Tuesday, October 25, 2011

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.

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