Even the Wall Street Journal is beginning to embrace bank asset-level disclosure

A recent Wall Street Journal editorial marks another milestone in the mainstream media's embrace of bank asset-level disclosure.

In the sociology of "The Life of Brian," a world in despair is a world casting about for messiahs. Despair over the problem of big banks has some now reaching for the messiah of higher capital standards. 

If banks had more capital, goes the argument, they wouldn't have needed bailouts. This is true—if you make an unwarranted assumption that the riskiness of bank assets would have been unaffected, or even improved, under higher capital requirements. 

As we discussed in previous posts, under higher capital requirements, both Merrill and Citi could have substituted super senior tranches of CDOs for Treasury securities and improved their return on equity without significantly changing their risk adjusted capital ratios.

... So the equation more capital = safer is not as straightforward as it seems. 

Happily, the complexities are not lost on the gnomes of Basel ... Their latest solution, Basel III, would seriously hike the amount of capital banks must hold, but otherwise persists with the basic strategy of setting different levels of capital against different assets precisely to preserve the incentive of banks to invest in assets perceived as safe. 

The fatal conceit, of course, is "perceived." Triple-A mortgage securities once were seen as safe. Greek bonds were safe. Under TBTF, when banks receive no discipline from their own creditors who expect to be bailed out, it falls on regulators not only to guess which assets are safe but to lean against the incentive of banks to categorize risky assets as safe in order to hold less capital against them. 

How well regulators have performed this function can be guessed from a succession of global financial crises...  

Nor is it pound-foolish to avoid banking panics at the cost of increasing moral hazard. But the fact remains: Everything we do ends up increasing moral hazard. 

Actually, everything that the regulators have tried so far increases moral hazard.

... Lacking, meanwhile, has been any willingness to grasp the nettle of moral hazard directly. We want a messiah, but apparently not one who asks anything radical of us or challenges us to relinquish any sacred cows. 

All but dismissed, for instance, has been the idea of contingent capital—requiring banks to sell a bond that would convert to equity if the bank gets in trouble. 

Forget the trifling argument over whether such convertibles should count as "capital." What matters is the creation of a class of tradable debt exempt from bailout, giving speculators an incentive to scour for early signs of trouble. 

The issue with contingent capital is that there is no readily apparent market for it.  Without asset and liability-level disclosure, investors have no way of assessing the riskiness of what they are buying.

It is one thing to make an investment when you know what the bank's exposures are, but quite another to make an investment on what may or may not be there.

Or how about requiring government-insured deposits to be 100% backed by Treasury bills? 

We already have this.  Since the beginning of the credit crisis, it is called a money market mutual fund.

Don't underestimate the importance of FDIC deposit insurance to the edifice of TBTF. If government were seen acting in advance to protect its own claims in a bank failure, and devil take the hindmost, it would have a powerful effect on the thinking of the hindmost. 

Bank creditors might begin to doubt their own rescue and demand more transparency and less complexity from bank CEOs. 

Following the messiah of transparency comes market discipline and the government acting in advance to protect is own claims in a bank failure.

As this blog has discussed at length, market participants need to have access to all the useful, relevant information in an appropriate, timely manner.  For banks, this information is current asset and liability-level data.

With this data, market participants can determine if a bank is solvent or not.  With this data, market participants can determine how much risk a bank is taking and adjust the pricing and amount of their exposure to the bank accordingly.  

ECB's ABS Data Warehouse and Why issuers always pay for disclosure

To date, I have documented two strikes against the Market Group's version of the ECB data warehouse and why it is unlikely to restore investor confidence in the structured finance market.  They are:

• It is riddled with conflicts of interest that most likely will not be acceptable to investors or the European Union's Competition Committee based on that committee's preference that financial information data vendors be free of all conflicts of interest; and

• It is based on providing data on a once-per-month basis that the rating agencies have already testified before the US Congress is inadequate for timely updates to ratings (a form of valuation) so by definition, this data is not adequate for financial institution investors to know what they own under Article 122a of the European Capital Requirements Directive.  Furthermore, the SEC is investigating the rating agencies for potential fraud from publishing ratings based on out of date information.  

Today, I would like to add strike three.  The Market Group is moving forward with a plan to a) collect the data for free from the issuers and b) charge the investors and data distributors for accessing the data in the data warehouse.  Unless the issuers also provide the data for free at the same time to all market participants, this plan is likely to violate existing disclosure regulations in the US and Europe.

In the US, the relevant disclosure regulation is Regulation Fair Disclosure (Reg FD for short).  This regulation is the global gold standard for fair disclosure and is very explicit in the requirements it places on issuers.

• It requires that all material items in the investment mosaic be disclosed.  When it comes to the loans underlying a structured finance security, it would suggest that all the borrower privacy protected data fields track by the originator as well as the firm engaged in the daily billing and collecting be disclosed because there is reason to believe that these fields are part of the investment mosaic for valuing the loans and hence the security.  Please note that this definition excludes price and trading data;

• It requires that all market participants have equal access to the information used in analyzing and valuing a security at the same time.  This rules out the business model where issuers only release the information to a distributor that charges for access to the information because not all market participants can afford the access charge.

Please note that Reg FD and the European disclosure regulations do not say that a data distributor cannot collect publicly available information, package this information and sell it to investors.  There are several companies that already do this for structured finance including LoanPerformance, Lewtan, Bloomberg and ThomsonReuters.

What Reg FD and the European disclosure regulations do say is the model of collecting, packaging and selling cannot be applied to non-public performance data that is used for analyzing and valuing a security as a means for making the non-public data public.

Like baseball, with three strikes the Market Group should be out as far as any involvement in the ECB's ABS data warehouse.

The ABS data warehouse I proposed several years ago does not suffer from the problems plaguing the Market Group's version of the ECB's ABS data warehouse.  It has no conflicts of interest.  It offers current loan-level performance data so that financial institution investors can always know what they own.  It provides the data for free to all market participants at the same time.

I look forward to hearing from the ECB and being given the mandate to create their ABS data warehouse.

Checking how banks measure riskiness of their assets requires disclosure of asset-level data

A Bloomberg article reports that now that the battle over risk-adjusted capital requirements is over, regulators are turning to examine how banks' measure the riskiness of their assets.

The best way to ensure 1) that the risk adjustments are not manipulated and 2) that banks converge on the same risk adjustments for the same assets is disclosure of the asset-level data.  The market will force a common risk-adjustment across all financial institutions.

Global banking regulators are moving their attention to disparities in the way firms measure the riskiness of their assets on concern lenders may be using their internal models to mitigate rules aimed at making them boost capital. 

... Now regulators are preparing to assess how banks set risk weightings amid criticism firms’ calculations are inconsistent, said a person with direct knowledge of the matter who declined to be identified because the talks are private. 

“There is no question that the weightings can be manipulated,” said Charles Goodhart, a former Bank of England policy maker and professor at the London School of Economics. “They are light years away from being scientific. The idea that risk can be captured and then not adjusted to reflect dynamic markets is absolutely flawed.” 

The internal ratings rules determine how much capital banks should set aside to cover assets such as mortgages, derivatives as well as consumer and corporate loans. The riskier the asset, the higher weighting it attracts and the more capital a bank is required to allocate. That affects the profitability of trading and investing in those assets for the lender. 

Firms use their own internal models to decide how much capital to assign based on their own view of those assets defaulting. The models aren’t disclosed and banks can reach different risk weightings for the same assets, regulators and analysts say. 

“The basic problem with all this data is can you trust the banks to tell you the bad news?” said Prem Sikka, an accounting professor at the University of Essex. “Regulators won’t have the resources to scrutinize things in detail, but if things are publicly available, ordinary people, academics, lenders, depositors -- anyone who’s interested -- can look and help with the regulation of these banks by pointing out anomalies.” 

A clear statement of the benefits of asset-level disclosure as it applies to risk-weighting assets.

... Regulators are considering a peer-review process, setting up a sub-committee of the Basel Committee to ask a sample of banks to calculate risk weightings on a group of comparable assets to assess whether they are being calculated consistently, the person with knowledge of the plans said. A spokesman for the committee declined to comment. 

However, in a world where regulators are protecting their information monopoly, regulators would rather consider a one-off solution like a peer-review assessment of comparable assets.  The problem with a peer-review is that neither the regulators nor the market knows if the responses a bank gives to the peer-review are consistent with how it actually risk-weights the assets.

“The definition of risk weights is incredibly important,” Adair Turner, chairman of Britain’s Financial Services Authority and a member of the Basel Committee, said in a June 24 speech. “There is a major project for the Basel Committee and the international authorities to really focus on the commonality of risk weights,” he said. “The integrity of this whole system depends on us really being confident” that banks are using the same risk-ratings. 

Given that the numerator in the capital ratio, namely capital, is an accounting construct that at best is a lagging indicator and at worst is subject to substantial manipulation, the integrity of the whole system is already compromised.

... Lloyds Banking Group Plc (LLOY), the U.K.’s biggest mortgage lender, reduced the estimated risk of default on its mortgages to 12 percent in 2010 from 17 percent in 2009, according to a May filing. By contrast, Royal Bank of Scotland Group Plc, owner of NatWest, raised its estimate for defaults to 13 percent over the same period from 12 percent, according to Morgan Stanley analysts. Officials at the two banks declined to comment on their calculations. 

HSBC Holdings Plc (HSBA)’s Finance Director, Iain Mackay, said last month at an investor meeting that Europe’s biggest bank had been able to make “significant risk weight asset savings” in the past years through a process of “data cleansing.” 

“It’s not transparent to anybody outside whether the model is as good as it could be and, therefore, the capital weighting is right,” Chairman Douglas Flint told the meeting on May 11.

Standard Chartered confirms that lack of disclosure by banks is a direct contributor to bank runs

In case you missed it, a Telegraph article reported that Standard Chartered is practicing the modern day equivalent of a run on the Eurozone banks.  Their action publicly acknowledge the legitimacy of using the FDR Framework as a tool for risk management.

Bank runs occur when depositors and other investors no longer believe that the asset value of the bank exceeds its liabilities.

Please note, bank runs are based on the "fear" about the value of the bank's assets. If there was asset-level disclosure, the assets could be valued and banks, like Standard Chartered, could adjust their exposure based on facts.

Standard Chartered, the UK’s third-largest bank by market value, has made clear its fears of the likely fallout from the eurozone debt crisis by cutting back its lending to other European banks. 

Discussing the bank's first half performance, Richard Meddings, Standard Chartered's finance director, said lending to eurozone banks had been cut substantially due to concerns at the potential for contagion to the wider European banking system from the sovereign debt crisis. 

"We have been withdrawing liquidity from eurozone financial institutions and recycling it back into Asia," said Mr Meddings. 

Standard Chartered has no direct exposure to the sovereign debt of peripheral eurozone countries like Greece and Portugal, but Mr Meddings warned that the "dislocation" caused by a worsening in the crisis would hit all banks. 

Mr Meddings said there were likely to be "second order consequences" and that even banks with no holdings of the indebted countries' bonds could be hurt, though he added that Standard Chartered remained a net provider of funding to the interbank lending market.

Bethany McLean and "Capital Punishment" [updated]

Slate carried an article by Bethany McLean on why stricter capital requirements would not have prevented our most recent financial crisis.  I made this point in two posts that pre-date her article: bank capital's moment of truth, and debunking the myth of bank capital.

What caught my eye in this article was her solution in an ideal world for preventing financial crisis.  She championed asset-level disclosure as required under the FDR Framework.

Pretty much everyone—everyone, that is, except bankers and a handful of their supporters—agrees that there's one surefire way to make the global financial system safer: Require banks to increase capital reserves. 

But there's a risk in seeing stricter capital requirements as a catchall solution. Think about the past (the financial meltdown in 2008) and the present (the fear that a default by Greece will ignite another financial crisis ). If banks had held more capital, would we have avoided either mess? I'm afraid the answer is no. 

... A curious paradox of capitalism is its aversion to capital. When you think about it, capital is money (classically in the form of common stock) that isn't owed to anyone, so it can protect those who are owed money, like bondholders, by absorbing losses first. It's expensive, because the providers of capital want to be paid for putting their necks on the line. 

Bankers, whom we think of as the ultimate capitalists, can't stand the stuff. Indeed, the new capital standards being contemplated in Basel have bankers up in arms. 

At a House Financial Services Committee meeting last week, industry representatives argued, among other things, that large capital requirements will raise the cost of the loans they make. Prominent economists, including Simon Johnson, former chief economist of the International Monetary Fund, andAnat R. Admati of Stanford, say this is bunk. 

Regardless of who's right about that, what seems to get lost in the public debate is what capital isn't. It isn't a literal pile of cash or stock certificates, but rather an accounting construct based on the difference between what the bank says its assets are worth, and what its liabilities are. 

If the bankers are wrong about how much their assets (i.e., their loans), are worth, then they're wrong about how much capital they have.

Her description of what capital is needs to be re-read.  She is very explicit in telling you that capital is an accounting construct.  As a result, it is a number that is subject to being gamed by the banks and their regulators - think suspension of mark-to-market accounting at the start of the credit crisis.

The reason this blog has been down on capital is because it is an accounting construct.  It may or may not reflect reality.

This blog has favored solvency (a bank is solvent if the market value of its assets is greater than the book value of its liabilities) instead because it does reflect current reality.

... Historically, most, if not all, bank failures have resulted from a run on the bank, meaning that short-term lenders or depositors yank their money because they doubt the value of the bank's assets. Once that fear sets in, it doesn't matter whether the bank is well-capitalized or not: It runs out of cash anyway.  

The long form of this point was made in the posts on bank runs found in the guide to FDR Framework.

Bear Stearns and Lehman Brothers could plausibly argue, at the time of their demise, that they were well capitalized, but they still suffered a run because investors no longer trusted the value of the assets. The very situation in which a bank most needs a lot of capital is when investors start to suspect that the bank might be lying about the value of its assets. At that point, no amount of capital is enough.

... More broadly, think about how the crisis was finally averted. The common perception is that the Troubled Asset Relief Fund, or TARP, which put billions of dollars of capital into the biggest banks, did the trick. But that's not quite right. TARP showed that the government wasn't going to let the banks fail, and it was that demonstration which averted the crisis of confidence. What really made a difference was the other things the government did, most notably the FDIC's blanket guarantee of all the banking sector's debts.

This blog has repeatedly made the point that it was the US government putting its credit on the line, not programs like stress tests, that stopped the crisis of confidence.

... Not only would higher capital requirements have failed to prevent these crises; conceivably they might have made them worse. 

The risk weighting that the regulators apply to assets encourages banks to hold more of the assets that are supposed to be low-risk. That's why banks all owned a lot of mortgage-backed securities—they were purportedly low-risk, and banks didn't have to hold much capital against them. Sovereign debt like Greece's was also purportedly low-risk; that why banks owned a lot of it. 

Subsequent events showed that the risk weightings left something to be desired. 

... If banks had more capital, wouldn't they take less risk, because the bankers would have more to lose? I'm not sure the answer is yes, because the capital is still other people's money.

Previously, using Merrill Lynch as an example, it was shown that more capital could in fact lead to more risk taking.  By simply substituting low risk mortgage-backed securities for low risk sovereign debt, Merrill would have improved its return on equity without having changed the risk weightings under the capital requirements.  As a result, Merrill could have lost far more money.

A better argument in favor of stricter capital requirements is that if there were more capital and less debt in the system, then the likelihood would diminish that short-term lenders and depositors would get scared enough to create a run. 

But in the gigantic, murky, interconnected world of global finance, I'm not sure there's any amount of capital—any amount that still allows the system to function, that is—that would provide enough comfort under all circumstances. 

In an ideal world, we would do a lot more than require banks to hold more capital. We'd mandate transparency in the valuation of their assets, so that outsiders had a prayer of knowing what the stuff on banks balance sheets was actually worth.

With transparency in the valuation of their assets, we would also get each of their individual positions.  This would allow outsiders the ability to value these assets for themselves and determine what they are actually worth.

We'd force banks not to rely on short-term funding, so they couldn't have a liquidity crisis. And we'd make sure that regulators understood all the unique risks in each institution that they were regulating.

As discussed at length in the post on the new model for bank supervision, it is the disclosure of the asset and liability-level data that allows the regulators to understand all the unique risks in each institution.  This disclosure allows the regulators to harness the analytical capabilities of the market to understanding each institution.

But none of that is going to happen. So maybe requiring more capital is the best we can do. But we should be aware that it's an imperfect solution, and that getting the details wrong risks creating catastrophic problems down the road.

Do not be so pessimistic Bethany!

When politicians (see UK Prime Minister David Cameron), central bankers (see Bank of England's Mervyn King and the Financial Policy Committee), regulators (see the Bank for International Settlements, otherwise known as the central bankers' bank) and the mainstream media (see the Economist magazine) call for asset-level disclosure, it is a clear signal that they too know that disclosure is needed.

To paraphrase Winston Churchill, the overseers of the financial system always get it right with disclosure, they just have to try everything else first.

Update
The U.S. General Accounting Office issued a report that weighed in on the short-comings of bank capital that result from it being an accounting construct.

More than 300 insured depository institutions have failed since the current financial crisis began in 2007, at an estimated cost of almost $60 billion to the deposit insurance fund (DIF), which covers losses to insured depositors. Since 1991, Congress has required federal banking regulators to take prompt corrective action (PCA) to identify and promptly address capital deficiencies at institutions to minimize losses to the DIF. 

The Dodd-Frank Wall Street Reform and Consumer Protection Act requires GAO to study federal regulators' use of PCA. This report examines (1) the outcomes of regulators' use of PCA on the DIF; (2) the extent to which regulatory actions, PCA thresholds, and other financial indicators help regulators address likely bank trouble or failure; and (3) options available to make PCA a more effective tool. 

... Although the PCA framework has provided a mechanism to address financial deterioration in banks, GAO's analysis suggests it did not prevent widespread losses to the DIF--a key goal of PCA. 

Since 2008, the financial condition of banks has declined rapidly and use of PCA has grown tenfold. However, every bank that underwent PCA because of capital deficiencies and failed in this period produced a loss to the DIF. Moreover, these losses were comparable as a percentage of assets to the losses of failed banks that did not undergo PCA. 

... Since the 1990s, GAO and others have noted that the effectiveness of PCA, as currently constructed, is limited because of its reliance on capital, which can lag behind other indicators of bank health. That is, problems with the bank's assets, earnings, or management typically manifest before these problems affect bank capital. 

... GAO tested other financial indicators, including measures of asset quality and liquidity, and found that they were important predictors of future bank failure. These indicators also better identified those institutions that failed and did not undergo the PCA process during the recent crisis.

An unbiased observer like the GAO realizes that looking at a bank's assets and their quality is of more predictive value in measuring the solvency of a bank than looking at a bank's capital position.  This is not surprising, because deterioration in the assets shows up before accounting losses are recognized.

The FDR Framework and its requirement to disclose the asset-level data incorporates this practical reality.

Complexity of the financial system far exceeds the capacity of the market participants

Ezra Klein observed in his Washington Post blog on "What 'Inside Job' got wrong" and Brad DeLong seconded on his blog  in "what lessons from the little depression" the notion that

The complexity of the [financial] system far exceeded the capacity of the participants, experts and watchdogs. Even after the crisis happened, it was devilishly hard to understand what was going on. Some people managed to connect the right dots, in the right ways and at the right times, but not so many, and not through such reproducible methods, that it’s clear how we can make their success the norm. But it is clear that our key systems are going to continue growing more complex, and we’re not getting any smarter, or any less able to ignore risks that we know we should be preparing for.

Yves Smith responded in a post on NakedCapitalism,

To the extent it has been hard to figure out what happened (and I submit that the mechanisms that turned what would otherwise have been a contained subprime meltdown into a global financial crisis actually are not that hard to understand), it is because the perps and the regulators have made sure some of the key drivers have not been investigated and continue to be opaque and complex, which allows the financial services industry to continue looting. 

For instance, it is simply inexcusable that after the collapse of Bear Stearns that there was not a full bore coordinated effort among international regulators to get to the bottom of credit default swaps exposures (CDS were the reason Bear, a firm that most would have judged to be non-systemically important, was rescued). 

But who is doing what to whom in the CDS market still continues to be a mystery, even though the AIG bailout made it clear that it would be government backstopped and hence is a matter of public interest. 

Indeed, one of the reasons presented by Angela Merkel, among others, for why Greek debt can’t be restructured is the bugaboo of the CDS exposures. They’ve now become a preferred vehicle for holding governments hostage, which serves the big end of the banking industry just fine. 

In general, the failure to have regulators to demand data from the major banks and do decent post mortems is a mind-boggling dereliction of duty. 

I agree with Yves that the complexity of the market does not exceed the capacity of the market participants to understand.  Rather, what blocked understanding of what was going on was opacity.  It is exceedingly difficult to analyse anything without information.

Both Ezra and Brad focus on the idea that few people were able to connect the dots in the right way and that how they did so is not susceptible to being reproduced and becoming the norm.

Regular readers of this blog know that your humble blogger is the exception to this idea.  I have a public track record that shows I was able to connect the dots.  Not only in seeing the crisis coming but also in predicting which regulatory responses were going to be successful and which were not going to be successful (see for example the posts on Ireland and Spain).

More importantly, as illustrated by the FDR Framework, the methods I used are reproducible and can be adopted as the norm.

If they have the time, I would be willing to explain the FDR Framework to Ezra and Brad.

Spain's Cajas make the case for asset-level disclosure

As predicted under the FDR Framework, Spain's Cajas are going to have to disclose their current asset-level data if they are to raise capital.

A Bloomberg article on the Spanish Cajas hiding bad debt should be the death knell for the Cajas raising additional capital without current asset level disclosure.

After all, what investor is going to buy equity in a financial institution without first determining if the financial institution might still be insolvent even after their investment?

Spanish banks have 50 billion euros ($70.7 billion) in unrecognised problematic real estate assets, El Confidencial reported, citing a report by the Boston Consulting Group. 

The consulting group estimates that Spanish banks need between 20 billion euros and 30 billion euros in additional capital and that Spain’s bank rescue fund, known as the FROB, could end up taking over 20 percent of the banking industry, El Confidencial added.

Bank for International Settlements calls for current asset and liability-level disclosure

A Reuters' article reports that the Bank for International Settlements (BIS) is calling for financial institutions to have to disclose their current asset and liability-level data.

BANK DATA FRAMEWORK 

The BIS welcomed efforts by Britain, the European Union, the United States and other countries to set up a new breed of watchdogs to spot broad, systemic risks to financial stability and tackle them with "macroprudential" tools. 

Such tools include forcing banks to top up capital cushions in good times for tapping when markets turn sour, a step that also may help to cool overheated credit markets. 

"Nonetheless, a substantial amount of trial and error is likely to be needed for the time being, given the still-limited history of macroprudential policy usage," the BIS said. 

The BIS report said gaps are also evident in both the analytical framework and company-level and aggregate data which policymakers will need to take action. 

An international data-sharing framework should be set up to give supervisors a common view of the balance-sheet positions of the largest global banks, the report said. 

This was crucial when the 10 biggest banks each have about 3,500 subsidiaries in about 80 countries. 

"A key data gap during the crisis was the lack of information on banks' asset and liability positions, broken down by currency, counterparty sector, counterparty country and instrument type," the report said. 

Regulators must be able to jointly analyze the balance sheets of many banks to determine exposures to particular asset classes or concentrations. 

Under the FDR Framework, this blog has described why it is important that not only the regulators have access to this data, but also market participants.


David Cameron, Mervyn King and the Economist magazine have recently made the case for sharing this data with market participants.  Specifically, they want the data disclosed to eliminate fear borne contagion.  With access to the data, the market can determine who is solvent and who is not and adjust appropriately.

The Treatment for Financial Contagion is Disclosure

The Economist magazine ran an interesting article on the Greek debt situation and contagion.  It supports this blog's conclusion that the only sure cure for financial contagion is disclosure.

CONTAGIOUS diseases are usually dealt with by isolating the patient, lest he infect anyone else, and then by trying to treat the illness. Isolation is not always possible with physical ailments; with financial ills, it almost never is.

Actually, the equivalent of isolation can be achieved if there is disclosure of all useful, relevant information in an appropriate, timely manner.

Under the FDR Framework, investors know that under the principle of caveat emptor (buyer beware) they are the beneficiaries of any gains and the bearer of any losses.  As a result, investors have an incentive to use disclosure to adjust their exposure to financial risk.  It is the adjustment of their exposure that creates the financial equivalent of isolation.

With the Greek government perilously close to default, investors and policymakers are wondering whether European banks have caught something nasty. Many are comparing the choices facing the euro zone and the IMF to those faced by the American Treasury and the Federal Reserve in the days before Lehman Brothers collapsed in 2008, causing a seizure in the global financial system. 

The comparison is not exact. The Greek government owes more than €300 billion ($435 billion); Lehman’s balance-sheet before its failure was $613 billion. The chief difference, though, lies in complexity rather than in scale. Wall Street’s fourth-largest investment bank was at the centre of tens of thousands of interconnected trades that were hidden from view and difficult to value. Its fall caused panic because others in the markets had no way of knowing who the counterparties to its trades were and whether Lehman owed them so much that they too might fail.  

That ought not to be true of Greece. It has far fewer creditors: two-thirds of its debt is probably held by about 30 institutions. And whereas Lehman’s exposures were hidden from public view, Greece’s are largely out in the open and are also reasonably easy to value. The more light has been shone into the dark vaults of banks holding Greek government debt over the past year, the more markets have been reassured that few, if any, foreign banks are dangerously exposed.

The chief difference lies in disclosure and not complexity.  Lehman's exposures were hidden from public view and therefore no one knew who was solvent and who was insolvent.

There is much more information available about the exposure to Greek government debt.  However, regulators and the markets still do not know where the real exposure to losses on Greek debt lies.  David Cameron and Mervyn King have said that banks should be required to publicly disclose their exposure, including their hedges.

... Holdings of bonds do not tell the full story of banks’ exposure to Greek government debt. By buying credit-default swaps (CDSs), which are essentially insurance policies against a default, banks are likely to have shifted some risk to insurers or investment funds that are less important to the financial system as a whole. Some banks, however, will have sold CDSs. 

Across the entire financial system these CDS exposures largely net off, Barclays reckons, and collateral and margin-calls should have reduced the outstanding exposures to relatively small amounts. However, not everyone will end up with a net position close to zero. It is reasonable to suppose that there would be some large losses (and some large gains) on CDS contracts if Greece stopped paying its bills. Quite where these would emerge is causing some worry in markets. 

Bank regulators have made progress in publishing information on exposures. Banks themselves have been giving quarterly or half-yearly updates on their ownership of Greek bonds. But weaker banks have been the most reluctant to come clean: public data on their holdings are a year out of date. Were panic to seize the banking system, regulators could do much to restore calm by releasing information they have collected in the past three months as part of “stress tests” of Europe’s banks. 

The Economist recognizes two themes that this blog has been discussing under the FDR Framework.

First, disclosure stabilizes the financial markets.  With disclosure, market participants can adjust their exposures based on facts.  Without disclosure, market participants adjust their exposure based on fear.

Second, the regulators' monopoly on the useful, relevant information is a source of financial market instability.  If they did not have a monopoly on this information, then they would have nothing to release that would calm the markets.

... The hard numbers alone thus suggest that a Greek default would do little lasting harm to the rest of Europe’s financial system. Yet investors act on fear as well as figures. 

What is more worrying for Europe’s policymakers is the thought that Greece’s affliction would spread not just to foreign banks but to foreign governments. Just as Lehman’s collapse told investors that a Wall Street bank could fail, a Greek default would tell them that a Western government could renege on its debts: Greece would be the first developed country to default for 60 years. 

This is why disclosure should not be limited.  The only way to understand the impact of restructuring the debt of Ireland, Portugal, Spain and maybe Italy is to know what the exposures are and to what extent the losses have already been recognized in the financial system.

... Another cause for unease is European banks’ reliance on short-term wholesale financing from outside the continent. Fitch, a ratings agency, reckons that roughly half the cash entrusted to big American money-market funds is lent on to European banks. This is skittish money that can be gone in a trice. 

Banks in vulnerable countries have already found money-market funding harder to come by, or at least dearer.

This is the modern day run on the bank.  When the portfolio managers of money-market funds do not know if a bank is solvent or not, they reduce their exposure as they are not compensated for taking solvency risk.

Worse than jitters in the money markets would be a loss of faith by depositors. The Bank of Greece thinks that in the first four months of the year Greek banks lost deposits at the rate of €2.8 billion a month. 

Greece is encountering the same run on the bank deposits that the Irish banking system is experiencing. Depositors do not know if a) the bank is solvent or b) the government has the resources to support any guarantees of their deposits.  Faced with this situation, depositors have an incentive to withdraw their money and try to find a safer place to put it.

David Cameron Seconds Mervyn King's Call for disclosure

In a Telegraph article,  David Cameron seconded Mervyn King and said banks must disclose their Greek exposure.

[He] urged European leaders to force their banks to disclose their exposure to Greek debt as fears over the sovereign debt crisis disrupted markets again.

The Prime Minister also called for national governments to ensure that banks are properly capitalised and prepared for more shocks. 

Speaking at the European Union leaders' summit in Brussels, Mr Cameron said: "All European countries need to use the time that we have to strengthen banks and bank balance sheets and make sure they are meeting all of the requirements so that they are strong and can withstand any problems and difficulties." 

He added: "Banks right across Europe that have exposure to Greece... every bank needs to make absolutely clear what its exposure is."

As regular readers of this blog know, it is not just the banks' current exposure to Greece that needs to be disclosed, but also the rest of their current asset and liability-level data.

It is only with this data that market participants can determine who is solvent and who is not solvent.

It is only with this data that market participants can examine the various ways that contagion could possibly spread through the financial system.

It is only after doing this type of analysis that market participants can adjust both the price and amount of their exposures to reflect the risk of these exposures.

It is only after this adjustment has been made that contagion is controlled and regulators do not have to worry about which market participants are absorbing the losses.

It is clear from Mr. Cameron's statement that he understands the benefits of disclosure under the FDR Framework.

US Covered Bond Act of 2011: Wall Street's next opaque security

This past week, a HousingWire article reported that the House Financial Services Committee had voted for the US Covered Bond Act of 2011.

As discussed in an earlier post, this Act is fundamentally flawed as losses on the collateral backing covered bonds are ultimately covered by the US Treasury.  Therefore, as it is currently written, the Act should never be passed and signed into law.

The earlier post describes how adding disclosure on the current performance of the assets in the covered pool would protect investors and the US Treasury.  Europe, in particular the ECB, must think this is a good idea because it is currently considering this type of disclosure for covered bonds that are eligible to pledge as collateral.

Unfortunately, Congress elected not to include disclosure on the current performance of the assets in the covered pool into the Act.

The House Financial Services Committee voted 44-7 in favor of a bill to establish a regulatory framework for a U.S. covered bond market. 

...The bill would allow a U.S. covered bond market to pool residential and commercial mortgages into debt securities. Unlike the European system, however, the bill would include auto loans, credit cards, student loans and government-guaranteed small business loans.

So the pre-credit crisis securitization market could be repackaged as covered bonds.

Issuers of covered bonds are on the hook against losses.

In theory, this statement is true.  But what happens if the issuer goes bankrupt?  Remember, the issuer is a bank.  Are investors in covered bonds still protected against losses on the underlying collateral?  The Act says yes.  As a result, the taxpayer is on the hook when the FDIC steps in to take over the issuer.

Payment to investors is via swap agreements and are meant to cover the scheduled payments should the issuer become insolvent or there is a discrepancy in timing, where the interest being paid on the loans does not align with payments due to investors. 

A third party trustee represents covered bondholders. Adding these layers of additional recourse, as it compares to securitization, makes it pricier by comparison. 

In the Act, the swap agreements smooth out the cash flow.  They do not guarantee the payments should the issuer become insolvent.

... The housing and mortgage industry supported the bill, including the National Association of Realtors, the Mortgage Bankers Association and the Securities Industry and Financial Markets Association.

Since it is good for Wall Street, Wall Street's trade associations support it.

The committee passed an amendment introduced by Rep. John Campbell (R-Calif.). According to the amendment, regulators will set a maximum amount of outstanding covered bonds as a percentage of an issuer's total assets. The issuer's regulator will then review that cap for possible adjustments every quarter. 

"The number 4% has been thrown around," Campbell said. 

At 4% of total assets, an issuer can issue covered bonds equal to its total loss absorbing capital required under Basel III.

The committee denied two amendments introduced by Rep. Barney Frank (D-Mass.) that would grant the Federal Deposit Insurance Corp. powers to establish a covered bond oversight program and veto power for any program submitted by an eligible issuer. Frank said the FDIC raised concerns the covered bond program would put the still recovering deposit insurance fund at risk. 

"The FDIC has concerns not with the concept but with the extent to which the FDIC will be protected," Frank said. 

Garrett said such oversight would subject investors to prepayment risks he said do not belong in the definition of a working covered bond market. Lawmakers continued work to determine to what extent the FDIC would play in the new system. 

"Neither of us want to see the FDIC as a government backstop," Garrett said. 

"If the government is going to provide a guarantee let's make it clear and explicit not some backdoor method," Campbell added.

Clearly, Congress recognizes that the US Treasury through the FDIC is backstopping covered bonds issued under the Covered Bond Act of 2011.  

The question is, do the US taxpayers get any benefit from guaranteeing the losses?

As HousingWire reported in a separate article on the covered bond legislation, the US taxpayers do not get any benefit from guaranteeing the losses.

"The covered bond legislation now pending before the Garrett subcommittee in the House is all about Wall Street and does nothing to increase the availability of housing credit," said market analyst Christopher Whalen with Institutional Risk Analytics. 

"The bill lacks basic protections for investors in bonds and for the FDIC, which would be fully exposed to losses from covered bonds under the Garrett proposal," he said. 

"Most banks today have more funding than can be employed. (Covered bonds) do not add any new, non-bank funding leverage to the system, which is the key objective if we are to avoid a catastrophe in housing."

Mervyn King and the Financial Policy Committee embrace the FDR Framework [update]

The Telegraph article on Mervyn King and the initial report of the Financial Policy Committee appears to indicate that the FPC embraces the FDR Framework.

"Sovereign and banking strains are the most material and immediate threat," the committee, chaired by the Bank of England governor, said in its inaugural report. 

The committee called for banks to improve their disclosure of sovereign and bank sector exposure and also warned that authorities needed to keep a closer eye on the explosion of "opaque" products such as exchange traded funds (ETFs), which banks increasingly use to raise funds. 

Regular readers know that the FDR Framework requires improving disclosure by banks of their sovereign and bank sector exposure.  Specifically, the FDR Framework requires them to disclose to market participants all their current asset and liability-level exposure.  It is only with this data that market participants can address the issues of individual bank solvency and the risk of contagion.

... Speaking at a news conference hours later, Sir Mervyn King said uncertainty over exposure to countries such as Greece could lead to a "crisis of confidence", which posed a bigger risk than direct exposure. 

"There is always uncertainty about the scale of exposures, which counter-parties out there are the ones which are heavily exposed," he said. 

"That uncertainty can lead at various points for funders of banks...to draw back and there can be a crisis of confidence in sentiment in which people say 'I simply don't understand the complexity of the interconnectedness of these exposures and I just won't take the risk of lending'. And that is the bigger risk, I think." 

Without disclosure, there is nothing to anchor investors or regulators.  It becomes a matter of psychology.  Do the investors believe the banks are solvent or not.  If not, then the banks are subject to an old fashion bank run which the regulators will attempt to head off.

With disclosure, investors and regulators can actually determine if the banks are solvent.

Mr King also said that the ongoing crisis in Greece was not a matter of liquidity, but solvency, and a build-up of large amounts of debt: 

"Right through this crisis...an awful lot of people wanted to believe that this was a crisis of liquidity. It wasn't, it isn't. And until we accept that we will never find an answer to it. It was a crisis based on solvency or to be more precise, the build up of very large amounts of debt where concerns crept in on the ability of the borrowers to repay that debt," he said. 

The report came as EU leaders scramble to avert a Greek debt default that would send shockwaves through international markets. 

Mr. King has eloquently restated one of the central themes of this blog:  the financial markets froze when market participants could not answer the question of who is solvent and who is not.  This was also the finding of the Financial Crisis Inquiry Commission.

As Mr. King says, it is only when we accept that the issue is a question of solvency and the related issue of the ability of borrowers to repay their debt that we will find an answer.  When we do accept this, the answer we will find is the adoption and implementation of the FDR Framework.

Update:

Both the Guardian and Bloomberg expanded on the need for disclosure to address contagion concerns.

According to the Guardian article,

The crisis enveloping the eurozone is a "mess" that poses the "most serious and immediate" risk to the UK banking system, Sir Mervyn King warned on Friday as he called for banks to provide more information on their exposures in the region. 

In his new role of chairman of the financial policy committee (FPC), the new "guardian of the resilience of the UK financial system", King also warned that banks may be providing a "misleading picture of their financial health" if they were not making big enough provisions for borrowers having difficulty repaying loans. So-called forbearance has taken place in up to 12% of mortgages, including 30-80% in the commercial property sector.

This is the reason that under the FDR Framework, banks have to provide their current asset level data.  Market participants can analyze this data to determine if the provisions are large enough.

... UK banks' exposure to Greece directly was "remarkably small", he said, but he warned that the bigger risk was a "crisis of confidence". 

"There is always uncertainty about the scale of exposures... which counter-parties out there are the ones which are heavily exposed," he said. "That uncertainty can lead at various points for funders of banks... to draw back, and there can be a crisis of confidence in sentiment." 

He said more data was needed about exposures to allay any unnecessary concerns. 

Mr. King has identified why the FDR Framework restores and maintains confidence in the financial system.  With the data, market participants know what is happening.

According to the Bloomberg article,

“Direct U.K. bank exposures to those economies are limited,” King said, referring to euro members whose borrowing costs have soared as Greece tries to stave off a default. “But experience has shown that contagion can spread through financial markets, especially when there is uncertainty about the precise location of exposures.” 

The FPC said strains in the euro region pose a risk to Britain’s lenders because U.K. banks’ combined claims on France and Germany account for about 130 percent of their so-called core Tier 1 capital, with close to half of that representing claims on banks. 

“Any escalation of stresses could also be transmitted via interconnected global markets, including via the U.S., leading to a tightening of bank funding conditions,” the panel said. “Such contagion could be amplified if bank creditors were unsure about the resilience of their counterparties.” 

The panel has identified an important benefit of implementing the FDR Framework.  With the disclosure required under the FDR Framework, bank creditors can determine which banks are solvent and which are not.  As a result, the risks of contagion are minimized.

Hector Sants asks for a new bank supervision model, the FDR Framework provides one

In all the commotion over whether or not Greece will default, Hector Sants', the future chief executive of the UK's Prudential Regulation Authority, speech on how the PRA would prevent future financial crisis was not given adequate attention.

This speech is very important because Mr. Sants asks for help in rethinking the bank supervision model.

Allow me to offer the FDR Framework's bank supervision model.  Under this framework, bank supervision harnesses the market to protect the safety and soundness of the financial system.

As regular readers know, under the FDR Framework, it is the responsibility of the regulators to ensure that all market participants (including the regulators) have access to all the useful, relevant data in an appropriate, timely manner (and yes, using 21st century information technology this is easily done).  In the case of financial institutions, this useful, relevant data is their current asset and liability-level data.

Making this data available to all market participants dramatically improves the lot of a bank supervisor.

First, it brings market discipline to financial institutions.

Previously, since the regulators had a monopoly on all the useful, relevant data, it was impossible for market participants to exert market discipline by changing the pricing and amount of their exposure based on the riskiness of the financial institution.  As a result, the stability of the financial markets was dependent on the regulators properly analyzing this data and taking the appropriate steps to discipline the financial institutions.

Under the FDR Framework, market participants, including competitors, have an incentive to use this data because they know that under the practice of caveat emptor (buyer beware) they are responsible for any losses that result from their exposure to any financial institution.

As a result, the stability of the financial markets is now dependent on market participants adjusting the pricing and amount of their exposure to exert market discipline.  To the extent that a bonehead management team misses the signal, it is up to the supervisor to point out the obvious:  the market thinks you are taking on too much risk, either cut back your risk or raise more equity.

Second, it brings many more eyes looking at the data to see if something is wrong.  Instead of substituting the supervisor's judgement for the market's, supervisors can now turn to the market and its participants.  After all, who would be better at analyzing the current asset and liability-level data for RBS, bank regulators or firms like Barclays, HSBC and JP Morgan?

His speech raises a number of issue that the FDR Framework's bank supervision model addresses.

... The purpose of this event is to lay out our views of the supervisory regime required to deliver the government’s vision of prudential regulation for banks. 

To facilitate both this conference and subsequent discussions, we published today a document which outlines our initial thinking on this issue. It is not a formal consultation document, but we do invite you to engage with us in dialogue which will help us as we proceed to the detailed design and implementation stage. 

Thanks for the invitation to provide some feedback on your initial thinking and introduce you to bank supervision under the FDR Framework.

... It is vital that we take this opportunity to go to back to first principles. We need both to recognise why we supervise and have a clear, coherent and transparent methodology for that supervision. 

... Turning first, therefore, to the purpose of the PRA. That purpose should rightly be determined by Parliament, and the government’s intentions are clear. The purpose is:

‘to contribute to the promotion of the stability of the UK financial system. It will have a single objective – to promote the safety and soundness of regulated firms – and will meet this objective primarily by seeking to minimise any adverse effects of firm failure on the UK financial system and by ensuring that firms carry on their business in a way that avoids adverse effects on the system.’ 

This purpose is fundamentally different from that of previous regulatory regimes and will lead to a fundamentally different model of supervision to that which was in use before the financial crisis. 

As discussed above, the disclosure of all the useful, relevant data fundamentally changes the model of supervision because it allows the supervisors to harness the market to promote stability, safety and soundness.

These words I believe are straightforward, but I would like to highlight four points: 

• Firstly, they make it clear that the purpose of the PRA is to focus on the stability of the system overall, albeit through the mechanism of the supervision of individual firms. This will require close coordination with the new Financial Policy Committee (FPC), whose role it will be to manage the risks in the system as a whole. The PRA will be a key contributor to the information and analysis on which the FPC will base its judgements, recognising the determination of the intervention tools with respect to system-wide risks rests with the committee, not the PRA.  

• Secondly, in the light of this objective, there has been much debate as to whether a regulator whose purpose is to promote financial stability could do so by solely minimising the consequence of firm failures, or whether such a regulator has an obligation to minimise the risk of individual firms failing in the first place. 

In a world without uncertainty, it might well be a justifiable theoretical position to state that the regulator should not be obliged to seek to reduce the risk of firm failure. However, in practice the inherent uncertainty and complexity of both firms and the overall system mean that this is not a realistic objective. The PRA will thus always seek to reduce the risk of individual firm failure, but will be giving particular focus to ensuring that if failure occurs, it does so in an orderly manner. 

Furthermore, it needs to be recognised that international regulatory standards are explicit with regard to major firms and the need to maintain a baseline of supervisory oversight, with the intention of reducing the probability of failure. 

The FDR Framework minimises both the consequences of firms failing and the risk of an individual firm failing in the first place.

As discussed above, market participants who are at risk of loss from their exposure to an individual firm have an incentive to exert discipline on the firm to keep it from failing.  It is a fundamental principle of finance that as investment risk increases, so too does the rate of return required by investors.

As the return to hold a financial institution's debt and equity increases relative to its peers, it is a easily understood signal that the institution is becoming riskier.  Either management will voluntarily react by lowering the financial institution's risk profile or supervisors will need to step in.

Despite this, some financial institutions with truly bonehead management will fail.  Fortunately, this is not a source of financial instability as investors have had a chance to analyze the useful, relevant data and adjust their exposure to levels where they can afford the resulting losses.

• Thirdly, the obligation of baseline supervision should not detract from a key strand of the PRA’s approach, namely to ensure that the role of regulators is to complement and promote the disciplines of the marketplace, not to substitute for them. The ultimate responsibility for managing a firm prudently rests with its management, board and shareholders.

By definition, bank supervision under the FDR Framework complements and promotes the disciplines of the marketplace and does not substitute for them (with the exception for bonehead management).

• Finally, the consequence of this approach undoubtedly means that the PRA needs to recognise that if firms fail, society will rightly ask whether that was a regulatory failure. 

Conversely, society needs to recognise that the PRA should not be held accountable for all failures. Failure should be seen as a necessary element of a healthy, innovative system. 

Furthermore, as I have just said, we need to consistently remind ourselves that the primary obligation to ensure a firm is prudently managed within its statutory obligations lies with the management, and in particular the board, not with the regulator. 

Under the FDR Framework, failure is seen as a necessary element of a healthy, innovative system.

Moving now to how we do it. A supervisor effectively has three buckets of tools: 

• rules and regulations, primarily in the form of capital, liquidity, leverage and governance standards; 

• resolution plans; and 

• supervisory oversight of management actions and strategies, including recovery plans. 

The effectiveness of each of these tools is amplified when combined with market discipline under the FDR Framework.

There is a view that says if there is sufficient capital and liquidity buffers, then the probability of failure could be all but eradicated, which would render the concept of supervisory interventions over and above compliance with those standards irrelevant. 

Theoretical studies can demonstrate what that number might be, but the reality is, for a number of practical reasons, such a level of capital is not going to be achieved.

True, we are not going to set capital equal to 100% of assets.

There is also a view at the other end of the spectrum which says, if we could be absolutely sure we could resolve all firms without any material cost to the system, then we need neither capital nor supervisory oversight. This perfect world of resolution is not likely to be achieved and indeed at present we seem some years off being able to offer even reasonable certainty about being able to resolve a complex cross-border group.

This is a very important point.  Simply put, we are a long ways from being able to resolve a Goldman Sachs.

Given these realities, the PRA supervisory approach will be to deploy all three tools.... Furthermore and critically, this supervisory approach, to be effective, will need to be based on judgement and a forward-looking assessment of risk. 

One of the strengths of the FDR Framework is that it harnesses the market to make a forward-looking assessment of risk.  Naturally, the market will have different views on this forward-looking assessment.

Bank supervision under the FDR Framework benefits from being able to examine these different views and their implications.

In designing our supervisory approach, as well as going back to first principles, it is vital to ensure we have drawn on all lessons of the past. 

Bank failures occurred under the past supervisory regimes of both the Bank of England and the FSA. In designing the PRA’s approach, we have taken into account the lessons from both periods of supervision. 

Let me briefly summarise those principal supervisory lessons. 

The central regulatory failing in the period of FSA supervision was the inadequate standards for capital and liquidity. These failings have been addressed in the short term by the FSA’s interim capital and liquidity regimes, while the long-term solution is the responsibility of the Basel Committee. I believe that if we had had effective capital, liquidity and leverage standards in place in 2005, then history would have been significantly different.

This blog has spent considerable time debunking the myth of capital and liquidity standards.  Higher standards would not have prevented the banks from holding toxic securities.  In fact, had higher standards been in place, it is entirely possible that the credit crisis would have been even worse.  For example, Merrill Lynch might have chosen to own more toxic securities to enhance its return on equity had there been a higher capital ratio.

Clearly, the conclusion from this supervisory lesson is not the need for higher capital and liquidity standards.  The conclusion is the need for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.

Had this been in place in 2005, there would have been no such thing as opaque, toxic securities.  While there would have been securities holding sub-prime mortgages, the market could have more accurately priced these because it could have evaluated the true risk of the underlying collateral.  Similarly, the market would have exerted discipline on Merrill Lynch when it saw that its risk was increasing from an accumulation of high risk securities.

However, in addition to the issue of over-reliance on the then capital and liquidity standards, we also need to recognise that the FSA’s supervisory approach rested on another presumption which has proved to be false; namely that senior management judgement and market discipline should not be questioned by supervisors.

Clearly, supervision should not rely on the judgement of senior management about their own firm.

The presumption that supervisors should not question market discipline has not been proven false.  As I discussed above, since the regulators had a monopoly on all the useful, relevant data, the markets were not able to provide market discipline.

Under the FDR Framework, the markets will, for the first time, be able to exert market discipline on financial institutions.  In addition, supervisors are encouraged to ask for senior management's judgement when it concerns one of their competitors who they have an exposure to.

... The PRA will take a different approach. It will, as has already been said in the Treasury’s Consultation Document, build on the post-crisis approach adopted by the FSA, which focuses on outcomes and thus can be termed ‘judgement-based’. 

Central to this supervisory model is the presumption that regulators cannot rely on the judgement of the management of the firms they supervise, and must take their own view formed from their own analysis about the significant issues which affect the safety and soundness of the firm. Furthermore, where that judgement differs from the firm’s management, the regulator must act. 

The firm failures in the period of supervision by the Bank of England throw light on how these regulatory judgements should be reached. In particular, they demonstrate the importance of basing those interventions on thorough analysis, particularly on the firm’s business model, capital and funding strategy. 

Along with the importance of ‘close intensive engagement’ with both the management of the firm being supervised and informed third parties, such as auditors and market participants, they also demonstrate the need for effective global coordination, particularly where the UK is not the home supervisor. 

It bears repeating that under the FDR Framework, supervisors will have many more informed third parties to talk with in analyzing any financial institution.  Many of these third parties will be acting on their analysis of the financial institution.

.... In order to make effective judgements, the PRA must equip itself with: 

• high quality, experienced supervisors who are willing to make difficult judgements and command the respect of the firms they supervise;
• high quality analysis of the critical risks in relation to a firm’s soundness, notably: its business model, particularly in relation to risk and profitability, its
• capital model and its funding model;
• high quality analysis of the effectiveness of a firm’s governance model and the competency of its key executives;
• a clear understanding of the firm’s culture and the implications of that culture on its risk profile;
• a clear understanding of its recovery and resolution capability;
• a clear understanding of the consequence of the failure of that institution on the wider economic system; and
• a clear understanding of informed third parties’ views of the risks that a firm is running.  

... The effectiveness of the PRA will rest heavily on its ability to deliver a judgement-based model. This raises the question of how will we ensure we equip the PRA to make the best possible decisions. 

A key factor in this goal will be ensuring we have individuals with the optimal experience and technical ability.

A feature of the FDR Framework is that it makes it much easier to find qualified supervisors.

... The challenge of delivering high-quality judgments will, however, not be entirely solved by the greater involvement of the senior executive team. The reality is, in order to make a credible and effective judgement about a firm, indepth analysis is required, along with the perspective that comes with continuity of oversight and understanding of that firm’s business model, management and culture. 

That skill set is one which requires a supervisor who is dedicated to an individual firm. The requirement for dedicated individual supervisors for each major firm will inevitably mean that more than a handful of senior executives are needed.   

The new model will not have solved the problem that such supervisors have overall compensation levels which are multiples less than the comparable role in a major bank or professional services firm. The economic reality is that good staff are hard to attract and retain.

By harnessing the market, the PRA effectively "hires" the needed senior executives without having to put them on its own staff.  As I discussed above, each competitor has an incentive to analyze its peers. This analysis will be overseen by exactly the type of individual that the PRA would want to hire as a senior executive (and this is before we get to all the credit and equity market analysts).

By providing the market with all the useful, relevant data, the PRA is not hiring a few senior executives, it is effectively hiring senior executives at every financial institution.  What the PRA needs from its bank supervisors is the ability to talk with and understand the analysis and conclusions of these executives.

The other challenge I would like to highlight is technology and data. If the envisaged small high-quality teams of supervisors are to make the best possible judgements, they will need a greater level of technology support and better quality data than historically supervisors have had. Achieving this goal will be a non trivial exercise. 

Mr. Sants, I would be happy to help you with this non trivial exercise.  You can get my number from the Bank of England's Andrew Haldane.

Bank capital's moment of truth [Update]

The NY Times' Joe Nocera ran an interesting column touting the virtues of bank capital.

What made the column fascinating is how it highlighted how little would be accomplished by raising bank capital requirements.  This is particularly true when compared to the alternative of providing market participants with access to current asset and liability-level data in an appropriate, timely manner.

Capital matters. Let me put that another way. The current fight over additional capital requirements for the banking industry, eye-glazing though it is, also happens to be the most important reform moment since the financial crisis broke out three years ago. More important than the wrangling over Dodd-Frank. More important than the ongoing effort to regulate derivatives. More important even than the jousting over the new Consumer Financial Protection Bureau.

Actually, requiring banks to disclose their current asset and liability-level data in an appropriate, timely manner would be the most important reform.  The fight over additional capital requirements is simply so that regulators can say they did something, even if this something is knowably of de minimus value.

As previously discussed on this blog, bank capital does not answer the question of who is solvent and who is not solvent.  Until that question can be answered, the financial system is prone to instability and taxpayers are on the hook for bailing out the banks.

The importance of being able to answer the solvency question cannot be over-stated.  The Financial Crisis Inquiry Commission determined that the interbank loan market froze because banks could not determine who was solvent and who was not.

Is the interbank loan market about to freeze in Europe again?  The Telegraph reported that Barclays and Standard Charter are reducing their unsecured loans to the eurozone banks because they are concerned with the solvency of these banks.

If investment banks like Merrill Lynch had had adequate capital requirements, they would not have been able to pile on so much disastrous debt.

Actually, higher capital requirements may in fact have made the situation worse.

With a higher capital requirement, Merrill would have been forced to hold fewer assets.  However, it is entirely possible that to offset the decline in income from holding fewer assets, Merrill would have changed the composition of its assets by shedding low risk securities, like government bonds, and holding much more of the disastrous debt in an attempt to generate a higher return on capital.

Merrill would have been able to do this because the individual assets on its balance sheet are hidden from the marketplace.

... If the big banks had not been able to so easily game their capital requirements, they might not have needed taxpayer bailouts.

Again, there is no direct connection between the ability to easily game the capital requirements and the need for a taxpayer bailout.  In fact, these two are not linked.

A bank can be gaming the capital requirements, aren't they all, and still be solvent and not in need of a taxpayer bailout.

A real capital cushion would have allowed the banks to absorb the losses instead of the taxpayers. That’s the role capital serves.

This is true in theory.  However, until banks are required to disclose their current asset and liability-level data, it is not true in practice.

The practical reason for bailing out the banks is the interconnectedness of the financial system.  Increasing bank capital to 20% of risk adjusted assets does not guarantee that the financial system will not collapse from contagion.  Without this guarantee, no government will gamble on the system not collapsing.

As this blog has discussed repeatedly, with disclosure of financial institution's current asset and liability-level data, it becomes possible to use bank capital to absorb losses and not bailout the banks.

Each bank has an incentive to use its competitors' data to determine the price and amount of its exposure to its competitors.  This exposure to its competitors will also reflect the bank's capacity to absorb losses.

In short, Jamie Dimon is not going to bet JP Morgan's existence on his dumbest competitor.

Adequate capital hides a plethora of sins. And because, by definition, it forces banks to use less debt, it can also prevent sins from being committed in the first place.

No. No. No.  Lack of disclosure hides a plethora of sins.  It is disclosure that prevents sins from being committed in the first place.

Regular readers of this blog know that with current asset and liability-level disclosure would come market discipline.

It is market discipline that prevents banks from taking on too much risk.  With market discipline, if a bank increases its risk profile, it can be expected to incur a higher cost of capital.  It is a fundamental principle of finance that investors need a higher rate of return when risk increases.  As the risk of insolvency increases, so will the return required by investors.  This will be reflected in a lower stock price.  Bank management, unless it is populated by boneheads, tends to be sensitive to the bank's stock price.

“There is no credible way to get rid of bailouts except with capital,” says Anat Admati, a finance professor at Stanford Business School and a leading voice for higher capital requirements.

Actually, there is a much more credible way to get rid of bailouts.  That way would be to combine current asset and liability-level disclosure with a simple solvency rule.

Financial markets are very good at valuing all the assets (loans and securities) and liabilities on a bank's balance sheet.  However, they can only do so if all the current assets and liability-level data is disclosed.

With this disclosure, financial market participants would have an incentive to analyze the solvency of each financial institution.  This is the basis for setting the price and amount of their exposure.

According to the Financial Crisis Inquiry Commission, a bank is solvent if the market value of its assets exceeds the book value of its liabilities.

Now for the simple solvency rule.  Regulators step in and resolve any financial institution where the amount by which a financial institution is solvent is less than 3% of the total market value of its assets.

The combination of disclosure and a solvency rule should virtually eliminate the possibility of a bailout.  Under this solution, the regulators have to step in while the financial institution still has value.

.... A few days ago, The Wall Street Journal wrote an editorial applauding the recent suggestion byDaniel Tarullo, a Federal Reserve governor, that the biggest banks hold as much as 14 percent of assets in capital....

I should point out that the proposed international standards — Basel III, as they’re called, which are still being negotiated by regulators around the globe — would require banks to hew to capital requirements of only 7 percent, not 14 percent. 

They are also talking about adding capital surcharges of up to 3 percent, on a sliding scale, to the 30 largest, most systemically important institutions worldwide, meaning that JPMorgan Chase, for instance, would have capital requirements of 10 percent. 

There are many experts, including Admati and, one suspects, Tarullo himself, who think this is still too low. The Basel committee has already agreed, somewhat absurdly, to delay the implementation of the requirements until 2019. (Good thing the world’s banks aren’t going to have any big problems between now and then!) 

And because the Basel standards, whatever their final form, must still be enacted and enforced by individual country regulators, there is no guarantee that every country will agree to them. 

Here are two more reasons for adopting disclosure of current asset and liability-level data.  First, it can be done well before 2019.  Second, it is the sort of standard that every country can agree to as disclosure does not negatively impact the competitiveness of their banks.

... Indeed, every argument put forth by the big banks and their Congressional spokesmen against higher capital requirements have been demolished by Admati as well as Simon Johnson, the banking expert, whose devastating rebuttal can be found in The New York Times’s Economix blog. But the idea that they will make U.S. banks less competitive with European banks deserves particular scorn. 

European banks, to be sure, have fought fiercely against higher capital requirements. It’s not really because they hope to get a leg up on the rest of the world, though. It is because these banks are in far worse shape than the banks in other parts of the world; they can’t afford higher capital requirements. If Europe began insisting that its banks begin holding enough capital to cushion against all the risk on their books — starting with Greek debt — the truth would be out: Their insolvency would suddenly be apparent. If Europe wants to keep kicking the can, by turning its back on the surest measure to increase the safety of its financial system, why on earth would we want to go along? 

On what basis does Mr. Nocera know that US banks are solvent?  If European banks are insolvent, is that also not true of US banks who are exposed to European banks?  What about the US banks that are exposed to the US banks who are exposed to European banks?

[Update:  A Telegraph article on Chairman Bernanke's press conference described what he knows about the answer to the solvency question:

Mr Bernanke said that he had instructed America's banks to stress test themselves to see the effects of a Greek default. The direct exposure of such institutions to so-called "peripheral countries" in Europe was small, he said. 

However, he added that "a disorderly default would roil global financial markets" and to that extent "the impact on America could be quite significant."

Translation: depending on who is and who is not solvent, he thinks the eurozone debt problem could be

• a bump in the road - the banks have either hedged their positon or have adequate reserves marking their exposures to market;
• or the financial crisis that developed countries cannot afford as contagion causes unexpected losses.]

I began this blog by observing that the fight over additional capital is much ado about nothing.

In the absence of disclosure, neither Mr. Nocera nor anyone else knows the answer to which banks are solvent and which banks are not.  So long as no one knows, taxpayer bailouts will continue into the distant future so long as governments prudently choose not to risk the collapse of their financial systems.

That is why the most important reform is requiring banks to provide all market participants with their current asset and liability-level data in an appropriate, timely manner.  It is the only way to answer the issue of solvency.