unfortunately for China, without current asset and liability-level data, no one can be certain if the banks are solvent or not.  What is clear is that the banks have exposure to real estate that vastly exceeds their capital base.

When doubts about their solvency begin, depositors are highly likely to line up at the banks to get their money back.

Fortunately for China, it has a significant amount of capital held at the government level that can be used to recapitalize its banking system.  However, recapitalizing is not the same as restoring trust in the banking system.  For that, the only solution is to provide the current asset and liability level data so that market participants can see for themselves that the banks are solvent.

China’s banking regulator set capital targets for the nation’s five biggest lenders above the minimum 11.5 percent ratio amid concern that credit risks may rise, three people with knowledge of the matter said.

When there are doubts about a bank's solvency, regulators always address it by having the bank's increase their capital ratios.  There are three ways for a bank to do this.

• Shrink the size of the balance sheet.  This typically results in the lowest margin and lowest risk assets being sold.  As a result, the risk of the bank stays the same or increases. 

• Sell stock.  This requires some level of disclosure.  Prior to investing, investors are going to want to know what is happening with the loan portfolio.

• Retain earnings.  Since the regulators are concerned about the bank's solvency, they are undoubtedly willing to engage in extend and pretend with the loan portfolio.  As a result, the banks can show higher earnings to retain.

The move may help China’s policy makers curb loan growth after inflation accelerated and real estate prices rose following a $2.7 trillion two-year credit boom. The central bank this month raised the amount of deposits lenders must set aside to the highest in at least two decades, while the banking regulator ordered a new round of stress tests on property loans. 

The current way that regulators like to show they are on top of what is going on at the banks is stress tests.  The problem with stress tests is that they lack credibility unless the underlying data is provided so that market participants can repeat the test for themselves and show that the regulators' conclusions are accurate or inaccurate.

... The banking regulator has stepped up measures to limit systemic risks since last year, including requiring banks to move off-balance sheet assets onto their books and curtailing credit to local governments and the property sector. The government has also raised down payments on second mortgages and ordered local authorities to cap new-home prices in some areas. 

There’s a “high likelihood of a significant deterioration” in banks’ asset quality after the two-year credit boom, Fitch Ratings said April 12. Fitch lowered its outlook on China’s long-term, local-currency rating to negative because of the risk that the government would have to bail out its banks. 

Naturally, market participants distrust that the actions taken be the bank regulators have actually fixed the underlying credit problems.

China, which holds the most banking assets in the world after the U.S. and Japan, faces economic uncertainties and lenders need to strengthen risk management, CBRC Chairman Liu Mingkang said on April 19.

As has been repeatedly said on this blog, the best way to strengthen risk management is to disclose current asset and liability level data to the market.  With all the market participants looking at the data, including competitors, there is much more accuracy in the evaluation of risk of the bank.  As a result, the cost and availability of funds to the bank becomes a better indicator of the level of risk at the bank and the market can discipline banks that take on too much risk.

What It Takes to Be Toughest Bank Regulator

Bloomberg ran an article in which Sweden's central bank Governor took the position that sometimes regulators have to take actions that the banks do not like.

With an attitude like that, he is a likely candidate to require banks to provide current asset and liability-level disclosure.  This requirement would greatly improve the stability of the Swedish financial system as it subjects the banks to market discipline. By making all the useful, relevant information on the banks available, market participants can exert discipline by adjusting the price and amount of their exposure based on the risk of the banks.

While adopting this requirement would be good for protecting the Swedish taxpayer, it would clearly be a requirement that the banks would not like.

Sweden must be ready to impose harsher bank rules than in the rest of Scandinavia even after its biggest lender signaled it may move its headquarters outside the Nordic country, central bank Governor Stefan Ingves said. 

“Harmony is a good thing but in the end, given that it’s the public purse that backs up the banking sector and as long as it remains like that, it’s going to be up to each individual country to choose what to do,” Ingves, 57, said in an interview in Stockholm. 

Ingves, who was one of the main architects of Sweden’s 1990s bank restructuring that led to the creation of Nordea Bank AB (NDA), said larger capital buffers will help the government safeguard taxpayer funds.

It is true by definition that increasing the amount of capital reduces the theoretical exposure of taxpayers and safeguards their funds.  However, since the beginning of the credit crisis, this has not been true in practice.

A requirement for capital to protect the taxpayers is that regulators require that losses in the banking system be absorbed first by the capital in the banking system before turning to the taxpayers.

 Nordea Chairman Bjoern Wahlroos’ suggestion this month that he may shift the bank’s headquarters to escape tougher capital rules is the latest threat from Sweden’s financial sector it will fight policy maker efforts to enforce some of the world’s strictest regulatory standards.

“We know how much a banking crisis costs and how troublesome it is to solve,” Ingves told Bloomberg today. “It’s not in the interest of society to in some sense have a race to the bottom when it comes to capital coverage.” 

That is why Sweden should adopt current asset and liability level disclosure for its financial institutions.  At very, very low cost, this disclosure works to prevent a banking crisis.

Unlike capital, this disclosure also involves a a race to the top among regulators.  After all, what country is going to allow a financial institution to move to it when the reason for moving is not to disclose the risk the financial institution is taking?

Fitch Believes in Loan-Level Data

According to an article in the Independent, Fitch is looking at loan-level data to get a better handle on mortgage loans backing structured finance securities in Ireland.

As this blog has repeatedly said, the only way that structured finance securities can be valued on an on-going basis, which is a basic condition if the securities are to be traded in a liquid market, is with the provision of current data on the underlying collateral performance.  The data needs to be current so that trends, like increases in non-performance, can be monitored and analyzed.

FITCH, one of three main global ratings agencies, plans to do a "loan-by-loan'' analysis of mortgage arrears as it grows concerned over the number of borrowers defaulting. 

The agency also wants to study more closely the actual prices paid by home buyers, as opposed to guide prices and asking prices, used in some surveys of the housing market. 

Fitch has placed 18 tranches of eight Irish mortgage pools on negative watch because of its arrears concerns. The agency said it was particularly concerned about those put together for investors in the period before 2011. 

"In many of these transactions, the volume of loans in arrears continues to increase rapidly while there have been very few repossessions and disposals across the market as a whole.
"These trends create uncertainty when estimating the amount and timing of future loan recoveries,'' said the agency, which monitors the performance of the mortgage pools, known as Residential Mortgage Backed Securities (RMBS). 

"Fitch intends to gather performance data on both a loan-by-loan and aggregated static pool basis,'' the agency warned. 

"The agency will seek further data on completed sales in the Irish market. Once this information has been received and analysed, Fitch will publish an updated criteria report and take necessary rating action,'' it added. 

The number of people in mortgage arrears has climbed to nearly 6pc of the entire market, making investors in RMBS bonds nervous. 

Those in arrears now owe €8.6bn, with some €6.2bn of this owed on accounts more than 180 days in arrears. 

In March, the Central Bank said 106 homes had been repossessed during the last quarter of 2010.

Credit Bubbles and Regulators: The Irish Case Study

The Irish Times ran an interesting article on credit bubbles and the role of regulators.  The article focused on Ireland.

Credit bubbles occur frequently around the world and the conditions which might give rise to bubbles are common. But not all incipient bubbles turn into real ones, and hardly any into the super-bubble Ireland experienced. The essential pre-condition for a credit bubble is a period of decent economic growth and a general improvement in business and consumer confidence. 

Just about every economy in the world, apart from North Korea, experiences conditions like these from time to time. But the enhanced willingness to borrow usually runs into an unwillingness to lend, and the baby bubble gets snuffed out. The unwillingness to lend can come from the banks themselves or, failing that, from the regulators.

Or the unwillingness to lend can come from the capital markets.  Since a sizable percentage of the loans originated by banks are distributed, either through covered bonds or structured finance securities, investors also have an ability to restrain lending.  Faced with a growing bubble, they could elect not to invest.  As a result, the banks would not have access to the funds to lend out and this would snuff out lending.

If the banks are able and willing to lend into the bubble, and the regulators are complacent, the incipient bubble turns into a real one.

And investors are willing to invest.

It is unusual for an incipient bubble to be halted through the exercise of self-discipline by borrowers, of which there tends to be a plentiful supply in any buoyant economy. 

The first line of defence against excessive credit growth is thus the commercial banking system itself. Banks are not providers of risk capital, which is the business of equity markets. They concentrate instead on well-secured lending designed to deliver low incidence of non-recovery. 

The dull, boring, sceptical bank manager is a socially necessary institution. Should the banks depart from this under-appreciated stereotype, the second line of defence is the regulatory and supervisory system, which has plentiful instruments at its disposal to deflate the bubble. 

As readers of this blog know, your humble blogger believes that with disclosure of all the useful, relevant information in an appropriate, timely manner, market participants, like investors, are the real second line of defense.

Market participants can exert discipline directly on the firms that are originating or heavily invested in lending into the bubble.  With all the useful, relevant data, market participants can analyze the risk and adjust the amount and pricing of any exposure to both the firms that originate and invest in the lending into the bubble as well as the loans themselves.

If both of these lines of defence fail, there will be trouble in the form of failing banks and the final resort is to the taxpayers and their representatives in government. 

The role of finance ministries in banking crises is a fire-brigade function. In Ireland, the first line of defence, the banks, crumbled across the line. Virtually every bank lost its entire capital, with the worst ones losing large multiples of their capital. Several appear to have lost one-half of all the loans they had made, equivalent to eight or 10 times their capital. 

The second line of defence, the Central Bank and Financial Regulator, failed to respond adequately.

The fire brigade arrived late, and has expended prodigious sums without fixing the problem.

100% of the time, if the regulators fail, the taxpayer have to pay the cost of their failure.  Therefore, the taxpayers' goal is to take every reasonable, prudent action to reduce the chances or eliminate the possibility of the regulators failing.

The current problem with the regulators having a monopoly on all the useful, relevant information on financial institutions is that it sets up the situation where it is much more likely they will fail and the taxpayers will have to bail them out.

This occurs because the information monopoly means that the market cannot intervene first and save the regulators from failure by exerting market discipline.

Getting the regulators to give up their informational monopoly will be a difficult task.

As has happened after every crisis, the regulators promise to do the job of keeping the banks solvent better.  The example from the current crisis of the regulators doing this job better is stress tests.  Regulators cannot wait to tell the financial markets about these tests and how it shows that the regulators are on top of what is happening at the financial institutions.  The only individuals who believe a once per year test where the results are known in advance, see previous discussion that JP Morgan would be allowed to resume paying dividends, proves the regulators are doing their job better are the regulators.

Stress tests are emblematic of how much effort regulators will put into preserving their informational monopoly.  Regulators are in pursuit of a mythical middle ground between full disclosure of the current asset and liability-level data and the current status of no disclosure.  With the stress tests, the regulators are claiming they have reached the mythical middle ground and are providing the market with the information it needs to exert market discipline.

As has been previously discussed on this blog, all stress tests do is reinforce the financial market's perception that the regulators are still practicing "see no evil" supervision of their banking "clients" and taxpayers are going to continue to pay the cost of their most recent failure.

This is the only possible conclusion because the regulators refuse to disclose the data necessary so that financial market participants could run the tests for themselves and prove or disprove the regulators' conclusions.  Absent this current asset and liability-level disclosure, all regulators are doing is maximizing the chances of failure in the financial system.

The Case for Why Financial Regulators Must Give Up Their Information Monopoly - Updated

As this blog has discussed several times, see here, here, here and here for example, financial regulators are a major source of instability in the financial system.

The reason why financial regulators are a major source of instability is they have a monopoly on all the useful, relevant current asset and liability-level information for the regulated financial institutions and when they do not use this data properly the result is a systemic financial crisis.

One potential reason regulators do not use this data properly is that regulators do not know what to do with the data.  As Andy Haldane, a senior Bank of England (BoE) official, observed in a Wall Street Journal article

[T]he FSA's practice of dispatching dozens of examiners to banks to collect loads of  granular information ... rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.

A second potential reason for regulators not using this data properly is even if some individuals working for the regulators do know how to use the data, their analysis fails to convince their bosses.

As shown by the Nyberg Report on the systemic causes of the Irish banking crisis, individuals working for the regulators are forced to convince a bureaucracy that is naturally biased towards believing the financial institutions that everything is okay.

Regardless of which reason is correct, the failure to draw the right conclusions from the data generates instability in the financial system.  It is one thing if the regulators misjudge the solvency of a single financial institution.  It is entirely another thing when regulators misjudge the solvency of every financial institution.  The latter results in a systemic financial crisis.

An Irish Times article on the Nyberg report highlights this systemic aspect,

Mr Nyberg said the absence of sufficient information on the underlying quality of loan books at the banks impacted on the options considered by the Government when it decided to introduce the bank guarantee in 2008. 

“If accurate information on banks’ exposures had been available at the time it seems quite likely to the commission that a more limited guarantee combined with a state take-over of at least one bank might have been more seriously contemplated,” his report said.

In short, without accurate information, the regulators managed to blow up the Irish financial system.  This includes both the banking system and the sovereign credit worthiness.

The experience of the Irish regulators is not unique.  For example, the US regulators misjudged solvency with regards to the Less Developed Country Loans Crisis, the Savings and Loan Crisis and the recent credit crisis.

That regulators have a monopoly on all the useful, relevant information for financial institutions is an exception to the way the global financial system works.

As the Congressional Oversight Panel’s Special Report on Regulatory Reform (2009) states:

From the time they were introduced at the federal level in the early 1930s, disclosure and reporting requirements have constituted a defining feature of American securities regulation (and of American/global financial regulation more generally). 

President Franklin Roosevelt himself explained in April 1933 that although the federal government should never be seen as endorsing or promoting a private security, there was ―’an obligation upon us to insist that every issue of new securities to be sold in interstate commerce be accompanied by full publicity and information and that no essentially important element attending the issue shall be concealed from the buying public.’

Why is disclosure important?

Because disclosure is what distinguishes investing from gambling.  Investing is buying the contents of a clear plastic bag after examining the contents and verifying there is something of value in the bag.  Gambling is buying the contents of a brown paper bag and hoping there is something of value in the bag.

Without disclosure of all the useful, relevant information on financial institutions, investors are gambling that the regulators are right when they say that there is something of value in the brown paper bag which represents a financial institution.

Why is this distinction important?

Because it supports a financial system where investors are responsible for bearing any losses that result from their investment activities without looking to the government for being bailed out.

Since investors bear the losses, they have an incentive to do their homework to avoid losses before investing on a buyer beware basis.  In order to do their homework, investors need the disclosure of all useful, relevant information in an appropriate, timely manner.

It is only with the ability to do their homework, that investors can adjust the pricing and amount of their exposure appropriately for the risk of the investment.

Currently, for financial institutions, the information required by investors to do their homework is not disclosed and regulators make representations as to their solvency.  Given these facts, it is not surprising and only fair that investors expect to be protected from losses if it turns out the financial institutions are insolvent.

Our modern financial system is built on the FDR Framework which combines a philosophy of disclosure and the principle of caveat emptor [buyer beware].  Without disclosure, the system does not work.

As designed in the 1930s, disclosure under the FDR Framework was based on the idea of providing the investor with access to all the useful, relevant information they needed at the time of their investment to make a fully informed investment decision.  Of equal importance, no burden was placed on an investor to use this disclosure!

How does the market for an individual security (stock, bond, structured finance product) work if investors are not required to look at the information disclosed?

The fact that all investors are not required to look at the disclosed information does not mean that some investors will not look at the disclosed information.

It is the investors who look at the information who are likely to understand how to use it in the analytic and valuation models of their choice to independently value the security.  These investors are also likely to add liquidity and stability to the price of the security by being buyers when the price is below their valuation and sellers when the price is above their valuation.

In the absence of all the useful, relevant information itself, the investors who provide liquidity and stability to prices in the market are absent.  As a result, prices for securities make movements similar to what occurred for structured finance securities in 2008 - one day the price is par and the next it is 20% of par.  In the case of financial institutions, the interbank loan market freezes.

Deep, liquid markets require disclosure because it is the market participants who can analyze the information to independently value a security that create liquidity and stability in prices.

For purposes of full disclosure, your humble blogger was recognized in the main stream media well before the credit crisis began for identifying the problems with structured finance securities and advocating for providing loan-level disclosure on an observable event basis to solve these problems and minimize the cost of a crisis.

The bank/sell-side dominated lobby pushed back strongly against this type of disclosure.  One of their leading argument against providing loan-level disclosure on an observable event basis was that providing this much data would confuse investors.

Frankly, Joe Six-pack cannot analyze or value structured finance securities.  However, Joe Six-pack is not likely to buy these securities directly.  He is likely to invest through a mutual fund or hedge fund with a professional portfolio manager.  The portfolio manager can choose to use the loan-level disclosure to value structured finance securities or they can hire an independent pricing service that is capable of valuing the securities using loan-level disclosure.

Let me repeat that, Joe Six-pack cannot analyze or value structured finance securities.  Nor can he evaluate all the current asset and liability-level data at a financial institution.  So, he hires a professional portfolio manager.  That manager and his firm either have the ability to analyze and value the structured finance or financial institution securities using the asset and liability-level data or the firm hires an independent third party service to do so.

As Yves Smith points out on the NakedCapitalism blog, nobody was ever highly compensated on Wall Street for developing transparent, low margin products.

"Disclosure has come to be a dirty word. Disclosure has become like shrubbery, a dense thicket of words that are a good place to hide tricks and traps. Clarity is about emphasizing the key pieces of information that someone needs to know... I have great faith in the capacity of people to make good financial decisions — when they have good information. No one makes great decisions — consumers or businesses — if the relevant information is hidden from view"  Elizabeth Warren

The quote from Mrs. Warren appeared in an interview with the Chicago Tribune.  She was talking in reference to all the financial products offered to consumers.  These products exemplified Yves Smith's observation.

The fault lines along which the financial system fractured in the recent credit crisis match up exactly to the parts of the financial system, structured finance securities and financial institutions, characterized by a lack of disclosure of all the useful, relevant information in an appropriate, timely manner.

To paraphrase Ms. Warren, no one makes great decisions if the all the useful, relevant information is not available in an appropriate, timely manner. 

The Case for Ending the Financial Regulators Self-Imposed Impossible Task

As discussed in an earlier post, financial regulators face a self-imposed impossible task.  The self-imposed impossible task that financial regulators face is to accurately assess the riskiness and solvency of financial institutions without any help from other financial market participants.

The reason that the other market participants cannot help is that financial regulators retain a monopoly on all the useful, relevant information on a financial institution in the form of its current asset and liability-level data.  Without this data, the other market participants cannot tell if a financial institution is solvent or not. [According to the Financial Crisis Inquiry Commission, this was the reason the interbank loan market froze during the credit crisis.]

Since their self-imposed task is impossible, financial regulators are prone to failure.  When the financial regulators do fail, the financial system itself is put at risk and taxpayers are put into the position of having to bail it out.

Ireland is a textbook example of what happens when regulators fail.  The failure to properly assess risk in the banking system combined with the sovereign guarantee of the banking system liabilities threatens the entire Irish financial system.

That the failure of the financial regulators in their self-imposed task was the factor that jeopardized the entire Irish financial system is not in doubt.  According to an Irish Times article on the Nyberg Report entitled Misjudging Risk:  Causes of the systemic banking crisis in Ireland,

[T]he regulatory authorities were aware that banks were engaging in "risky" behaviour ahead of the recession but did little to stop it. 

... Both the Financial Regulator and the Central Bank either failed to detect or “seriously misjudged” the risks associated with the property boom. Both regulatory bodies were aware of the "macroeconomic risks" and of risky bank behaviour but appear to have judged them “insufficiently alarming” to take major restraining policy measures, his report concluded. 

... The report notes that only a small number of individuals working in regulatory authorities saw the risks taken by banks as significant and actively argued for stronger measures to be introduced. However, it says that in all cases they failed to convince their colleagues or superiors of the need to take action.

... External organisations such as the IMF, the EU and OECD are also noted for being at most, "modestly critical and often complimentary" regarding Irish developments and institutions.

Not only did all the national financial regulators fail, but so too did the international financial regulators.

The failure of the global financial regulators suggests a simple test for predicting if any specific way of reorganizing the banking system will work to prevent taxpayers having to bailout the financial system when the next crisis hits.  The test is

Had the banking system been reorganized in this way prior to the recent credit crisis, would taxpayers still have been required to bailout the financial system.

One reform that has been proposed is to ring-fence or legally separate the retail bank from casino banking.  This reform would not have stopped the taxpayers from having to bailout the financial system as the losses in the Irish banking system occurred in the retail bank.  This is not the first time financial regulators have missed losses in retail banking.  In the US for example, there were considerable losses during the credit crisis in retail banking even though the regulators knew what could happen from their previous experience with the Savings and Loan crisis.

Another reform that has been proposed is to have the banks have capital equal to as much as 20% of assets.  This reform would not have prevented the Irish taxpayers from having to bailout the financial system as the Irish regulators did not step in before the losses in the Irish banking system exceeded 20% of assets.  The additional capital would most likely have allowed the Irish government and its taxpayers to absorb the losses and remain solvent.

Another reform that has been proposed is to break up the Too Big to Fail.  In the case of Ireland, this would not have helped because all the Irish banks failed.

Another reform that has been proposed is to establish a council of regulators or to merge the regulators performing bank supervision into the central banking authority.  The report highlights one of the reasons that a council or merger of financial regulators will fail.  Unlike the financial markets where the price is a reflection of everyone's opinion, regulators only speak with one voice.  Even if a few individuals saw the problem, they are always in a minority.  As a result, there is no reason to believe that action would be taken before it is too late.

Of all the ways to organize a banking system, the way the banking system is currently organized is the worst.  The reason it is the worst is that the regulators maintain a monopoly on all the useful, relevant information on financial institutions.  

With this monopoly, all other market participants are dependent on the financial regulators to properly assess the riskiness and solvency of the financial institutions.  If the financial regulators do not properly assess the risk and solvency, then market participants mis-allocate capital and taxpayers are on the hook for bailing out the financial system and addressing issues like contagion.

There is one reform that had it been in place pre-credit crisis would have prevented the reliance on taxpayers to bailout the financial system.  That reform would have been to end the financial regulators' monopoly on all the useful, relevant information.

From a separate article in the Irish Times on the report on the Irish banking crisis,

Mr Nyberg said the absence of sufficient information on the underlying quality of loan books at the banks impacted on the options considered by the Government when it decided to introduce the bank guarantee in 2008. 

“If accurate information on banks’ exposures had been available at the time it seems quite likely to the commission that a more limited guarantee combined with a state take-over of at least one bank might have been more seriously contemplated,” his report said.

If accurate information on the underlying quality of loan books at the Irish banks would have altered the decision to guarantee all the bank liabilities, it is reasonable to assume that this same information in the hands of market participants would have altered their behavior too.

If accurate information on bank exposures had been available, the other market participants would not have been dependent on the financial regulators to assess risk and solvency.  They would have done so for themselves since they expected before the credit crisis that they would have had to absorb any losses on their investments.  [We know they would have done so because at Davos this year Jamie Dimon of JP Morgan and Peter Sands of Standard Chartered have said they would use this information to determine who their 'dumbest competitor' is.]

Given their incentive to avoid losses, the other market participants would have reacted well before the risk of loss would have wiped out their investments.  At a minimum, they would have dramatically raised the cost of funds and reduce the availability of funds to the Irish banks.  This action would have significantly reduce the total losses incurred by the Irish banking system and may have completely eliminated the need for any Irish taxpayer involvement.

Finally, please note the Mr. Nyberg makes a point of saying that modeling exercises like stress tests do not provide sufficient information on the underlying quality of the assets at the banks and in fact placed the Irish taxpayers and the financial system at greater risk.  According to the first Irish Times article, the report found

“There was almost an element of the Financial Regulator being ‘fobbed off’ by banks that had particularly full confidence in the quality and sophistication of their models and systems.”

Instead, he called for "accurate information on the banks' exposures" as this would have saved the Irish government from issuing a guarantee the Irish taxpayers could not afford.

Given the findings of this report apply not only to Ireland but on a global basis, it is completely unacceptable for financial regulators to try to protect their information monopoly and not ensure that all market participants have access to all the useful, relevant current asset and liability level information in an appropriate, timely manner.

Yet another reason for having current asset level disclosure by banks

In an article in the Telegraph, a Parliamentary committee observed that two the UKs leading banks could not provide basic data on their loans to the Treasury in a timely manner.

This is a simple example of how requiring current asset level disclosure helps both the bankers and the regulators.

The Public Accounts Committee (PAC) said that when RBS and Lloyds were in talks to join the Asset Protection Scheme (APS) in 2009, the "lack of certainty on the nature" of the bank loans "put the Treasury in a difficult position." 

The APS was established as state insurance scheme to guarantee the worst of the banks' bad loans to stabilise the system. By the time it was up and running, only RBS entered into the APS, but Lloyds was also assessed by the Treasury during the establishment of the scheme. 

In its report published on Tuesday, the PAC said: "It is alarming that two of the UK's major banks were simply unable to provide sufficient data to assure the Treasury that their assets were not linked to fraud or other criminal activity. It raises questions on the management controls within the banks and the quality of audit provided to the banks." 

The Committee, which has investigated the Government schemes set up to stabilise the banks, added that in giving evidence "RBS acknowledged that a lot of things had not been done well prior to the crisis, including keeping good books and records." 

The MPs have demanded that the Treasury "takes steps to ensure the banks address these gross deficiencies in basic data" and put in place a system through which they can check. 

... RBS declined to comment on the data gaps. A spokesman for Lloyds said: "We believe we provided the necessary data to the Treasury within the tight time frame required. The request for this data from the Treasury coincided with the Lloyds TSB merger with HBOS, making data collection difficult during those initial months, which was a position unique to Lloyds within the banking sector at that time." 

... The PAC ... warned that "there is a small risk" that the banks could fail again and urged the Treasury to be prepared.

Who is to blame for Irish Bank Crisis? Update

A Wall Street Journal article on the most recent government funded report on the causes of the Irish banking crisis found three parties to blame:  regulators, politicians and ordinary people.

A new report on Ireland's spectacular banking crash acknowledges that regulators and politicians allowed reckless lending to go unchecked but says ordinary people are also to blame for spurring on a property mania.

Without the reckless lending, ordinary people could not engage in a property mania, so blaming ordinary people is a non-starter.

The report, written by former Finnish senior government official Peter Nyberg, was published Tuesday after its contents were discussed by a cabinet meeting of the new Irish government. 

Mr. Nyberg told a press briefing that many players in Irish society—banking boards, politicians, former regulators, external auditors—didn't fully realize the risks of concentrated lending during the boom years and that the blame for the banking implosion should be shared with many thousands of people. The report therefore does not name names, he said. 

Since the Irish banks did not have to disclose current asset/liability-level data under the FDR Framework, market participants did not have access to the data which would have shown the reckless lending.  As a result, the banks were not subject to market discipline.

The Irish banks did and still do have regulators who face an impossible task.  The impossible task that bank regulators face given their monopoly on the current asset/liability-level data is to replace the analytical ability and market discipline of all those market participants who have skin in the game:

• They have to replace the analytical ability of the foreign banks who were investors in unsecured senior debt of the Irish banks; and

• They have to replace the analytical ability of credit and equity analysts for all the investors who purchased senior or subordinated debt and equity.

In addition, the regulators have to replace the analytical ability of all the independent third party experts.

Because so many players in Irish society were cheering on a property mania in 2004 and 2005, it would be "extremely difficult to blame one group or institution" for the subsequent crash, Mr; Nyberg said. 

Even though it is part of their mandate, bank regulators cannot be blamed for failing to take away the punch bowl when a party gets going.  Doing so would require bank regulators to incur a significant political backlash at a time when there were not significant visible problems.

It is equally difficult to blame the politicians.  Until the problems emerge, everything looks okay.

History has shown that the dynamics of the relationship between politicians and regulators will typically result in not removing the punch bowl until problems emerge.

The FDR Framework ends the waiting for the problems to emerge.  It relieves regulators of having to replace the analytical ability and market discipline of market participants or facing a political backlash for taking away the punch bowl when the party is just getting going.

By making the current asset/liability-level data available under the FDR Framework, market participants analyze the banks to see if they are engaging in reckless lending or other risky activity.  If so, the market participants vote by increasing the price of their investments to reflect the risk and limiting their exposure to the banks.  If this form of market discipline does not get the banks to reign in their reckless lending or other risky activity, the articles written by the credit and equity market analysts provide plenty of political cover for the regulators taking away the punch bowl.

However, Mr. Nyberg's report said external bank auditors were "silent observers" and that former regulators knew of corporate governance failings at the worst of the banks.

It is not the role of the external auditors to comment on a real estate mania.  Their role is to make sure that the banks accurately report the information that the regulators require the banks to report.

Update


From an article in the Irish Times on the report on the Irish banking crisis,

Mr Nyberg said the absence of sufficient information on the underlying quality of loan books at the banks impacted on the options considered by the Government when it decided to introduce the bank guarantee in 2008. 

“If accurate information on banks’ exposures had been available at the time it seems quite likely to the commission that a more limited guarantee combined with a state take-over of at least one bank might have been more seriously contemplated,” his report said.

The bottom-line of the report is that it shows why it is critically important to implement the FDR Framework and have financial institutions disclose current asset/liability-level data.

Objection to FDR Framework: Too Big to Fail are Too Big to Understand

This is the first in a series of posts that addresses objections to fully implementing the FDR Framework.

Objection:  A $2 trillion financial institution is too complex for every market participants to be able to analyze.

Response:  Under the principle of caveat emptor [buyer beware] in the FDR Framework, the investor takes the responsibility for bearing all the losses on their investments and therefore they have an incentive to do their homework.  With its deposit guarantee, the government is limiting the number of investors who are subject to caveat emptor when investing in a financial institution.  The investors who exceed this limit are perceived to have the capability to do the analysis for themselves or to hire a third party expert to do the analysis for them.

Objection:  A $2 trillion financial institution is too complex for any market participant to be able to analyze.

Response:  Those investors, like shareholders and lenders and counter-parties, who are not protected by the government guarantee have to deal with the complexity.  They have three choices:

1. Follow Warren Buffett's advice and not invest in a company they do not understand;
2. Hire a third party expert, like a mutual fund manager, to analyze the data and make the investment decision for them; or
3. Analyze the data for themselves.

An example of an investor who could analyze the data for themselves is the financial institution's competitors.  They have the in-house expertise.  These firms also have an incentive to analyze the data because they have numerous exposures, like loans and derivatives, to the financial institution.

Objection:  A $2 trillion financial institution is too complicated to report at the current asset/liability level.

Response:  There are three types of complexity for financial institutions:

1. Complexity based on organizational structure;
2. Complexity based on the sheer number of assets and liabilities; and
3. Complexity based on the specific asset or liability.

Fortunately, the modern database handles all this complexity.  It is the modern database that allows the management of a $2 trillion financial institution to actually know what is going on.

It is the modern database that is at the heart of the successful implementation of the FDR Framework for financial institutions.  It is the database that makes it possible to provide the market participants with all the useful, relevant information in an appropriate, timely manner.  Just like management, these participants, which range from financial regulators to credit and equity market analysts to financial competitors to pricing services to rating services to counter-parties to investors, can use the database to find the answers to their questions.

Myths and Fallacies Watch: Informationally-Insensitive Debt

Myth and Fallacy:  Informationally-insensitive debt exists.

Fact:  Informationally-insensitive debt does not and cannot exist in a financial system based on the FDR Framework.

The reason it does not exist is that under the principle of caveat emptor [buyer beware] the investor accepts responsibility for bearing the losses on all their investments.  With responsibility for bearing the losses comes the incentive for the investor to do their homework before investing so as to avoid losses if possible.  Hence, all investments, debt or equity, are informationally-sensitive.

In a financial system based on the FDR Framework, the government must ensure that investors have access to all the useful, relevant information in an appropriate, timely manner so the investors can do their homework and assess the probability of loss.

Some investments, like demand deposits, require less effort to assess.  If the size of the investment in demand deposits is equal to or less than the amount of the government guarantee, as soon as the investor establishes that the demand deposits are covered by the government guarantee they are done with their assessment of loss until the government announces a change in the amount of the guarantee.

Other investments, like senior tranches of structured finance securities, require a significant amount of effort to assess initially and on an ongoing basis.  To assess the probability of loss, an investor would use a valuation model that combines the structure of the deal, the current performance of the underlying collateral and the projected future performance of the underlying collateral.  Naturally, this investment is highly sensitive to information on the performance of the underlying collateral.  If actual performance is worse than projected, the value of the security is subject to change rapidly.

Myth and Fallacy:  Since the price did not change very much on senior tranches of structured finance securities despite the apparent increase in risk of these securities prior to the beginning of the credit crisis, this proves that informationally-insensitive debt exists.

Fact:  Actually, what this example shows is that bankers were able to design a financial instrument where all the useful, relevant information was not disclosed in an appropriate, timely manner.

The bankers were aided in this by the rating services who did not dispel the notion that they did not have access to all the useful, relevant information in an appropriate, timely manner until September 2007.  Until then, investors relied on these rating services to have this information since the investors knew they did not have access to this data themselves.  As a result, what appears to be informationally-insensitive debt was merely a reflection of how slowly the rating services downgraded the securities.

The regulators also failed to require disclosure of all the useful, relevant information in an appropriate, timely manner for this financial instrument in 2005 because the regulators could not justify it based on a cost/benefit analysis.  Now that the regulators know the financial market can lose hundreds of billions of dollars as a result of their not requiring disclosure, the cost/benefit analysis will always favor requiring disclosure of all the useful, relevant information in an appropriate, timely manner.

Independent Banking Commission and Taking on Too Big To Fail

The Financial Times published an interesting column reviewing how the Independent Commission on Banking took on the Too Big to Fail.

Britain’s Independent Banking Commission has recognised that it is better to create a structure that secures the right incentives than to try to control behaviour arising from the wrong incentives.  

From this description, you would think that the Independent Banking Commission had adopted fully implementing the FDR Framework and stripped the financial regulators of their monopoly on all the useful, relevant information on financial institutions.

'It is better to create a structure that secures the right incentives than to try to control behaviour arising from the wrong incentives' is exactly why the global financial markets based on the FDR Framework combine a philosophy of disclosure with the principle of caveat emptor [buyer beware].  The FDR Framework is a structure that secures the right incentives without trying to control behavior.

... It has also recognised that the objective of regulation is not to prevent bank failures. Governments cannot prevent them – though they can bail out failed banks. Such an objective would stifle innovation and undermine management autonomy and responsibility.

Under the FDR Framework, it is not the objective of regulation or the role of government to prevent bank failures, stifle innovation or undermine management autonomy and responsibility.  The objective of regulation and the role of government is to insure that all the useful, relevant information is accessible to all market participants in an appropriate, timely manner.

This is particularly true of financial innovations.  As Yves Smith observed on NakedCapitalism, Wall Street never rewarded anyone for developing transparent, low margin products.

Furthermore, central to the FDR Framework is the idea of market discipline.  With disclosure of all the useful, relevant information, market participants can analyze the risk of a bank and properly value its securities.  If a bank increases its risk and makes failure more likely, market participants will respond by requiring a higher rate of return to hold its debt and equity securities.  It is management's choice how it responds to this market feedback.

Institutions that run into trouble – like Lehman Brothers and Northern Rock – should be able to fail without unacceptable consequences for the financial system. 

It is only in a financial market which fully implements the FDR Framework and strips the financial regulators of their information monopoly on the useful, relevant information on financial institutions that the unacceptable consequences from failure can be avoided.

Without all the useful, relevant information, it is impossible for market participants to properly analyze and price the risk of a financial institution.  Pricing risk has two components:  amount of exposure to the financial institution and cost of this exposure.  If the amount of risk is underestimated, then market participants will provide too much capital, either debt or equity, at too low a price.

However, if all the useful, relevant information is made accessible in an appropriate, timely manner, then market participants can properly price risk.  Since it is buyer beware, market participants know that they could lose their investment if the financial institution fails.  As a result, they only invest as much as they can afford to lose.

Too big, or too complex, or too diversified, to fail cannot be tolerated in a competitive market economy.  A government backstop gives an overwhelming competitive advantage to large established firms and encourages the kind of risk-taking in which risk-takers receive much of the upside and little of the downside. 

In a competitive market economy with a financial system based on the FDR Framework, the only important 'too' is 'too opaque'.

Where the credit crisis hit the financial system was exactly along the fault lines of too opaque.

• The credit crisis hit the opaque structured finance securities.  Without adequate disclosure of the performance of the underlying collateral, the structured finance markets froze on August 9, 2007 when BNP Paribas announced that it could not value these securities.  

• The credit crisis hit the opaque financial institutions.  As reported by the Financial Crisis Inquiry Commission, in late 2008, financial institutions refused to lend to each other because they did not know what each institution's exposure to structured finance securities was and therefore could not determine who was solvent and who was insolvent. 

A government monopoly on all the useful, relevant information on financial institutions gives these institutions an ability to take risk.  Risk that these financial institutions would not necessarily take if their competitors could properly price their exposure to each other [why else would Jamie Dimon and Peter Sands want to know who their 'dumbest competitor' is?].

So the commission correctly focuses on increasing competition and on the separation of retail and investment banking. The analysis is effective, the direction of travel is right. But are the specific measures they propose sufficient to achieve the outcomes they seek?

Since the commission misses the only important 'too', its proposed cures may or may not be relevant or effective.  What is clear about its proposed cures is that unlike disclosure of all the useful, relevant information these cures do not lead to a race to the top among regulators.

... The other main argument the banks have deployed is better, but not much. They emphasise the costs of the split.

While the cost argument might have some traction when it comes to separating retail and investment banking, it has no traction when it comes to disclosure of all the useful, relevant information.

As this blog has documented, inadequate disclosure for structured finance securities resulted in hundreds of billions of dollars of losses.  The cost of providing the asset-level disclosure that would have prevented these losses is a small fraction of the losses.  Therefore, disclosure of all the useful, relevant information is easily justified looking at a cost/benefit analysis.

But the devil is in the detail .... So their proposal is to rely heavily on a 10 per cent capital ratio on these ring-fenced UK retail banking operations.... Have we not learnt that a capital ratio is an inadequate regulatory tool on its own once the range of balance sheet assets multiplies? 

Unlike capital, ensuring access for market participants to all the useful, relevant information in an appropriate, timely manner is both a necessary and sufficient tool by itself to cover the range of on- and off-balance sheet assets.

It is only with this disclosure that the assets can be valued.  It is only with this disclosure that market participants can properly price their exposure to financial institutions and exert market discipline.  It is only with this disclosure that the market can determine which financial institutions are solvent and which are insolvent.  It is only with this disclosure that governments can confidently seize control of a financial institution and not worry about unacceptable consequences.

We can apply two tests to the proposals. Do market prices reflect an expectation that a failed investment banking division of a conglomerate bank will be allowed to fail? Are these banks beginning the radical simplification of corporate structure needed to make such resolution a realistic possibility? 

The market reaction so far suggests a view that the banks have got away with it. Sir John is
understandably angry at this suggestion, as he stood up to unacceptable pressure from vested interests. But that the outcome is at once radical and weak is a measure of how biased the debate so far has been.

Had Sir John and the commission instead chosen to champion fully implementing the FDR Framework and strip the financial regulators of their monopoly on the useful, relevant information on financial institutions, the market would not believe that the banks have got away with it.

The market reaction would have been that the issue of the best structure for banks had finally been addressed as providing the market with all the useful, relevant information in an appropriate, timely manner is the best structure.

Breaking up Wall Street banks 'almost impossible'

At a recent conference at Bretton Woods,  a Telegraph article reports that Paul Volcker observed,

I don't like these banks being as big as they are...[but] to break them up to the point where the remaining units would be small enough so you wouldn't worry about their failure seems almost impossible. 

Without the option of breaking up the Too Big To Fail banks, the challenge is

... how to make the financial system safer without prompting banks to leave for jurisdictions where regulation is lighter. 

The pound of cure solutions do not inspire confidence.

The former Fed chairman's concern over the failure to protect taxpayers and the wider economy from the potential failure of large banks was echoed by George Soros, the billionaire financier and philanthropist. 

"I certainly consider they haven't addressed the problem correctly," Mr Soros said. "The whole issue of living wills and resolution authorities is not convincing." 

... Mr Soros said that authorities had not produced tough enough regulation to ensure that there won't be a need for governments to exercise the implicit guarantee that they would again bail out the financial system in a future crisis.

Ultimately, to paraphrase Winston Churchill, regulators are going to do the right thing by fully implementing the FDR Framework after having tried everything else first.

Making all the useful, relevant information available to all market participants in an appropriate, timely manner is the only solution that provides an ounce of prevention.  While nothing can eliminate the potential for a future crisis, if market participants have access to this information it is likely to reduce the severity of any future crisis.

Making all the useful, relevant information available to all market participants in an appropriate, timely manner is the only way for the Too Big To Fail competitors to put peer pressure on the "dumbest competitor" to reduce its risk profile.

Making all the useful, relevant information available to all market participants in an appropriate, timely manner is the only way to eliminate the need for bailouts as all market participants will know who is solvent and who is not solvent.

The ECB's Reason for the Irish Taxpayer Footing the Bill is Wrong!

Lorenzo Bini-Smaghi, a member of the executive board of the European Central Bank, wrote a column in the Financial Times in which he argued that Irish taxpayers should not complain about being required to foot the bill for the Irish banking crisis.

In making his argument, he reveals that the ECB prefers to selectively adhere to the FDR Framework that has been the foundation for the global financial markets for the last 75+ years.

Please recall that under the FDR Framework, financial markets combine the philosophy of disclosure with the principle of caveat emptor [buyer beware].

• It is the responsibility of the government and its regulators to be ensure that all useful, relevant information is made accessible to all market participants in an appropriate, timely manner.  

• It is the responsibility of the market participants, including the regulators, to do their homework as they know that it is buyer beware when they make an investment or guarantee deposits.

Mr. Bini-Smaghi observes

...In the years before the crisis several countries, like Ireland and the UK, took decisions aimed at ensuring a more benign environment for their financial sectors. These included favourable taxation for banks, and less stringent self-regulation, rather than thorough inspections and reports.

In short, the regulators in these countries committed two sins under the FDR Framework.  First, they acted as gatekeepers that prevented access to all the useful, relevant information on their banks.  Second, they did not do their homework using this information and therefore misrepresented to other market participants what this information would have shown was going on.  This misrepresentation distorted the capital allocation decisions of the other market participants.

He then observes that

As a result, their banks grew larger and more profitable, increasing leverage and lending to risky sectors such as real estate.

... In principle, the costs of restructuring these banks should mainly be passed on to shareholders and managers, and thus subsequently on to bondholders. 

Mr. Bini-Smaghi describes exactly how the costs of restructuring are handled under the FDR Framework.  100% of the time the costs of restructuring are borne first by the shareholders and then by the unsecured bondholders.  With access to all the useful, relevant information, investors accept these losses as a potential outcome of making an investment and do not expect to be bailed out.

Under the FDR Framework, taxpayers should never have more than minimum involvement in absorbing losses from the failure of a bank.  Unlike other investors, governments cannot easily sell their investment - the deposit guarantee - as the risk of the bank changes.  The way a government "sells" its investment is by resolving the bank.  It is up to the regulators to protect the taxpayer and step in and resolve the bank before the loss absorbing capacity of the shareholders and unsecured bondholders is exhausted.

However, Mr. Bini-Smaghi would like to make an exception and selectively move away from how losses are borne under the FDR Framework.

Only in a systemic crisis should taxpayers be involved. The question is, how should we judge if a crisis is truly systemic, and therefore whether taxpayers should rightly bear some of the costs of resolving the situation?

... [When] discretion is exercised at the national level in applying common EU regulations, and also when implementing prudential supervision. The taxpayers’ incentive to vote for a tougher, hands-on approach is also weakened if their bank’s liabilities are held abroad, and therefore the burden of adjustment can be shifted to non-residents.

If the decision on whether a crisis is systemic or not is in the hands of the authorities of the country where the troubled banks are located, their authorities will have an incentive to underestimate the systemic dimension of the crisis, and thus shift the burden to other European taxpayers.  

However, those other countries will rightly consider that, as long as supervision remains national and accountable to the taxpayers of the country with indebted banks, those taxpayers should, in the first instance, assume responsibility for any failures.

Mr. Bini-Smaghi thinks the home nation's taxpayers should absorb the losses ahead of non-home nation investors because it was the failure of the home nation's regulators to prevent these losses in the first place or to provide the useful, relevant information so that investors could have avoided investing in these banks and incurring losses.

His argument conveniently leaves out the fact that no-one forced the investors to invest in the failing banks.  They invested despite the fact that they did not have access to all the useful, relevant information.  They invested despite the fact that the home nation regulators announced a more hands off policy.  They invested knowing that it is a buyer beware market and they would have to absorb any losses on their investment.

... One way to reduce the burden on taxpayers arising from these perverse incentives is to minimise the degree of discretion enjoyed by national regulators. 

Ultimately this would mean the integration of independent prudential supervision at the European, or at least euro area, level – to match the way burdens are shared when a systemic crisis strikes. 

Such a move may seem politically unpalatable, as taxpayers around the eurozone fear having to bail out the banks in other countries. But these taxpayers would at least have the assurance that banks in different countries would henceforth be subject to uniform and independent supervision, and that there would be no incentive to tolerate excessive risk-taking by individual nations. 

Actually, there is a better solution that does not have perverse incentives, that does not force taxpayers around the eurozone to bail out the banks in other countries and would not require integration of the prudential supervision function in each country.

The better solution is to enforce every aspect of the FDR Framework.

What this would mean is that each country's banking regulators would have to give up their monopoly on all the useful, relevant information.  By making this information accessible to all market participants in an appropriate, timely manner, no longer would capital allocation be distorted by the inability of market participants, including the regulators in other countries, to properly analyze the risk of an investment in a bank, structured finance security or country.

It would also mean that investors absorb losses again.

Recent events have shown that, as long as the accountability of supervisors to taxpayers is primarily a national affair, and discretion in the implementation of national financial regulations and supervision is allowed, then there is a high risk that taxpayers will foot most of the bill. They should not complain when it actually happens.

What recent events have shown is that regulators are willing to set aside how losses are absorbed under the FDR Framework based global financial system and instead stick the taxpayer with the bill.  This is the ultimate in privatizing the gains and socializing the losses.

US Senate - Wall Street and the Financial Crisis: Anatomy of a Financial Collapse

After a two year investigation, the US Senate released its report on the causes of the financial crisis.  A New York Times article summary says,

... the report focuses on an array of institutions with central roles in the mortgage crisis: Washington Mutual, an aggressive mortgage lender that collapsed in 2008; the Office of Thrift Supervision, its regulator; the credit ratings agencies Standard & Poor’s and Moody’s Investors Service; and the investment banks Goldman Sachs and Deutsche Bank. 

"The report pulls back the curtain on shoddy, risky deceptive practices on the part of a lot of major financial institutions,” Mr. Levin said in an interview. “The overwhelming evidence is that those institutions deceived their clients and deceived the public, and they were aided and abetted by deferential regulators and credit ratings agencies who had conflicts of interest.”

Actually, the overwhelming evidence is how much of this behavior would have been prevented if the FDR Framework had been enforced.

Enforcement would have greatly restricted the ability of Washington Mutual to underwrite risky loans.  If investors had been able to do their homework on the loans and properly price the risk, they would have purchased far fewer loans at a much lower price.

Enforcement would have mitigated the impact of the deferential regulator.  To the extent that Washington Mutual was taking more on-balance sheet risk by holding dodgy loans, its cost of funds would have increased and its stock price decreased to reflect this risk.

Enforcement would have eliminated the problem of conflicted rating agencies.  Investors could have either analyzed the data themselves or they could have used independent third parties with no conflict of interest to analyze the data and properly price the risk.

Enforcement would have ended the gamesmanship by the investment banks.  Investors would have a) seen that the investment banks were reducing their net exposure to sub-prime mortgage backed securities and b) been able to do their homework so as to properly price the securities given the risk in the underlying collateral.