Monday, October 31, 2011

MF Global makes the case for enforcing FDR Framework disclosures

As MF Global files for bankruptcy protection, it makes the case for enforcing the current asset detail disclosure requirements set forth under the FDR Framework.

Quite simply, had market participants been able to see in real time the accumulation of the proprietary bet on European sovereign debt, they would have been in a position to exert discipline to stop it.

They would have exerted this discipline by a) moving their trading to another firm, b) raising the cost of and lowering the availability of funds to the firm and c) probably the discipline with the biggest impact, hammered the stock price.

MF Global's blowing up also confirms that the global financial regulators are a source of financial instability as they continue to protect their information monopoly.  The regulators were in a position to see the trades and failed to convey the changing risk profile of MF Global to market participants.


According to a NY Times' Dealbook article, federal investigators have found that hundreds of millions of dollars of customer money is missing.

For readers who are unfamiliar with how Wall Street should work, customer funds are suppose to be kept separate from the firm's funds.  That way, if something happens to the firm, nothing happens to the customers.

This article suggests that is not what happened at MF Global.

If in fact, MF Global used customer funds to cover its losses, it is even more reason that financial institutions should be required to disclose their assets, liabilities and off-balance sheet exposures at the end of each day.

That way, customers can protect themselves and move to other firms at the first sign of risk taking by the financial institution.
Federal regulators have discovered that hundreds of millions of dollars in customer money has gone missing from MF Global in recent days, prompting an investigation into the brokerage firm, which is run by Jon S. Corzine, the former New Jersey governor, several people briefed on the matter said on Monday. 
The recognition that money was missing scuttled at the 11th hour an agreement to sell a major part of MF Global to a rival brokerage firm. MF Global had staked its survival on completing the deal. Instead, the New York-based firm filed for bankruptcy on Monday. 
Regulators are examining whether MF Global diverted some customer funds to support its own trades as the firm teetered on the brink of collapse. 
The discovery that money could not be located might simply reflect sloppy internal controls at MF Global. It is still unclear where the money went. At first, as much as $950 million was believed to be missing, but as the firm sorted through its bankruptcy, that figure fell to less than $700 million by late Monday, the people briefed on the matter said. Additional funds are expected to trickle in over the coming days. 
But the investigation, which is in its earliest stages, may uncover something more intentional and troubling. 
In any case, the unaccounted-for cash could violate a fundamental tenet of Wall Street regulation: Customers’ funds must be kept separate from company money. One of the basic duties of any brokerage firm is to keep track of customer accounts on a daily basis.

Wall Street's Opacity Protection Team meets Financial Watch

A Der Spiegel article discusses the formation of a new organization, Financial Watch, to battle Wall Street's Opacity Protection Team and its army of lobbyists.

According to its website,

Finance Watch is a public interest association dedicated to making finance work for the good of society. 
Our mission is to strengthen the voice of society in the reform of financial regulation by conducting citizen advocacy and presenting public interest arguments to lawmakers and the public as a counterweight to the private interest lobbying of the financial industry. 
Finance Watch works according to the following principles from its Articles of Association: 
 The financial industry plays an important role in allocating capital, coping with risk and providing financial services and this role has strong public interest implications. 
 The essential role of the financial system is to allocate capital to productive use in a transparent and sustainable manner.

Naturally, your humble blogger welcomes another voice calling for transparency.

The article tells a little more about the organization and the background of the individual who runs it.
..Indeed, some things will take getting used to in the offices Finance Watch has just leased near the building housing the European Parliament in Brussels. 
The project is backed by 40 European organizations, including unions, consumer-protection groups, foundations and think tanks. And it has a single goal: to make financial markets more transparent and influence future legislation so that it serves the needs of society rather than the financial industry. 
[Thierry] Philipponnat runs the organization, which will soon have a team of a dozen people. 
"When I heard about the project, I knew right away that it was the job for me," says the 50-year-old Frenchman. "As a former banker, I was immediately hooked." 
Philipponnat spent 20 years in the industry, which included positions at the Swiss bank UBS and the French bank BNP Paribas, where he was in charge of structured financial transactions, the highly complex products that have now come under sharp criticism for being both shady and highly risky. In his most recent position, Philipponnat was the global head of equity derivatives at the Euronext exchange in London....
Both areas of finance where Wall Street benefits from opacity.
Although efforts are underway worldwide to regulate the financial industry more rigorously, implementation is a different story, as evidenced by the work of the European Parliament in Brussels, where members are under constant observation and attack by an estimated 700 financial lobbyists. 
These professionals work around the clock to ensure that none of the new laws adversely affects the interests of banks, hedge funds, insurance companies and private equity firms. 
The lobbyists target EU politicians like Burkhard Balz, a member of Chancellor Angela Merkel's center-right Christian Democratic Union (CDU) from the northern German city of Hanover and a former banker himself. 
"In the runup to the regulation of hedge funds, I was constantly receiving requests for meetings with lobbyists," says Balz, who is now his party's deputy parliamentary spokesman on the European Parliament's Economic and Monetary Affairs Committee. 
Balz says he met with many of the lobbyists -- or at least until he felt that he was familiar with all of their arguments. But the lobbyists were unrelenting. "If I had said: 'I'm at the Stadthagen swimming pool with my son,' they would have said: 'No problem, we'll bring our trunks,'" he says, with some irritation. 
If you listen around in Brussels, you can hear about the opulent dinners members of parliament have in the city's most expensive restaurant during which representatives of a major bank will explain to them why their speculation in agricultural commodities has absolutely no effect on the world's food supply. Or about the amendments to existing legislation that are sent to members of parliament prewritten, and of the printed copies of voting lists that explain to the parliamentarians exactly which box to check
"There are 200 financial-industry lobbyists for every paragraph of the law," says Udo Bullman, a member of the European Parliament from Germany's center-left Social Democratic Party (SPD). 
This problem prompted members of the Economic and Monetary Affairs Committee to take an unusual step in June 2010, when they publicly called for the creation of "one (or more) non-governmental organization(s) capable of developing a counter-expertise on activities carried out on financial markets by the major operators … and to convey effectively this analysis to the media." 
The gulf between the capabilities of the financial industry and politicians' relatively poor understanding of the field "poses a danger to democracy," a group of parliamentarians wrote. 
Please re-read this point as even the EU lawmakers realize there is a problem.
The petition initially had 22 signatures, but soon more than 140 politicians in Brussels -- from all member countries and the entire range of political parties -- added their signatures. Eleven members donated money to fund a six-month exploratory phase and began searching for the right person to head the organization: Philipponnat. 
When he left the banking industry in 2006, Philipponnat had lost faith in the sense and purpose of his work. "Many financial transactions are useless at best," he says, "but, at worst, they have a massive impact on politics and society." He then made his way to Amnesty International and became the head of its French section.... 
Philipponnat will need both because his job comes with high expectations. Finance Watch still has a small budget of only €1 million ($1.4 million) derived from member dues and donations.  But the various EU institutions are now considering injecting another million euros into the venture. 
Even then, it will still be difficult to become a counterweight to what is probably the richest and most powerful economic sector of all, whose lobbyists are backed by an estimated €400 million in funding.
Actually, regulators are suppose to help as a counter-weight to the industry lobbyists.  After all, their primary mission is to prevent a financial crisis.
In mid-October, Philipponnat spoke for the first time as an expert at a hearing on whether to require European banks to have higher equity capital requirements. 
Last Sunday, when EU leaders meet in Brussels to discuss how to battle the euro crisis, Finance Watch appealed to them to take a closer look at the balance sheets of major banks.
Philipponnat is careful to point out that: "We are not an anti-bank group, nor do we condemn any lobbyists." The only thing that Financial Watch really wants, he explains, is a balanced debate that includes not only the players, but also those affected by their actions. "The financial industry often uses highly technical arguments," he says. "On the one hand, (it does so) because many things actually do revolve around technical issues. But, on the other hand, (it does so) because it means that no one outside the financial world can seriously follow the debate." 
Finance Watch wants to change this. For example, it wants to explain EU banking rules -- such as the cryptic CRD IV and MiFID -- to the general public as well as issue position papers and compose informational materials. In addition, Philipponnat and his team will make themselves available to the parliament and the public to serve as individuals who can debate with bankers and hedge fund managers on a level playing field. 

This time is different if and only if the FDR Framework is implemented

Are the US, UK and European economies condemned like Japan to a long hard slog to rebound from the bursting of the credit bubble or is there an alternative?

Ken Rogoff and Carmen Reinhardt have documented the aftermath of credit bubbles covering several hundred years and have concluded that it will take a long time to recover.  The reason is that the credit machine that allowed individual, businesses and countries to borrow too much goes into reverse as they look to repay their debts.

The question I have is does this long time to recover have to occur in both the real economy and the financial sector or can it be isolated to the financial sector?

Regular readers know that I think that the long recovery period could initially have been and probably still can be "confined" mostly to the financial sector.

Why do I think this?

Under the FDR Framework, banks are the safety valve between excesses in the financial system and the real economy.

Specifically, with full disclosure made possible using 21st century information technology forcing banks in the words of Walter Bagehot to be "well-run", banks can absorb the losses on the excesses in the financial system and continue to operate.  As he said, "a well-run bank needs no capital."

Banks can show a negative value for book equity without fearing a run on the bank by depositors.  The depositors are protected by a guarantee from the government.

In the aftermath of all the credit bubbles that were studied, there was not one bubble where the banking system could be fully utilize as a safety valve to prevent the excesses in the financial system from causing a multi-year (think decade) drag on the real economy.

In every case, the ability of the real economy to recover was limited by the capacity of the banking system to continue to show positive book capital while generating the earnings to both absorb the losses caused by the financial excesses and support new lending.

What makes this time different is that there is information technology available and deposit insurance that eliminates bank earnings as a constraint.

What I am proposing that makes this time different is that banks should use up all of their capital plus whatever additional capital is needed to absorb the losses caused by the credit bubble.

Clearly this will leave the banks with a negative book value for their equity.  But, as Walter Bagehot observed, this is not a problem if they are "well-run" banks.

The way to force them to be well-run is to require disclosure of their current assets, liabilities and off-balance sheet exposures.  With this data, market participants, including their competitors, can exert market discipline to ensure that the banks retain a low risk profile as the banks steadily retain earnings to restore a positive book value.

Following a credit bubble, rebuilding bank book equity is where the lengthy recovery identified by Rogoff and Reinhardt should be.

This is not unreasonable given the existence of deposit insurance.  Deposit insurance is similar to an option.  When the market value of the bank's assets is less than the book value of its liabilities, the option is in the money -- its value is at least the book value of the insured deposits minus the market value of the bank's equity.

What is being proposed is having the banks rebuild their book equity and in the process reduce the value of the deposit insurance option.

There are many benefits to my approach.

For example, Greece's debts could immediately be written down to a level that the country could afford to pay without the need for austerity.  After all, why should the citizens experience all the negatives associated with austerity for the failure of the lenders to consider Greece's ability to repay its debt?  On the other hand, if Greece hopes to access additional debt in the future, it is going to have to make changes that would make lenders willing to extend this credit.

Trust me when I say that what I have just proposed is a radical departure from the approach that is currently being taken globally to address the impact of the credit bubble.

Let me spell out a couple of the critical assumptions that underlie my approach.

First, I think that market participants understand that we had a credit bubble that burst and as a result most, if not all, the major banks in the US, UK and Europe are insolvent.  Where insolvent means that the market value of these banks assets and off-balance sheet exposures is less than the book value of their liabilities.

So acknowledging this fact allows us to change policies.

Why is this important?

Because the "extend and pretend" policies that are effectively ever-greening loans to bad borrowers so that banks can show a positive value for book equity, can be stopped as they are not fooling anyone.

All these policies have done is hurt the real economy by effectively discouraging investment as it is easier for a bad borrower to get money from the banks to continue the myth their loan is performing than it is for a good borrower to get money from the banks to invest in the real economy.

Second, I think that market participants understand that the credit bubble drove real estate prices much higher than they would have been in the absence of the credit bubble.  The size of the credit bubble impact being the difference between prices before the bubble burst and what prices would have been assuming they had continued to appreciate on a trend line reflecting long term growth and demographics.

Market participants expect a significant decline in real estate prices as a result of the credit bubble bursting as the prices decline to the level consistent with the long term growth and demographics trend line.

Why is this important?

Because the policies of artificially propping up the real estate market can be stopped as they are not fooling anyone nor have these policies stopped the ongoing decline in real estate prices.  In fact, Japan has shown that despite these policies prices can continue to fall for a long period of time with real estate prices declining for 18 of the last 20 years.

All these policies do is hurt the real economy by forcing it onto a suboptimal growth path as it makes lenders reluctant to lend when there is great doubt about the value of real estate pledged as collateral.  For small businesses, this doubt lowers the availability of credit as real estate is typically the largest asset that they have to pledge.

Third, I think that market participants can value every asset and off-balance sheet exposure that a bank has. It is not important if "every" market participant can value "every" asset and off-balance sheet exposure.  What is important is that there are a significant number of market participants, including each bank's competitors, that can.

Why is this important?

Because it forces banks to address their losses and restructure the assets to a level where the borrowers can afford the terms of repayment.  It is only when this restructuring takes place that individuals, businesses and countries can move forward without the debt overhang.

In addition, it ensures that there will be market discipline on the banks going forward.

Surprise! Europe's banks to raise little new capital from investors as a result of 9% Tier 1 mandate

According to a Bloomberg article, the analysts have crunched the numbers on the European regulators requiring Eurozone banks to hit a 9% Tier 1 capital ratio and discovered the Eurozone banks will require little in the way of new capital from investors.

The analysts reached two conclusions.

First, the 9% Tier 1 capital ratio will not restore investor confidence as the issue is what are the banks' current exposures and the lack of credibility of their risk models.  In addition, it is the peripheral banks and not the core "systemic" banks that need to raise capital.

This conclusion is not a surprise to regular readers as they know that it will take disclosure by each bank of its current asset, liability and off-balance sheet detail data to restore investor confidence.

Second, the 9% Tier 1 capital ratio mandate is just another exercise in "extend and pretend" by the Eurozone policymakers and financial regulators designed to buy time.
Europe’s largest banks may raise just a tenth of the total capital shortfall estimated by regulators, fueling concern policy makers’ plans to bolster the region’s lenders could fail.... 
Rather than tapping investors or governments, firms are trying to hit the 9 percent core capital target by adjusting risk-weightings, limiting dividends, retaining earnings, reducing loans and selling assets. Banks had threatened to curb lending, risking a recession, to meet the goal rather than take government aid that would bring limits on bonuses and dividends...
“The issue is how much fresh capital will be brought in,” Philippe Bodereau, head of credit research at Pacific Investment Management Co. in London, said in a telephone interview. “It would be positive if we saw banks launching rights issues, but they won’t. This is hardly shock and awe.” 
Lenders may sell as little as 6 billion euros of new stock to investors to plug the shortfall, according to Alastair Ryan, an analyst at UBS AGin London. That’s seven times less than the amount banks will raise from retaining earnings and adjusting risk-weightings, he said. 
Before last week’s summit, analysts at JPMorgan Chase & Co. and Credit Suisse Group AG had estimated banks might need as much as 250 billion euros more capital. 
Now, only Banco Bilbao Vizcaya Argentaria SA of Spain, Germany’s Commerzbank AG, France’s BPCE SA, Austria’s Raiffeisen Bank International AG and four Italian banks -- UniCredit SpA, Banco Popolare SC, Banca Monte dei Paschi di Siena SpA and Unione di Banche Italiane ScpA -- need to raise money, according to [Morgan Stanley analyst] Van Steenis. 
“Surely, no one thinks that by allowing banks to avoid raising capital in all these various ways it’s going to give investors more confidence,” said Peter Hahn, a professor of finance at London’s Cass Business School and a former managing director at New York-based Citigroup Inc. “Part of the issue for a long time has been the lack of credibility of bank balance sheets and their risk models. This isn’t going to help.” ...
Greece’s six banks will need to raise about 30 billion euros, more than any other EU member state, the EBA said. That shortfall is covered by existing backstop arrangements with the EU and International Monetary Fund, so Greek lenders wouldn’t have to tap investors, according to the EBA. 
Spanish banks have the next-biggest deficit, according to the regulator. Yet Banco Santander SA and BBVA SA, the country’s two biggest lenders, have said they won’t raise capital. 
They will instead rely on profit and changes to the way they calculate risk-weighted assets to meet the target.
Under the Basel rules, firms use internal models to decide how much capital to assign to assets based on their own assessment of a default. The models aren’t disclosed and banks can reach different risk-weightings for the same assets, regulators and analysts say....
Italian banks have a 15 billion-euro shortfall, according to the EBA. UniCredit, which has a 7.4 billion-euro deficit, said it may be able to reduce that to 4.4 billion euros by counting 3.3 billion euros of hybrid securities as core capital. The Milan-based lender, the country’s biggest, said it’s working to identify “capital management actions to be put in place,” without adding further details.... 
France’s BNP Paribas SA and Societe Generale SA, which in September began programs to trim a combined 300 billion euros in assets, said last week they can meet the new capital targets without tapping shareholders or the government. 
President Nicolas Sarkozy said on Oct. 27 he has asked the banks to shift “almost all” of their dividend payments into strengthening their balance sheets and make their bonus practices “normal.” 
Deutsche Bank AG and Commerzbank AG, Germany’s biggest lenders, also are cutting assets and selling businesses to meet the threshold. 
The method used to determine how much capital banks need to raise “puts the onus on peripheral banks and limits the impact on core banks,” said Pimco’s Bodereau. “The big weakness is that banks that are truly systemic are headquartered in London, Paris and Frankfurt and not in Athens.” 
Southern European banks that can’t raise capital may still need to shrink their balance sheets by as much as 40 percent to meet the new requirements and run the risk of having to rely on state injections, Mediobanca analysts including Alain Tchibozo wrote in a note to clients on Oct. 28. 
“They’ve cobbled together a sticking-plaster solution,” said Jonathan Newman, an analyst at London-based Brewin Dolphin Holdings Plc, which manages about 25 billion pounds ($40 billion). “While it’s desirable for them to have been tougher, the reality was they couldn’t afford to be tougher. Banks wouldn’t have been able to raise the money privately, so they would have had to go to governments, which then puts the sovereign at risk.”

Sunday, October 30, 2011

NY Times' Thomas Friedman calls for meaningful transparency

In his NY Times column, Thomas Friedman calls for meaningful transparency.

His column is very interesting because despite his focus on foreign affairs, Mr. Friedman describes in the US exactly the behavior that the Nyberg Report associated with the causes of the Irish financial crisis.

He identifies the self-reinforcing feedback loop between the financial institutions and the politicians.  The financial institutions "donate" money to the politicians.  In return, the politicians "pass" laws that favor the financial institutions and "influence" the financial regulatory process.

As the Nyberg Report documented, politicians influence on the financial regulatory process goes well beyond passing laws.  It directly impacts the enforcement of the laws.

Mr. Friedman confirms this finding of the Nyberg Report when he observes that even the judge was surprised by the terms of the SEC's proposed settlement with Citigroup over Citigroup's version of the "Abacus" CDO.

Regular readers are not surprised by the settlement as it is just another example of the Wall Street Opacity Protection Team in action.

Finally, Mr. Friedman offers his solution to offset the Wall Street Opacity Protection Team:  meaningful transparency.
[W]hat happened to us? Our financial industry has grown so large and rich it has corrupted our real institutions through political donations. As Senator Richard Durbin, an Illinois Democrat, bluntly said in a 2009 radio interview, despite having caused this crisis, these same financial firms “are still the most powerful lobby on Capitol Hill. And they, frankly, own the place.” 
Our Congress today is a forum for legalized bribery. One consumer group using information from calculates that the financial services industry, including real estate, spent $2.3 billion on federal campaign contributions from 1990 to 2010, which was more than the health care, energy, defense, agriculture and transportation industries combined. 
Why are there 61 members on the House Committee on Financial Services? So many congressmen want to be in a position to sell votes to Wall Street. 
We can’t afford this any longer.... 
Capitalism and free markets are the best engines for generating growth and relieving poverty — provided they are balanced with meaningful transparency, regulation and oversight.
The only way you can have meaningful transparency is if the financial institutions are required to disclose their current asset, liabilities and off-balance sheet exposure details to market participants in an appropriate, timely manner.

Market participants can use this data to enforce market discipline on the financial institutions.  Part of enforcing market discipline is assisting the regulators in understanding the risks that the financial institutions are taking.  Part of enforcing market discipline is adjusting both amount of and the price of any exposure to a financial institution to reflect the riskiness of that financial institution.
 We lost that balance in the last decade. If we don’t get it back — and there is now a tidal wave of money resisting that — we will have another crisis. And, if that happens, the cry for justice could turn ugly. Free advice to the financial services industry: Stick to being bulls. Stop being pigs.
A tidal wave of money from Wall Street's Opacity Protection Team...

Occupy Wall Street: In London is focusing on breakdown of social contract between banks and economy

As Heather Stewart observed in a Guardian column, the Occupy London protesters are focusing on the important issue of the breakdown of the social contract between finance and the rest of the economy.
What the protesters, in their kooky way, are rightly identifying is that something has gone badly awry in the relationship between finance and the rest of the economy. 
Gordon Brown got it just right – only a decade late – when he warned in a speech in November 2009 that the "social contract" between banks and the people had broken down. 
Banks should be buried deep in the engine room of the economy, shovelling our savings towards profitable opportunities so that businesses can expand and evolve. 
Instead, in the 25 years since the Big Bang, finance has moved into the driving seat. Having a competitive advantage in financial innovation became one of the UK's selling points. 
That helped cement the power of the money men in Westminster, with Sir Fred Goodwin's knighthood being just the most egregious example of government believing the mystique the financial sector wove around itself. Protecting the status of the City as a world financial centre became a central goal of government policy. 
At the same time, the overvalued pound, caused in part by the surge of investment into the financial industry, helped to hollow out Britain's fragile exporting sector. And the rewards at the very top of banking ran beyond the wildest dreams of average workers — who, to add insult to injury, received consistently terrible service from the high street banks. 
For a decade or so, the pact between the banks and ordinary families held. The economy expanded steadily. The wall of cheap money flowing from China – the so-called global savings glut – helped to pay for cut-price mortgages. Supine regulators nodded through 100% home loans, driving property prices to unheard-of levels. Mortgage equity withdrawal totalled a stunning £365bn in the 10 years of Tony Blair's premiership. 
Yet beneath the surface, the banks were taking extraordinarily risky bets – with our money. 
By 2007, when Northern Rock began to shake, and politicians and central bankers finally realised the size and power of the financial monster they had unleashed, banks' assets were more than five times the size of the economy: much, much too big to fail. 
Osborne tried to close down the issue of banking reform by setting up the Vickers commission. Its recommendations would involve erecting a "ring fence" between risky casino banking and the job of looking after our savings; but they fail to tackle the deeper question – the one nagging at the protesters – of what role finance should play in the economy and society. 
It's one that's been taxing anyone in their right mind over the past three years. Adair Turner notoriously pointed out that much of what the City gets up to is "socially useless". Mervyn King said he would have liked to have seen Alistair Darling order the state-backed banks to throw open the lending taps during the recession; and he's also reflected on the "absurd" risks banks were taking before the crisis. 
There are plenty of radical ideas being drawn up outside Whitehall, starting with splitting up the bailed-out banks into a series of German-style regional champions, and establishing a state-backed investment fund to boost infrastructure. 
Yet the coalition's reflex response remains to defend the City against the pesky meddling of Brussels. While the protesters were discussing how to reform the financial system, David Cameron was warning that proposed European regulations on derivatives would harm the competitiveness of London. Sound familiar? 
Wandering among the tents last week, it was not hard to share the puzzled disbelief of the capital's happy band of tent-dwellers. Their demand was a simple one: a banking sector that serves the economy. It doesn't seem too much to ask.

LSE Chairman insists that irresponsible governments to blame for global financial crisis

In a Guardian article, the London Stock Exchange chairman lays the blame for the global financial crisis squarely on governments and the regulators for their failure to rein in the financial sector.

Regular readers know that this was also one of the central conclusions of the Nyberg Report on the causes of the Irish financial crisis.
The chairman of the London Stock Exchange has urged the Occupy movement to blame irresponsible governments rather than City institutions for the global financial crisis. 
The LSE is the target of the Occupy the London Stock Exchange protest, but Chris Gibson-Smith believes the inhabitants of the impromptu tent city in the capital are blaming the wrong people. 
He said they should target the politicians who allowed banks to run up huge debts. 
"There are unintended consequences of free markets," he added. "It's not capitalism that has been the problem, but irresponsible governments and politicians who have allowed the financial system to explode by permitting the build-up of ludicrous amounts of debt and leverage. 
"No one ever said that free markets could or would be self-regulating. That's where people over the past few decades have got it wrong, and many are still in denial – look at Alan Greenspan, [the former chairman of the Federal Reserve], who is still defending free markets."
In an interview with the Independent on Sunday, Gibson-Smith said the protesters' argument was misguided....
Following the eurozone deal struck in an attempt to shore up market faith in sovereign debt, Gibson-Smith said voters should ask how countries such as Greece were able to build up unsustainable borrowings. 
"How on earth did governments – here and in Europe – get away with spending so much?...
"Politicians, and the civil service, lost control of the system. Where has all the money gone?"

Saturday, October 29, 2011

Despite paying high rates to attract deposits, depositors still not flocking to Irish banks

The Central Bank of Ireland released the latest report on bank deposits.

The report shows that despite paying interest rates that are so high to attract deposits that the banks cannot profitably reinvest the deposits (see here), depositors are still not flocking to Irish banks.

Instead, they are putting their money into foreign owned banks with branches in Ireland.

As reported in an article in the Irish Times,
Last month an increase of almost €11 billion in deposits was recorded on the previous month.
The figures, published yesterday by the Central Bank, show that the total deposit base of all banks located in Ireland rose to €590 billion in September. 
This was the second consecutive month in which deposits grew. It follows a protracted period of precipitous decline. 
In September 2010 a massive outflow of cash from the banking system began. Between August 2010, when the deposit base stood at €893 billion, and July of this year, the banking system lost one-third of its total deposits. 
The loss of deposits forced banks to replace this cash with loans from the lender of last resort – the European Central Bank and the Central Bank. The increased dependence on emergency, short-term funding from central banks was the main factor that propelled the State to accept a bailout in November last year. 
Almost all of September’s increase was accounted for by non-Irish residents placing more money on deposit in Ireland-based banks. 
The figures suggest that most of the increase in non-resident deposits went to offshore banks operating in the IFSC. These banks do not service the domestic economy. 
Aggregate deposits in the 20-odd institutions which do service the domestic economy rose by €3 billion on the month in September, to stand at €352 billion. 
Among these institutions are the five banks covered by the State’s liability guarantee, which includes deposits. They are: AIB, Bank of Ireland, EBS, Irish Life and Permanent, and the Irish Bank Resolution Corporation. 
These five institutions also registered an increase in deposits in September, to €265 billion, up €2 billion on the month. 

Friday, October 28, 2011

What does 'recapitalizing banks' really mean?

In an excellent Economix column in the NY Times, Princeton Professor Ewe Reinhardt defines what he means by recapitalizing banks.

Regular readers will recognize his definition as it is the one that your humble blogger uses.  This definition of recapitalization looks at the market value of the bank's assets and subtracting from it the book value of the bank's liabilities.  If the market value of the assets is less than the book value of the liabilities, then the bank needs additional equity .... this is the amount needed to recapitalize the bank.

Unfortunately, Professor Reinhardt's and my definition of bank recapitalization is not the same one used by global financial regulators and policymakers.

They use the book value of the bank's assets and the book value of the bank's Tier 1 capital (primarily equity).

In the recent European agreement to deal with the sovereign debt and bank solvency crisis, the Eurozone policymakers and financial regulators said that all Eurozone banks must reach a 9% Tier 1 capital ratio or raise equity.

This 9% ratio is calculated by dividing the book value of the bank's Tier 1 capital by the book value of the bank's assets.

Regular readers know this is a meaningless ratio for showing whether a bank is solvent or not.  Solvency is defined as the market value of the bank's assets minus the book value of the bank's liabilities.  If the result is greater than zero, the bank is solvent.  If less than zero, the bank is insolvent.

Regular readers also know that the reason global policymakers and financial regulators do not use Professor Reinhardt's and my definition of bank recapitalization is because banks do not disclose their current asset, liability and off-balance sheet detailed data so that market participants can determine what the market value of the bank's assets is.

It is this lack of disclosure that effectively blocks Eurozone banks from raising new equity from the capital markets.  After all, what investor is going to want to buy stock in an insolvent bank with great book Tier 1 capital ratios if that bank could end up like Dexia and be nationalize shortly after their investment.


Please note that there is an important distinction between determining how much is needed to recapitalize a bank and when this capital is needed.

In a modern banking system with deposit insurance and access to central bank funding, banks do not need to be recapitalized today.  Rather, they can rebuild their capital through retention of future earnings.

Citizens of any country have reasons to smell a rat when the country’s elite speaks to them of “recapitalizing” banks. In this regard, for example, theUnited States bailout of its troubled banks, and Ireland’s bailout of its banks, are hardly reassuring. The Occupy Wall Street movement appears to be fed in part by this suspicion. 
Recapitalization is a generic term. It can be done in different ways, some more unseemly than others. My inquiry among a nonrandom sample of educated adults suggests that many people do not actually know exactly what recapitalization means. Can we blame them, given that financial experts speak mainly to one another in opaque jargon, and government shuns transparency in these matters? 
To see clearly what is involved, it is helpful to start with a simple accounting identity that describes a business company’s financial position, at market values, at any moment in time as “t.” It is 
At – Lt = Et 
Here At denotes the total, realistically realizable dollar value of assets to which the firm has legal title; Lt denotes the total dollar value of the company’s liabilities, if it paid off all of that debt at time t; and Et denotes the company’s net worth or “owners’ equity” – all as of the point in time t. 
A business is solvent as long as the realizable value of its assets exceeds its debt (At > Lt).
It bears repeating that global policymakers and financial regulators do not use this definition when they are talking about recapitalizing a bank.  They are strictly looking at the book value of the bank's assets and the book value of the bank's equity.

This blog, however, uses Professor Reinhardt's definition.
Even such a company, however, may find itself illiquid if it does not have on hand enough cash or liquid assets that can quickly be converted to cash to meet short-term debt coming due within the next month or year. An illiquid but solvent business can easily be helped through a short-term bridge loan secured by other assets or an open credit line at a commercial bank that can be tapped in such cases. For solvent banks the central bank is a short-term lender of last resort. 
Prudent executives manage the balance sheet of their enterprises so that, at any time t, the realizable dollar value of the company’s assets are enough, under most foreseeable future contingencies, to repay all of the company’s debts and, it is to be hoped, leave some positive net worth for the owners.... 
These assets consist mainly of the right to cash flows inscribed in financial contracts – Treasury and corporate bonds, short-term commercial loans to businesses. In the United States, the banks’ assets also included so-called “structured loans” secured by mortgages (increasingly subprime mortgages) and other derivative securities, including rights to cash flows implied by in bond-insurance contracts (credit default swaps).
European bankers, too, invested in such risky securities – often sold to them by their American colleagues. In addition, they loaded up on loans to governments living way beyond their means (Greece) or loans to real estate developers thriving in a real-estate bubble (Ireland, Spain).... 
By mid-2007, news had penetrated all the way to the banks’ executive suites that a good many of the structured securities on the asset side of their balance sheets were secured by dodgy mom-and- pop mortgages that had been extended to people unlikely ever to earn enough to be able to make their monthly mortgage payments on time. The market value of these securities began to shrink. 
In Europe, on the other hand, it became clear that some governments – especially that of Greece — would not be able to pay debt service on the sovereign bonds they had sold as investments to European bankers. 
Eventually, then, it dawned on everyone, even bankers, that, realistically, the ... banks were not just illiquid, which could easily have been fixed by central banks. Many of the banks were effectively insolvent, if all assets were realistically marked to realizable values.

We can think of the generic term “recapitalizing the banks” simply as “restoring the balance sheets of the banks to financial health.” It requires that somehow the banks’ debt-to-asset ratio Lt/At be reduced to more prudent levels, which is the same thing as saying that its complement, the equity-to-asset ratio, Et/At, also known as the “capital ratio,” provide a robust enough cushion for possible future declines in asset values (Lt/At and Et/At add up to 1, of course).

Run on the Irish banks continues

According to an article in the Independent, Ireland's banks are now paying depositors more for their money than they are charging for a mortgage loan.

Regular readers know that the reason the banks are offering to pay so much for deposits is that individuals and firms do not trust that they are solvent.  By forcing the depositors to keep their money with the bank for at least one year, the banks are hoping to slow down the run on deposits they are experiencing.
SAVERS have seldom had it so good.  So desperate are our banks for us to lend to them that they will actually give you a higher interest rate on your deposit than they are charging on some mortgages. 
Money that is deposited for a year or more is the most sought after with interest rates in excess of 4pc not unusual. 
Some banks are advertising deposit rates that are almost the same as their mortgage rates. 
Take AIB. It is currently offering 4.1pc on deposits for a 12-month term. 
The same institution is offering mortgages for new buyers as low as 3.34pc. 
Simon Moynihan of the price comparison website says this means those with savings are in a very lucky position. 
"Instead of lending us money, the banks are now desperately trying to get us to lend money to them. 
"But they don't want to be troubled with pesky withdrawals, so they're offering the highest interest rates on accounts where money is locked down for a year or more."

Opacity has a high price: Iceland shows a path not taken

In his NY Times column, Paul Krugman discusses the high price of opacity through the failure of the bank bailout doctrine to remedy a solvency crisis.

He looks at the case of Iceland and its decision not to bailout its banks.

He makes the incredibly important point that we did not have to make our citizenry pay the entire painful price.

I agree with Professor Krugman that as it was implemented, the bank bailout doctrine is a failure.  The problem was the implementation including the fact that it did not make capital pay a large part of that price.

Regular readers know that before bailing out the banks the government needed to require that each bank disclose its current asset, liability and off-balance sheet exposure detail.  With this information, market participants could figure out who was solvent and who was insolvent.

More importantly, market participants could figure out which of the insolvent banks had the capacity to "earn" its way back to solvency based on the strength of its franchise and which insolvent banks either needed a bailout or needed to be closed.

It is only by going through the steps of disclosure and then analysis that the market participants can be confident that the solvency issue is addressed.

It is only by going through these steps that banks are forced to recognize their losses and mark their assets to market.  This is where banks perform their safety valve function and protect the real economy and its citizenry from paying the full painful price of the banks' follies.

It is only when the assets are marked to market that banks are comfortable making new loans against similar assets and investors are comfortable buying these loans when packaged in structured finance securities that also have current asset level performance disclosure.

Under my proposed implementation of the bank bailout doctrine, the impact on the real economy, the pain placed on the citizenry and the amount of debt taken on by the government is minimized.
But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine — a doctrine that has inflicted huge damage both in Europe and in the United States. 
The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So a crisis brought on by deregulation becomes a reason to move even further to the right; a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed. 
This doctrine was sold both with claims that there was no alternative — that both bailouts and spending cuts were necessary to satisfy financial markets — and with claims that fiscal austerity would actually create jobs. 
The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks...
Now, however, the results are in, and the picture isn’t pretty. Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared....
So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? Well, that’s why I’m in Iceland, attending a conference about the country that did something different. 
... Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position. 
But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver. 
So how’s it going? Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph. 
And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.

Thursday, October 27, 2011

Opacity has a high price: EU response to sovereign debt and bank solvency crisis shows it

Opacity has a very high price.

First, there were the losses on the opaque securities sold before the solvency crisis began on August 9, 2007.  This includes the opaque toxic structured finance securities loaded with fraudulently underwritten sub-prime mortgages as well as CDOs like Abacus that were designed so that Wall Street could profit from the collapse in the sub-prime market.

The Bank of England's Andy Haldane estimated the losses from the opaque securities exceeded $4 trillion globally.

Second, there is the on-going cost of bailing out the banking system.  The banks themselves hid risk both on and off their opaque balance sheets.

Based on a chart showing actual US Debt versus its pre-crisis trend line by Diapason's Sean Corrigan, Zero Hedge suggests that this cost is $3.5 trillion.

Third, we have the EU's sovereign debt crisis which to a significant extent is the result of attempting to bail out the banks in 2008/2009.

Based on the tentative agreement reached by EU policy makers, it appears that the cost is at least 440 million euros - the "equity" that the EU is putting into the European Financial Stability Fund.

This tally of costs only looks at the direct costs of opacity.

Hidden are the indirect costs like zero interest rate policies that transfer wealth from savers to bankers (banks pay nothing for the deposits and can park them at central banks and earn a risk free spread).

In short, opacity has a very high price.

Unfortunately, so long as we have pockets of the financial system that remain opaque, the cost of opacity will keep increasing.

For example, in the Eurozone, bank balance sheets are opaque.  What this means is that no one, including the regulators, knows how much exposure any bank has to any other bank, to any sovereign or how the bank might be trying to hedge the risk of this exposure.

As a result, the options available to Eurozone policy makers and financial regulators in how to respond to the sovereign debt and bank solvency crisis are limited.

For example, how many times did the policy makers express fear of causing contagion.  This "fear" clearly influenced the negotiations over the size of the haircut on Greek debt.  The banks knew that the policy makers would not be willing to risk a blow-up of the Eurozone banking system.  Hence, banks could negotiate to minimize the haircut and receive a 30 billion euro credit enhancement.

Imagine how differently the negotiations would have gone if all market participants knew the intimate details of each bank's assets, liabilities and off-balance sheet exposures.  With this information, policy makers could have seen if it fact a 100% write down of the Greek debt would have triggered contagion.

[This blog has suggested on several occasions that disclosure is the cure for contagion.  I have argued that   as soon as the data is made available to the market, it is in each bank's best interest to adjust their exposures to the other banks so that their exposures are not more than they can afford to lose.]

However, the EU policy makers and financial regulators did not have disclosure.

  • This is despite the fact that all of the assets, liabilities and off-balance sheet exposures are knowable facts since they are in each bank's information systems.  
  • This is despite the fact that the EU policy makers and financial regulators had gone through the first stage of the financial crisis in 2008/2009 and seen that the the financial markets broke down everywhere that there was opacity and that the policies that they adopted then had failed to provide disclosure - actually, they bought time in which disclosure could have been implemented and the current round of the financial crisis avoided.

Instead, the EU policy makers and financial regulators were faced with opacity and the fear of the unknown.

The results were predictable.  Once again opacity extracted its high price.

Now the question is will the Eurozone policy makers end opacity by setting up a data warehouse to collect the current asset, liability and off-balance sheet exposures from each bank and providing this data for free to market participants.

Wednesday, October 26, 2011

Needed: An alternative to European banks starting credit crunch to meet capital requirements when they cannot raise new equity

It is becoming clear that Eurozone banks are going to be required to a) write down the value of their assets - say Greek debt to 30% of par and b) increase their Tier 1 capital to 9%.

According to the European Banking Authority, this will require Eurozone banks to raise 108 billion euros in fresh capital.

The problem with raising new capital is twofold.  First, none of the banks want to sell stock at today's price because it will be dilutive to existing holders.  Second, no investor believes that 108 billion euros is adequate - Credit Suisse estimated 400 billion euros, Goldman estimate 1 trillion euros and BlackRock's Larry Fink estimated 2 trillion euros were needed.

As an alternative to raising this capital, Eurozone banks can instead sell assets and not renew existing loans as they mature.  The problem with this approach is that it sets off a negative spiral of credit crunch leads to recession leads to more problem loans leads to more write offs leads to more capital needed leads to further credit crunch....

There is a desperate need for an alternative to effectively forcing the Eurozone banks into starting a credit crunch.

This alternative is to trade off disclosure for higher capital.

Specifically, rather than increase their Tier 1 capital to 9%, banks can instead make available to market participants their current asset and liability detail.

With this data, market participants will be able to a) assess the true risk of the bank, b) monitor this risk and c) enforce market discipline which should discourage the bank from increasing its risk profile.

Perhaps more importantly, the issue of bank solvency is put behind each of the disclosing banks.

The problem is not bankers' incentives, the problem is opacity

For those of you who have not read Andy Haldane's Wincott Annual Memorial Lecture, I think you will find it very interesting as it is the exception to what is Andy's reliably excellent work.

Mr. Haldane provides a broad history of the development of banks from small firms where the owners put their entire net worth on the line in the mid-19th century to today's financial behemoths were owners have limited liability.

What is remarkable about his discussion is that he does not mention regulators until the last sentence of the speech despite the fact that banking has been regarded as a highly regulated industry since the Great Depression.

This omission is significant as the regulators were in a position to restrict the growth of these financial behemoths.  For example, they could have disapproved of their merger plans.

Instead, he discusses how along with this transformation in the structure of banks came a change in bankers' incentives and it was these incentives that led to our current banking sector problems.

Simply put the change in incentives was from when your entire net worth is on the line, you tend to error on the side of less risk to when it is only your bonus on the line, you tend to error on the side of taking too much risk.

According to Mr. Haldane, this change in bankers' incentives lead directly to changes in the riskiness of the assets that banks held and to the degree of leverage in the banking system.  By increasing both, bankers were able to earn more money.

To support this thesis, he observers that there was a steady increase in leverage or decrease in equity to assets from the mid-19th century to today.  Mr. Haldane attributes this increase to the incentives of bankers since increasing the leverage of the bank was an easy way to meet your earnings target and trigger your bonus.

I would be interested in what happened to bank leverage after the introduction of deposit insurance in 1934.

According to the paper, leverage was approximately 6x in 1900 and by the 1950-80 period had increased to slightly over 15x.  Was leverage still around 6x shortly before the introduction of deposit insurance?  After the introduction of deposit insurance, has leverage moved in lock step with an explicit or implicit cap set by the financial regulators?  If there was no cap on leverage, did bank leverage jump to 15x after the introduction of deposit insurance?

The reason I am interested is that the financial regulators had to know from day one that if they permitted banks to increase their leverage deposit insurance made it easy.

Prior to deposit insurance, the depositor had to be concerned with the liquidity and solvency of the bank.  This concern may have acted as a brake on growth in leverage.  Given the risk to the investor of losing their deposits, maybe the accepted rule of thumb was not to put deposits into a bank with greater than 6x leverage.

With deposit insurance, the depositor was guaranteed both liquidity and the equivalent of 100% equity backing for the deposits.  As a result, any increase in the bank's leverage did not make the bank riskier to depositors. Therefore, bank leverage became irrelevant to the depositors.

Deposit insurance had the impact of removing the depositors' "cap" on leverage.  This freed depositors up to make a choice of where to put their deposits on issues like convenience.

While I agree with Mr. Haldane that bankers' compensation has a bias towards leverage, it is not clear that deposit insurance and the financial regulators did not facilitate this.

Second, Mr. Haldane observes there was a steady increase in the use of debt in the bank capital structure.  This was another way for bankers to increase leverage and meet their compensation targets.

Mr. Haldane notes that using debt in principle is not a bad thing because with it should come the disciplining effect of debt.  In theory, debt holders should restrict increases in risk by the bank by either increasing the cost of debt or reducing its availability.

As he points out, debt was an effective discipline in the 19th century with the potential for a run on the bank by depositors rewarding bankers for maintaing liquidity and conservative investments.  This was still true through the Chicago banking panic of 1932.  As he notes, the effectiveness of debt discipline became patchy to non-existent after that.

The introduction of deposit insurance in 1934 would cause the effectiveness of debt discipline from depositors to completely vanish.  Why would depositors engage in a run on the bank when even if it becomes insolvent the depositors can still get their money back?

With the introduction of deposit insurance, the role of deposit debt discipline was taken over by the government since it and not the depositors was now in a position to lose money if the bank was badly run.

As a result, there was only one source of discipline on banks...their financial regulator.

Third, Mr. Haldane focused on an increase in risk in the asset mix held by banks.

With bank runs no longer a fear because of deposit insurance, a change in the industry's asset mix should have been expected to the extent that the government allowed or encouraged it to happen.

For example, to get the economy going again in the 1930s, the government might have pushed for a decrease in liquid assets, think government bonds, and an increase in illiquid assets, think loans.  We see something like this happening today in the UK with Project Merlin requiring banks to originate a specific volume of loans.

It is hard to disentangle how much of the shift in asset mix was driven by the bankers' incentives and how much by government policy.

Finally, Mr. Haldane looks at uninsured debt and sees a lack of effective debt discipline.  In particular, he looks at the cost of credit default swaps prior to and after the beginning of the financial crisis and sees significant mis-pricing of risk.

The mis-pricing of risk is also consistent with uninsured debt holders, who did not have access like the government does to a bank's current asset and liability details, relying on the representation by the government that the banks had a low risk of insolvency (this seems reasonable particularly when the Fed was cheerleading about how structured finance had reduced risk in the financial system).

Mis-pricing of risk is not a function of bankers' incentives, but rather of opacity.

Market participants cannot accurately assess the risk of a bank if they do not have access to its current asset and liability details.  If they cannot accurately assess the risk, market participants are not able to properly exert debt discipline.

When the role of deposit insurance and the financial regulators is added to Mr. Haldane's work, it changes the conclusions dramatically.

Given bankers' incentives, all market participants should have access to each bank's current asset and liability detail and not just the financial regulators.  This eliminates reliance on the financial regulators and brings market discipline to the banks.

Expect European banks to voluntarily adopt detailed disclosure of assets and liabilities

As we approach the finish line for the EU's resolution of its sovereign debt and bank solvency crisis, it is becoming clearer that Eurozone banks are going to opt for providing 'utter transparency.'

As this blog has said on several occasions, utter transparency is disclosure of the bank's current asset and liability details.

Why are banks going to voluntarily adopt detailed disclosure of their current assets and liabilities?

First, because no investor is going to put money into a Eurozone bank without being able to assess the risk of the bank and knowing if it is currently solvent or not.  This was definitively shown in Spain, where the cajas did not disclose this information and most of them ended up being nationalized because they could not tap the capital markets for new equity.

Second, because the Eurozone bank managers want to raise equity from the capital markets and avoid the numerous restrictions that will be placed on them if they cannot do so and instead have to turn to their host government or the European Financial Stability Fund for capital.  These restrictions cover bonus payments and dividends.

As the Telegraph live reports,
Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. 
Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. 
If necessary, national governments should provide support, and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.

Tuesday, October 25, 2011

Add Italy to the list of EU countries experience a run on its banks

According to a column by Hans-Werner Sinn on Project Syndicate, Italy has joined Ireland, Greece, Portugal and Spain in experiencing a run on its banks.

But the bond purchases are just the tip of the iceberg. Equally important, but largely unknown, is the fact that the Banca d’Italia has resorted to the printing press to cover Italy’s gigantic balance of payments deficit. The extra money printing and lending, as measured by the so-called Target deficit, effectively means drawing a credit from the ECB. 
This credit replaces the private capital imports that had hitherto financed the country’s net purchases of foreign goods, but which dried up because of the crisis, and it finances a capital flight, i.e. the purchase of foreign assets. 
The ECB in turn draws the Target credit from the respective national central bank to which the money is flowing and which therefore has to accept a reduction in its scope for issuing refinancing credit. 
Until July, only Greece, Ireland, Portugal, and Spain had drawn Target credit, for a combined total of €330 billion. Italy was stable and did not seem to need the printing press to solve its financial problems. No longer. 
In August alone, Italy’s central bank drew €40 billion in Target credit, and it probably drew roughly another €50 billion in September, when the Bundesbank’s Target loans to the ECB system increased by €59 billion (after a €47-billion hike in August). This is the highest Target loan ever drawn from the Bundesbank in a single month, and in all likelihood it went primarily to Italy....
As Italy’s monthly current-account deficit approximates only €3-4 billion, the Target credit must have compensated primarily for capital flight. Italian investors sold their assets to the banking system, which paid with newly printed money. The investors then invested the proceeds in Germany, buying shares, bonds, and other assets. In essence, Germany and Italy traded Target claims against marketable assets....
This is not the end of the world, not even for the ECB. However, the Bundesbank has entered a new regime in which it will have to borrow extensively from the private banking sector to absorb the flight money from the crisis countries. They, in turn, will continue to compensate for capital flight by cranking up the money-printing press. 

In sign Irish banks a long way from solvency, Irish property prices continue to decline

According to an Irish Times article, the decline in the price of houses in Ireland is accelerating.

This would be a problem for the Irish banking system if it were already current in recognizing the losses on the mortgages on the banks' balance sheets.

This is a bigger problem given that the banks have so far deferred working with the borrowers and calls into question the "solvency" of the two re-capitalized Irish banks.

Irish house prices continued to fall last month with the rate of decline actually increasing when compared with 12 months ago. 
The latest figures from the Central Statistics Office (CSO) indicate that prices dropped 1.5 per cent in September and they show the decline since the beginning of the year now standing at 14.3 per cent.... 
The comprehensive index, which was first published by the CSO earlier this year, gives detailed data by type of property (house/apartment) and by geography (Dublin/non-Dublin).... 
Looking at the broader picture, house prices in Dublin are now 49 per cent lower than at their highest level in early 2007 while apartments in Dublin have fallen by 59 per cent since February 2007. The fall in the price of residential properties across the rest of the State is 40 per cent.

Bank of England finds its voice

A Telegraph column by Damian Reece argues that the Bank of England has found its voice.  To back up this assertion, he focuses on Sir Mervyn King's comments about what Europe is doing to address its sovereign debt and bank solvency crisis and Andy Haldane's comments on bankers' pay.
Sir Mervyn King, the Bank's Governor, told MPs on Tuesday that the eurozone rescue plan will simply buy some time but is not a solution. 
He was echoing his speech of a week ago in which he urged on Europe a "transparent recognition" of losses and a "substantial injection" of additional capital in order to restore market confidence....
Regular readers know that it is the transparent recognition of losses that restores market confidence.  The issue that is debatable is the timing for adding the additional capital.

This blog has taken the position that so long as the banks have to disclose their current asset and liability detail (which is a requirement of making it transparent that the banks recognized all their losses) the banks should have time to recapitalize through retain earnings and additional stock sales.

This position is supported by Walter Bagehot and his observation that "a well-run bank needs no capital."

Delaying the injection of capital also has obvious positive implications for sovereign debt.
But elsewhere the Bank's other senior staff have also been making muscular interventions. 
Take Andy Haldane's Wincott Memorial Lecture on Monday. Haldane is the Bank of England's executive director of financial stability and a member of the new interim Financial Policy Committee (FPC). 
In some ways it appears predictable with its spotlight on bankers' pay, particularly the remuneration of chief executives. But it highlights the unhealthy relationship between a bank's management and its shareholders. 
Haldane takes the US experience to make his point, but it can be assumed to apply here. In 1989, the chief executives of America's largest seven banks earned, on average, $2.8m (£1.75m), almost 100 times the median US household income. ... 
Shareholders didn't object because they had insisted in preceding years that managements' interests should be aligned with their own, so the chief executives were often substantial personal holders of their bank's shares, too. This suited the increasingly short-term view that investors took, which was that lenders had become massively leveraged and volatile beasts. 
If you were a short-term "volatility junky" banks were the place for you. This led to a very unhealthy relationship between those who controlled banks (management) and those who owned them (shareholders, even though their equity represented as little as 5pc of a bank's balance sheet - the rest being debt).... 
In 2006, the top five equity stakes of US bank chief executives were: Dick Fuld (Lehman Brothers), James Cayne (Bear Stearns), Stan O'Neal (Merrill Lynch), John Mack (Morgan Stanley) and Angelo Mozilo (Countrywide). 
"We know how these disaster movies ended," said Haldane.... 
I confessed to a whole lot of confusion over the argument of chief executives having substantial personal holdings in the bank's stock and being short-term volatility junkies at the same time.

My confusion comes from the "skin in the game" idea adopted in post-crisis regulation of structured finance securities.  Having skin in the game is suppose to improve the quality of the underlying assets and hence reduce the risk of the securities.

Wouldn't you think that having $1 billion of skin in the game (see value of Fuld's and Cayne's ownership in their firms before the crisis) would be enough to cause most people to reduce the risk/volatility of their firm's equity? 
It's what he went on to say about reform that is of real significance. 
Pay should be linked to returns on assets, not equity. He raised the prospect of removing the tax advantages of debt. He's a fan of banks holding yet more capital. "Basel III is a good starting point, but may not be the right finishing line." And he's a fan of contingent capital that can result in pre-emptive recapitalisations and impose more effective discipline on banks than the current equity/debt mix. He's also sympathetic to at least the theory that longer-term shareholders should have greater voting and control rights than short-term investors. 
Traditionally, many of these reforms may have proved out of reach for a regulator. But the Bank of England is designed to be different. It will have much greater discretion to intervene with a bank's balance sheet and its management to avoid a repeat of the systemic risks that intoxicated finance in the previous decade. 
Having lost a degree of credibility in its handling of inflation through its Monetary Policy Committee (although Sir Mervyn insists it will, eventually, be proved right), the Bank is regaining that in its analysis of the crisis and its initial approach to regulation, which will involve less box ticking and more sophisticated and challenging discussions between banks' senior management and senior Bank of England regulators. As a prudential regulator, lectures such as Haldane's provide valuable insight into the Bank's thinking. 
If true, this initial approach to regulation points to very troubling signs about what to expect from the Bank of England going forward.

Walter Bagehot might suggest that the BoE is succumbing to his observation about the English monarchy:  "We must not let daylight in upon the magic."

Like the Fed, the Bank of England is moving away from box ticking to more challenging discussions with banks' senior management.

If these discussions are to have any real teeth, then what is needed is that each bank disclose its current asset and liability detail to the market.  This will allow market participants, including competitors, to assess the riskiness of the bank.  An assessment that can be shared with the Bank of England.

This saves the Bank of England from having to have the best analysts on staff (frankly they cannot afford to pay these analysts to join their staff - a fact the Bank of England has already admitted).  Instead, the Bank of England can piggy-back off these analysts' assessments in their discussions with each bank.
Ultimately, Haldane wants regulation done as if the real economy matters. The interests of banks and bankers will be secondary.
In that case, he should be leading the charge for each bank to disclose its current asset and liability detail.