Monday, August 29, 2011

Disclosure is the only proven way to restore confidence and liquidity

With Christine Lagarde's call to recapitalized European banks, the solvency crisis that started in 2007 has officially resumed.

In the 1930s, when the global financial system faced a similar solvency crisis, FDR observed that "we have nothing to fear, but fear itself."  He then set about backing up these words.  Specifically, he transformed the financial system from being based on the practice of caveat emptor to being based on the philosophy of disclosure.

The one area where he could not bring disclosure fully to was banking.  The lack of 21st century information technology made it impossible to share with market participants all the useful, relevant information for each bank in an appropriate, timely manner.

Instead, FDR introduced deposit guarantees and enhanced regulation and supervision.  With deposit guarantees, he shifted the risk of loss on deposit investments from the depositor to the government.  With enhanced regulation and supervision, he put in place bank supervision that allowed for examiners to look at all of a bank's useful, relevant information 24/7/365 - to this day, bank examiners still sit full-time in the offices of the countries largest banks looking over everything a bank does from loans to investments and funding.

Given the lack of 21st century information technology, this was the best that FDR and his government could do.  However, it is a solution that is fundamentally flawed.  It creates a systemic point of failure in the financial system by making market participants dependent on the regulator.

This blog has documented a number of ways that failure could occur including:

  • The Bank of England's Andrew Haldane provided one in his discussion of the ability of the examiners to transform the data they received from the banks into useful information.
  • In Ireland, the Nyberg Report provided another in its observation that the financial regulatory bureaucracy itself is an obstacle because, even when the analysis is correct, the examiner must convince everyone above them in the bureaucracy before action can be taken.
What is clear since the beginning of the solvency crisis is that FDR's solution of enhanced regulation and supervision no longer works and needs to be replaced.

For any doubters, just look at the stress tests. 

European regulators have run stress tests twice.  The first time, banks in Ireland passed the stress test and were nationalized within a couple of months.  The second time, most of the banks passed the stress test and within a couple of months the IMF chief is calling for mandatory recapitalization of the entire sector.

The US experience with stress tests has not been any better.  In 2009, using their monopoly on all the useful, relevant information, the US regulators stress tested Bank of America.  As a result of the tests, BofA had to raise a trivial amount of capital relative to its $2 trillion balance sheet.  In the most recent round of stress tests designed to let banks resume paying higher dividends, the US regulators determined that BofA did not pass, but the regulators did not publicly require that BofA tap the capital markets for additional capital.  Today, some analysts think the capital shortfall could be as high as $200 billion.

There is nothing about the stress tests that suggests they could, would or should restore investor confidence in the banks.  This is not a surprising finding.  Why should investors, including banking counter-parties, trust the regulators after the regulators permitted the financial system to get into so much trouble in the first place?

The failure of the stress tests to restore confidence also confirms FDR's observation that governments should not tell investors what is a good or bad investment, but rather should ensure that investors had access to all the useful, relevant information in an appropriate, timely manner to determine if an investment was a good or bad investment for themselves.

Once again, the global financial system has entered a period of fear.  Banks are limiting the amount of lending to other banks because they cannot tell who is solvent or who is insolvent (another failure of the stress tests).

So how should the financial system be transformed to restore confidence?  By updating FDR's transformation.  Specifically, the financial system has to be based on a combination of the philosophy of disclosure and the principle of caveat emptor.

No longer do financial institutions need to be handled differently.  Today we have low-cost 21st century information technology that makes it feasible to disclose to market participants all the useful, relevant information (current asset and liability-level data for financial institutions) in an appropriate, timely manner.

Providing disclosure to market participants using 21st century information technology eliminates the systemic point of failure in the financial system and increases the stability of the financial system.

Rather than having market participants dependent on regulators, market participants can analyze the facts for themselves and adjust their exposure based on their own assessment of risk.  It is the ability to analyze the facts for themselves that is the source of both investor confidence and market discipline.  
  • Investors are more confident when they know what they own.  
  • Financial institutions are subject to market discipline when investors can change the amount and pricing of their exposure in response to changes in the financial institution's risk profile.
Rather than having regulators dependent on their own internal analysis or the analysis provided by a bank's management, regulators can turn to third party experts, like a bank's competitors.  This enhances the stability of the financial system.

Saturday, August 27, 2011

IMF's Lagarde calls for urgent recapitalization of Europe's banks

A Bloomberg article reports that in her speech at the Jackson Hole conference, IMF chief Christine Lagarde called for the urgent recapitalization of Europe's banks.

With this speech, she acknowledges that Europe's banks are still facing the solvency crisis that Mervyn King identified four years ago.

Regular readers know that the key to ending a solvency crisis and the risk of contagion is to address the issue of who is solvent and who is insolvent by using disclosure of each financial institution's current asset and liability-level data.

  • It is only with this data that market participants can determine if the market value of a financial institution's assets exceeds the book value of its liabilities (the definition of solvency). 
  • It is only with this data that market participants know just how insolvent an insolvent bank might be.
  • It is only with this data that the "chains of contagion" are permanently severed as market participants use this data to assess the risk of each financial institution and adjust the price and amount of their exposure.  Market participant will limit the size of their exposure based on their analysis of the risk of losing their investment and their capacity to absorb this loss.

Simply adding capital without disclosure does not mean that a financial institution is solvent.

In 2008 and 2009, policymakers injected capital into the banks without also providing current asset and liability-level disclosure.  Now, in 2011, the solvency of these same banks is once again being questioned.

Bank of America illustrates this point.  Despite raising all the equity required under the 2009 stress tests and $5 billion from Warren Buffett, some analysts believe that BofA still needs to raise an additional $100 - $200 billion to cover the difference between the market value of its assets and the book value of its liabilities.

The time has come to address the solvency crisis and fix the contagion problem once and for all.  First, policymakers must require disclosure of each financial institution's current asset and liability-level data.  Second, only after this data has been made available to market participants should a decision be made as to how to recapitalize or close the insolvent institutions.

... European banks should be forced to build up their capital to prevent the continent’s debt crisis from infecting more countries. 
Bolstering banks’ balance sheets “is key to cutting the chains of contagion,” Lagarde said today in remarks at the Federal Reserve’s annual forum in Jackson HoleWyoming
Without an “urgent” recapitalization, “we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis.” 
Lagarde, a former French finance minister who took the helm at the Washington-based IMF in July, said recapitalization should be “substantial” and called a mandatory move “the most efficient solution.” Banks should look for funds in the markets first and seek public money if necessary, including from the European bailout fund, she said.
Disclosure of current asset and liability-level data is the most efficient solution because it answers the question of who is solvent and who is insolvent.  Private investors are not going to invest without knowing if a financial institution is solvent or not.
The stress tests on 90 European banks published on July 15 showed eight lenders had a combined 2.5 billion-euro ($3.6 billion) capital shortfall, failing to ease concern that many of them remain vulnerable to a potential sovereign default. European lenders are dependent on aid from the European Central Bank, including unlimited loans that are keeping many banks in GreecePortugalItaly and Spain solvent. 
ECB President Jean-Claude Trichet today dismissed any idea that Europe could face a liquidity shortage, saying efforts to combat the financial crisis will prevent such an outcome.

“The idea that we could have a liquidity problem in Europe” is “plain wrong because of these non-standard measures we have taken,” Trichet said in Jackson Hole. 
The ECB, which is also buying sovereign debt from some euro countries including Portugal, is acting in part because governments have yet to ratify a plan to extend the scope of the 440-billion euro rescue facility to allow it to buy bonds and inject capital into banks. 
The fact of the matter is that the ECB, the BoE and the Fed still have the programs in place to provide the financial markets with liquidity during the time it takes to implement disclosure of each financial institution's current asset and liability-level data.

There is plenty of time to implement a solution to the solvency crisis and contagion problem that the market will find credible.

What there is no more time for are more of the same policies that governments can no longer afford and that have not ended the solvency crisis and contagion problem.

Fed and other regulators need policing says Brown University economist Ross Levine

Yahoo carried a very important article on Brown University economist's Ross Levine and a paper he presented at the 2011 Jackson Hole conference on the Fed and other financial regulators needing policing.

This blog identified this issue and began discussing how the FDR Framework handles this issue months ago in posts titled regulators as source and perpetuator of financial instability and the future of finance: the end of opacity and the mother of all databases.

From regulators as source and perpetuator of financial instability:

In his speechBanking:  From Bagehot to Basel and Back Again, Mervyn King, the Governor of the Bank of England, observed,
A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. 
 Why is the banking system unstable?
As discussed in the post, Bank Capital and Bank Runs, banks are unstable because depositors and investors have no way of knowing if a bank is solvent or not.  If doubt about a bank's solvency is raised, the best course of action for the depositor and investor is to withdraw their funds as quickly as possible - this is referred to as a run on the bank.

To limit bank runs, the US government adopted deposit insurance.  This eliminated the solvency issue for retail customers [the depositors], but not for wholesale customers [investors].  The Financial Crisis Inquiry Commission documented how wholesale customers, including other banks, withdrew their funds because they could not determine if a bank was solvent or not.

How does the FDR Framework address this instability?

The FDR Framework provides the solution.

Our financial markets are based on the idea of combining the notion of disclosure with caveat emptor [buyer beware].  As the FDR Framework puts its, governments are responsible for disclosure and investors are responsible for doing their homework [trust, but verify].

To fulfill its disclosure responsibility, government must do two things:

  • ensure market participants have access to all the useful, relevant information in an appropriate, timely manner; and
  • avoid endorsing specific investments.
When it comes to the banking system, the government does not do either of these things. 

The result of the government's failure to fulfill its disclosure responsibility is that the instability of the banking system is increased and not decreased.

Why doesn't the government fulfill its disclosure responsibility?

One part history.  One part the failure to adhere to the FDR Framework.

In discussing the FDR Framework, this blog has highlighted how the absence of 21st century information technology in the 1930s required the government, with its exposure through deposit insurance, to take on the monitoring, analysis and discipline role for financial institutions that the financial markets would otherwise perform.
The regulators had to do this because they did not have the alternative of financial institutions disclosing all the useful, relevant information in an appropriate, timely manner to market participants.

For regulators operating in the 21st century, disclosing this information is a viable option. [please see the following article for a discussion on how this could be effectively and efficiently done using the shadow banking system as an example.]

What is the result of regulators not disclosing all this information?

As predicted by the FDR Framework, by not disclosing all the useful, relevant information they have access to, regulators are an obstacle to markets functioning properly. 
For example, they engage in stress tests in an effort to restore market confidence.  In reality, the stress tests only serve to perpetuate the notion of Too Big to Fail.  How can an investor be expected to be willing to take a loss investing in a bank when 1) the investor does not have access to all the useful, relevant information in an appropriate, timely manner to analyze and 2) the regulators are saying that the bank is in excellent financial shape because it passed a stress test?

It is the regulators who are perpetuating and increasing instability in the banking system. 

Regulators do this by acting as gatekeepers and maintaining information asymmetry between the information provided to the markets and the current asset-level data the market participants want and need if they are to analyze each financial institution and correctly price risk.
How do regulators increase instability in the financial system?

If only the regulators look at current asset-level data, the banking system has a critical weakness.  It is dependent on the regulators to be right in their analysis.  Since there is no back-up, if the regulators fail, the system is prone to crashes.

We know the financial system is prone to earthquakes when they are the only market participant with access to current asset-level data.  We had the U.S. Savings & Loan Crisis, the Less Developed Country Debt debacle, Long Term Capital Management meltdown, and of course the sub-prime wipeout.  

Please note, these failures occurred when the monetary authority and supervisory authority were combined (the Fed) or when they were separate (the BoE and FSA).  

Given this history of not spotting problems before they threatened to become systemic issues, why should the market believe that the regulators will not fail in the future?  

Your humble blogger prefers not to let the regulators gamble on redemption (when only they can see the current asset-level data, their reputation is redeemed until the next crisis hits).

The source of instability is a structure where only the regulators get to see the current data.  If the data were made available to the market, everyone would get to see what is going on.  This would allow the market to contribute to analyzing the data and taking corrective action before the problem threatens the financial system.

Rather than provide all the current asset-level data, why can't regulators provide a summary?

Anything less than providing all the current asset-level data means that regulators are substituting their analytical abilities for the analytical abilities of the market.

Regulators claim to have learned their lesson from the credit crisis when it comes to analyzing current asset-level data.

For example, the Fed put over 100 of its PhDs on the stress test.  They requested more asset level data than they had ever requested before from the banks so they could double check the results to the stress tests that the banks were reporting.

All of which leaves one question unanswered:  why would Jamie Dimon believe that a regulator could do a better job of analyzing this asset level data and the risk of his competitors than his organization could?
Are you recommending getting rid of the supervisory function?

Absolutely not! 

The goal is to get a stable banking system without the economic distortions caused by regulator enforced information asymmetry.  Markets, and the global banking system is a market, function best when ALL market participants, including regulators, have access to the same useful, relevant information in an appropriate, timely manner.

As has been said previously on this blog, by providing this data to the other market participants, the global regulators get to piggyback off of their analysis.  For example, they can compare their analysis to JP Morgan's.  If the results differ, it would be informative for the regulators to understand why.
From the Future of Finance:  the End of Opacity and the Mother of All Databases:

The future of finance is the elimination of opacity throughout the financial system by using 21st century information technology.

This statement is the logical conclusion of the Bank of England's plan to substitute market discipline for bank examination.  As discussed in an earlier blog, Bank of England Adopting 21st Century Oversight of Financial Institutions,  the current model of bank examination does not work.

The current bank examination model, as practiced by regulators like the Financial Services Authority and Federal Reserve, involves sending out large numbers of examiners to look through the banks' books, demanding lots of detailed information for their internal review and asking the banks to run stress tests on assumptions the regulators provide.  A key feature of this model is that no detailed information is shared with the markets.

If this model looks like it parallels how the rating agencies operate, it does.   The parallel in the US goes all the way to the issuance of a CAMELS rating by the regulator.  A CAMELS rating is for regulators eyes only and is a reflection of a bank's overall condition in the areas of capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L) and sensitivity to market risk (S).

Just like the ratings produced by the rating agencies, since the markets do not have the information to do their own homework, the markets have to trust that the regulators get their ratings right.  Unfortunately, recent history shows that regulators were just like the rating agencies and they did not always get their ratings right.

According to a WSJ article

"a top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data."
Mr. Haldane identified the flaw in the bank examination model and the reason that regulators need to have banks disclose more information to the markets.

The markets are not overwhelmed by the quantity of data disclosed by financial institutions.  There are a number of market participants who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.

... On February 23, 2009, in a Wired article, Daniel Roth provided the support for Mr. Haldane's observation and solution in much more detail.  

"Even the regulators can't keep up. A Senate study in 2002 found that the SEC had managed to fully review just 16 percent of the nearly 15,000 annual reports that companies submitted in the previous fiscal year; the recently disgraced Enron hadn't been reviewed in a decade. We shouldn't be surprised. While the SEC is staffed by a relatively small group of poorly compensated financial cops, Wall Street bankers get paid millions to create new and ever more complicated investment products. By the time regulators get a handle on one investment class, a slew of new ones have been created. 'This is a cycle that goes on and on—and will continue to get repeated,' says Peter Wysocki, a professor at the MIT Sloan School of Management. 'You can't just make new regulations about the next innovation in financial misreporting.' 
That's why it's not enough to simply give the SEC—or any of its sister regulators—more authority; we need to rethink our entire philosophy of regulation. Instead of assigning oversight responsibility to a finite group of bureaucrats, we should enable every investor to act as a citizen-regulator. We should tap into the massive parallel processing power of people around the world by giving everyone the tools to track, analyze, and publicize financial machinations. The result would be a wave of decentralized innovation that can keep pace with Wall Street and allow the market to regulate itself—naturally punishing companies and investments that don't measure up—more efficiently than the regulators ever could.
Tracking Wall Street's complex inventions may be difficult for regulators, but it's a snap given the right software....When data is kept under lock and key, as mysterious as a temple secret, only the priests can read and interpret it. But place it in the public domain and suddenly it takes on new life. People start playing with the information, reaching strange new conclusions or raising questions that no one else would think to ask. It is impossible to predict who will become obsessed with the data or why—but someone will.

'People care about money,' Tim Bray, director of Web technologies at Sun Microsystems says. 'There's money in money and substantial personal upside to someone who can mine the data and uncover the truth.'"

Regular readers know that the best way to police the Fed and other financial regulators when it comes to their regulatory function is to require that all current asset and liability-level data is disclosed to the market participants in an appropriate, timely manner.  With this data, market participants can Trust, but Verify what the regulators say and do.

From the article on Professor Levine's paper:
Global financial regulators are likely to impede growth rather than foster it unless they are better policed, an economist warned policymakers on Saturday. 
While regulatory reform since the 2007-09 financial crisis has given added clout to government regulators, the concentration of power is likely to do more harm than good unless the regulators themselves are subject to proper oversight, Brown University economist Ross Levine said in a paper presented at the Kansas City Federal Reserve Bank's annual meeting here. 
"As more responsibilities are heaped on official regulatory agencies, it is unclear whether they have either the capabilities or the incentives to properly shape the incentives of financial systems," he said in the paper. 
A case in point is the Fed itself, which won new authority over large financial institutions in the Wall Street reform legislation passed last year. 
Central bank regulators do not lack in integrity, he said, but nevertheless relying on the "moral compass" of regulators does not guarantee they will do the right thing. 
"People flow between the Fed and the financial services industry, raising concerns that this 'revolving door' threatens the Fed's independence and its ability to represent the broad interests of the public," Levine said in the paper "And, the daily interactions between regulator and regulated can influence the perspectives of regulators, such that regulators take a narrow, skewed view of regulatory policies." 
The Fed has drawn sharp criticism from politicians at home and abroad who say the central bank's super-easy monetary policy is driving down the dollar and pushing up the price of global commodities. 
Levine's critique of the Fed is different because it is focused on the bank's regulatory role. It is notable because it paints the world's most influential central bank and other U.S. regulators with the same brush as government financial watchdogs in countries around the world. 
Oversight of regulators is critically important for promoting economic prosperity, Levine said, because without effective regulators, the financial system will not operate correctly and will drag on growth. 
"This lesson is as applicable today for the United States as it is for countries with less well-developed institutions," he wrote.

Simon Johnson calls for more transparent bank stress tests

In his NY Times column, Simon Johnson, former chief economist for the IMF, calls for more transparent bank stress tests to address the issue of solvency.  What caught my attention in the article was his observation about why national financial regulators on a global basis were actively blocking full disclosure of financial institution balance sheets.

Regular readers know that under the FDR Framework there are two primary reasons that stress tests are a fundamentally flawed undertaking.
  • Governments are not suppose to be providing investment advice which is what publishing the results of a stress test is.  There is no upside particularly when subsequent events like the nationalization of Irish banks after they passed a stress test occur.
  • Rather, governments are suppose to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can run their own analysis.  This is particularly important since under the principal of caveat emptor market participants are responsible for any investment gain or loss.
As practiced, stress tests also suffer from a host of other well known problems including:
  • They are focused on book capital.  Book capital is an easily manipulated accounting construct that has little to no relationship to the solvency of a financial institution (ex:  Lehman Brothers and Irish banks before nationalization).  
  • Everyone knows the results before the tests are run as the tests are designed to minimize the number of banks that fail.  This is easily achieved by modeling financial institutions with a suspension of mark to market accounting (ex: level 3 securities include Greek debt for which there is no market and management gets to value) and ongoing extend and pretend regulatory forbearance (ex:  second mortgages).
So why does Professor Johnson call for more transparent stress tests?  Because he sees a solvency crisis and understands that raising more equity is an important component for ending a solvency crisis.
...The prevailing wisdom about Europe is that it faces primarily liquidity problems. In this view, a few of the larger countries have had trouble rolling over their debts, and some leading banks need help with short-term financing....
There are two problems with this ... The first is that sovereign debt problems can easily become solvency issues — that is, more about whether countries can afford to service their debts rather than whether they can raise enough cash at reasonable rates in any given week. 
.... The more immediate Achilles heel is banking....
The main immediate problem for Europe is that we still don’t know exactly the condition of its major financial institutions. 
Please re-read Professor Johnson's observation again.  Four years after the beginning of the global solvency crisis and we still do not know the answer to the question of which financial institutions are solvent and which are insolvent.
The Europeans have run bank stress tests twice recently, in mid-2010 and again earlier this year. But in both cases the tests were far too lenient and banks were not required to raise enough capital. 
They should have been compelled to increase their equity funding relative to their debt, in order to create a greater buffer against future losses. 
The 2009 banking stress tests in the United States can also be criticized for not including a scenario that was sufficiently negative. In recent weeks the market has expressed great skepticism about Bank of America, its inherited liabilities, future business model and, most of all, the adequacy of its capital.
This recitation of the history of bank stress tests confirms why they would not be done by governments for publication to all market participants.
... Yet the European stress tests to date must be rated a notch or three below even the [most recent US stress test] in terms of transparency and communication of information that allows market participants to make informed decisions. 
The latest round, conducted by the European Banking Authority through July 15, did not even examine what would happen if a sovereign borrower had to restructure its debts — exactly what Greece was working on during the same time frame. (To be precise, there was some “sovereign stress” in the tests but very little compared with what we have seen and could see.) 
This is worse than embarrassing. It creates exactly the wrong kind of uncertainty around European megabanks, including their operations in the United States and potential spillover effects. 
To the credit of the European Banking Authority, it made it a requirement of the stress test that financial institutions' make dramatically more disclosure about their exposures than had previously been done.
In part this happened because the European Banking Authority is new — it came into existence on Jan. 1 — and not sufficiently powerful relative to national bank supervisors, many of whom are stuck in an old mindset where transparency is bad and full disclosure of banks’ balance sheets is scary. 
Transparency and full disclosure require the regulators to give up their information monopoly and with it their ability to gamble with financial stability.

With transparency and full disclosure, financial institutions will for the first time be subject to market discipline.  Market participants will know who is solvent and who is insolvent.  Market participants will know the amount of risk that each financial institution is taking and will be able to adjust the price and amount of their exposure accordingly.

Transparency and full disclosure is scary because market participants are no longer dependent on the regulators.  Instead, market participants can Trust, but Verify what the financial regulators say and do.
...But partial facts and distorted information flow [from the financial regulators with their publication of the results of their stress tests] are exactly what creates fear and instability, not just in Europe but much more broadly. 
Please re-read this comment as Professor Johnson has articulated why financial institutions needs to provide full disclosure and why partial disclosure accompanying stress test results creates financial instability.

Friday, August 26, 2011

Rather than put up or shut up, Bank of America tries to buy credibility

We appear to be replaying events from 2008.

As readers might remember, investors were very concerned about the solvency of the largest financial institutions in the US.  Warren Buffett saw this concern as an investment opportunity and purchased preferred stock in Goldman Sachs and GE.  Shortly thereafter, the US government proceeded to bailout the banks and Mr. Buffett was able to profit handsomely on his investment.

Since then, the US government has implemented a series of policies that masked, but did not address the solvency problem.

Recently, the solvency problem has reappeared as investors have questioned whether Bank of America is solvent or not.  BofA's management has reacted by vehemently denying that BofA has any solvency problems.

To resolve this debate, your humble blogger suggested that it was time for BofA to disclose its current asset and liability-level data because it is only with this data that market participants can determine for themselves whether BofA is solvent or not.  After all, the failure to disclose this data is the equivalent of announcing to the market that BofA has something to hide.

Rather than put up the data or shut up, BofA's management tried to buy credibility by accepting an investment from Mr. Buffett.  An investment that management had previously gone to great lengths to claim BofA did not need.

It is nice that Mr. Buffett is a highly regarded investor, but the market still does not have the data it needs to determine if BofA is solvent or not.

His investment of $5 billion in preferred stock does not appear to be enough on its own to recapitalize BofA if its critics are right that it needs $100 - $200 billion in additional capital.

Despite accepting an investment from Mr. Buffett, it is still time for BofA to disclose its current asset and liability-level data.  He will appreciate the disclosure if it shows that BofA truly did not need his investment!

Thursday, August 25, 2011

Run on the Greek banks continues [updated]

A Telegraph article reports that Greece was forced to tap an emergency fund for its banks because they were running low on collateral to pledge to the ECB.

Previously, as depositors withdrew funds, the banks would turn to the ECB for funding.  However, the run on the banks has now exceeded the good collateral the banks have to borrow against.
In a move described as the "last stand for Greek banks", the embattled country's central bank activated Emergency Liquidity Assistance (ELA) for the first time on Wednesday night. 
Raoul Ruparel of Open Europe told The Telegraph: "The activation of the so-called ELA looks to be the last stand for Greek banks and suggests they are running alarmingly short of quality collateral usually used to obtain funding." 
He added: "This kicks off another huge round of nearly worthless assets being shifted from the books of private banks onto books backed by taxpayers. Combined with the purchases of Spanish and Italian bonds, the already questionable balance sheet of the euro system is looking increasingly risky." 
Clearly, there is the potential for shifting the losses on these assets to the taxpayers.

However, that is not necessarily the case.  Regular readers might recall the posts on central banks can offer a free lunch (see here, here, and here).  The idea behind the free lunch is that central banks do not have a cost of carry for any asset they purchase.  As a result, they do not incur an "economic loss" if the total paid in interest and principal is equal to or greater than the "purchase" price of the asset.
Although it was done discreetly, news that Athens had opened the fund filtered out and was one of the factors that rattled markets across Europe. At one point Germany's Dax was down 4pc before it recovered. In London, bank stocks - which have been punished by traders nervous about the European debt crisis - fell again. 
In a bid to curb the falls regulators in Italy, France, Spain and Belgium extended their short-selling bans. Although it was designed to support European banks, experts in London reacted angrily to the move, claiming that regulators were wrongly targeting hedge funds. 
Andrew Baker, chief executive of the Alternative Investment Management Association, the hedge fund lobby group, said: "Short-selling was not the reason bank share prices were under pressure and banning it has not relieved that pressure." 
Richard Payne, a finance academic at the Cass Business School in London, ... argued that the moves were an attempt to deflect attention away from the failures of European politicians to come up with convincing solutions to the financial crisis. 
Traders argued that the worsening crisis in Greece was the real driver of market concerns. 
There are particular concerns that the political will to solve the crisis is waning, particularly in Germany. 
Athens' activation of the ELA will raise concerns that Greece will simply shift debt to Brussels. 
The ELA was designed under European rules to allow national central banks to provide liquidity for their own lenders when they run out of collateral of a quality that can be used to trade with the ECB. It is an obscure tool that is supposed to be temporary and one of the last resorts for indebted banks. So far it has only be used in Ireland. 
Regular readers are very familiar with the ongoing run on the Irish banks.
By accepting a lower level of collateral the debt in the ELA is, in theory, supposed to be the responsibility of Greece. However, since the Greek state is surviving on eurozone bailouts and Greek banks are reliant on ECB funding, in practice the loans are backed by the eurozone. The terms of lending and other details are not disclosed publicly. 
Mr Ruparel said: "Though the ELA is meant to be a temporary emergency solution, we know from Ireland, where the programme has been running for almost a year, that once banks get hooked on ELA they rarely get off it."
The reason that banks cannot get off is that no one knows if they are solvent or not.  When there is a lack of confidence in a bank's on-going viability, depositors have an incentive to move their funds to another financial institution.

The solution to restore confidence and bring funds back to both the Greek and Irish banks is disclosure of current asset and liability-level data.  When market participants can analyze this data, they can determine for themselves if the banks are solvent.  This is the low cost path to restoring confidence in the banking system.

Another Telegraph article describes the run on the Greek banks and the need for ELA as follows:
[T]he untold amounts of cash that Greek banks are preparing to help themselves to through Europe's seemingly most generous but mysterious cash machine known as Emergency Liquidity Assistance (ELA). 
This is a liquidity faucet that any national central bank can turn on to prop up its lenders that will otherwise fail. The ECB defines it as support provided "in exceptional circumstances and on a case-by-case basis to temporarily illiquid institutions and markets". 
The Bank of Greece has turned on the flow of funds and all Greek banks stand to receive the emergency cash. 
It could just be a precaution. After all, these Greek bankers are well known for their conservatism. 
But it could also be a sign of the increasing stress Greek lenders are experiencing under the official bail-out terms agreed by the eurozone last month. Rather than post Greek sovereign debt as collateral for emergency funding, the ELA allows lenders to post any old toxic assets in return for cash. It is the lack of disclosure and accountability of the ELA that is of most concern. Its size and conditions are unknown. 

Put up or shut up time for China's banks

The Financial Times carried an article on how, despite repeated assurances from management, China's banks fail to convince market participants that they do not face a problem with bad loans.

Regular readers know that what convinces market participants is not management's opinion, but rather the market participant's own analysis when all the useful, relevant information is disclosed.

Clearly, China's banks face the same problem that Bank of America faces:  it is time to put up or shut up.

Like Bank of America, these firms are hiding their current asset and liability-level data behind opaque financial reporting.

Please note, I do not know whether China's banks or their critics are right.

What I do know is that China's banks are in possession of facts, their current asset and liability-level data, that are not available to other market participants.  If these facts were made available and they supported China's banks, then the critics would go away.  In fact, the mere announcement that these facts were going to be disclosed would tend to silence the critics as the critics would assume the facts would not be voluntarily disclosed if they did not support China's banks.

That China's banks do not make these facts available strengthens the argument of their critics.  Critics see the failure to disclose all their current asset and liability-level data as confirmation that China's have something to hide.

Like BofA CEO Brian Moynihan, it is time that China's banks either put up current asset and liability-level data or shut up.

In case China's banks elect to put up, they know how to contact your humble blogger for assistance in coordinating this disclosure.
Chinese banks have once again produced sparkling results but they were unable to dispel concerns that their good fortune might yet turn to trouble because of non-performing loans and a slowing economy.... 
The story for much of the past year has been the divergence between Chinese banks’ record results and the unshakeable doubts in the market that the bill for their past lending excesses has yet to come due....
Although Chinese bank shares jumped a touch on Thursday, they remained generally flat on the week and down heavily on the year, as investors appeared to focus less on the strong earnings and more on the cracks in the foundations of the banks’ success. 
“We continue to see decent results but the numbers will not convince the bears that there isn’t a NPL problem. It’s just that we’re not there yet,” said an analyst who wished not to be named. 
Worries continue to centre on the surge in lending in China since late 2008, when Beijing used the banks, all of which are state controlled, to lead a credit-fuelled stimulus for the economy. 
The risks of that approach have started to show in recent months as officials have tried to account for the loans given to local governments – about Rmb10,700bn ($1,650bn), according to the national audit office – and estimate how many might end up in default
Prodded by regulators, the banks used their first-half results to present the most thorough picture yet of these potential problem loans.... 
But the banks also tried to reassure about the health of these loans and their readiness for any defaults. 
China Construction Bank, the country’s second-largest lender, said 84 per cent of its loans to local governments were fully covered by cash flow. And with its capital adequacy ratio at 12.5 per cent, exceeding regulatory requirements, Guo Shuqing, CCB chairman, said he saw no need to raise any more equity. 
“We’ll be able to maintain a good level of capital for the next few years. This won’t be a problem,” said Mr Guo. 
At Bank of China, Li Lihui, president, said provisions had been made for 217 per cent of bad loans, also well above regulatory requirements. “We have been extremely prudent and conservative,” he said. 
But the undeniable strength of the numbers served as a reminder of the chasm between the banks’ confidence and the unease that has weighed on investors’ minds
“It’s somewhat a trust issue in the reliability of the banks’ due diligence and reporting,” said May Yan, head of China banks research with Barclays Capital. “From the data provided by the banks, it looks like the impact [of the loans to governments] may not be big, but it is dubious how they estimate cash flow.” 

Insights from the FDR Framework on why banks are not lending

Four years after the beginning of the credit crisis, policy makers, economists and other market participants are asking the question of "why are banks not lending".

Historically, banks are senior secured lenders.  This role implies that they only make loans that have the following characteristics:
  • The borrower has the proven financial capacity to perform on the terms of the loan; and
  • The value of the collateral pledged to back the loan exceeds the amount of the loan.
If either of these two characteristics is not present, then banks are not suppose to make the loan.

Clearly, banks demonstrated in the years leading up to the credit crisis that they were willing to make loans that did not satisfy both of these criteria.  No Income, No Job loans stand out as an example of this willingness.

However, and this is a major caveat, in the years leading up to the crisis, banks viewed their balance sheet as a place to "park" the loan for a short interval prior to repackaging and selling the loan to the capital markets.  Bankers were originating loans that conformed to what could be distributed to investors.

This was different than originating loans that would be held to maturity on the bank's balance sheet.

The simple fact is that there are investors who are willing to take more "risk" than banks.  Hedge funds come to mind.

With the collapse of the securitization market and the ability to distribute credit risk, knowing that they were going to have to hold the loans on their balance sheets, banks had to make an adjustment in their lending practices so that only loans that have both characteristics are made.  In the best of times, this would have reduced bank willingness to lend.

Looked at through the prism of the FDR Framework, the lack of disclosure by financial institutions and structured finance securities of all useful, relevant information further reduces bank willingness to lend.

The mechanism by which the lack of disclosure reduces bank willingness to lend is the feedback loop between the requirement that the borrower pledge collateral in excess of the loan amount and the bank's ability to value the pledged collateral.  The lack of disclosure negatively impacts a bank's ability to value the collateral and as a result reduces bank willingness to lend.

How does a lack of disclosure impact a bank's ability to value the collateral?

The largest source of collateral is real estate and there are significant doubts about what residential or commercial real estate is worth.

Bankers know by looking at their own balance sheet that they have a sizable number of loans secured by real estate that are experiencing performance problems.  To date, these loans have received regulatory forbearance in the form of extend and pretend.

The question that bankers have to ask themselves is what would happen to the price of real estate should regulatory forbearance end and they and all of their competitors needed to sell all the underlying real estate collateral to repay the loans.  Would real estate prices drop 10%? 30%? More?

If the bank thinks prices would drop 30%, then the maximum loan amount against the real estate collateral is going to be less than 70% of current valuation.  This represents a substantial reduction from pre-credit crisis lending standards that were closer to 100% loan to value.

Most of this guesswork by the bank could be eliminated with disclosure under the FDR Framework.  With disclosure, market participants could help in the valuation of the collateral by valuing similar properties and establishing market clearing prices that are not artificially distorted by government policies.

Wednesday, August 24, 2011

Credit markets signaling solvency crisis heating back up

A Harry Wilson Telegraph article documents how the credit markets continue to be concerned with the issue first raised in 2007 of who is solvent and who is not.

When banks question if their counter-parties are solvent, they stop lending through the interbank market and start buying protection against the possibility of a default.
Insurance on the debt of several major European banks has now hit historic levels, higher even than those recorded during financial crisis caused by the US financial group's implosion nearly three years ago. 
Credit default swaps on the bonds of Royal Bank of Scotland, BNP Paribas, Deutsche Bank and Intesa Sanpaolo, among others, flashed warning signals on Wednesday. Credit default swaps (CDS) on RBS were trading at 343.54 basis points, meaning the annual cost to insure £10m of the state-backed lender's bonds against default is now £343,540. 
The cost of insuring RBS bonds is now higher than before the taxpayer was forced to step in and rescue the bank in October 2008, and shows the recent dramatic downturn in sentiment among credit investors towards banks. 
"The problem is a shortage of liquidity – that is what is causing the problems with the banks. It feels exactly as it felt in 2008," said one senior London-based bank executive. 
"I think we are heading for a market shock in September or October that will match anything we have ever seen before," said a senior credit banker at a major European bank.

Failure to solve banking crisis returns to haunt markets

In a Telegraph column, Phillip Inman observes that banks are in a credit crunch again.
Broken banks are a problem that affect all western nations. European banks must raise about $100bn this year to maintain and in some cases boost their capital buffers and many could struggle. Investors are less keen on banks than a year ago as profits slide and economies slip back into recession. 
In the US, Bank of America has seen its share price sink back to post Lehman levels, turning $50 a share before 2007 into less than $7 a share. It may need to raise $40bn to $50bn to meet regulatory demands for higher capital now the mortgages on its books are clearly worth less than the bank says they are. 
German and French banks, despite their bluster, are in an equally parlous state. 
Banks are struggling to get credit insurance on dealmaking and many have withdrawn from interbank lending forums. These stroke-inducing levels of anxiety affecting the banks feel like a re-run of 2008. 
Lars Frisell, the chief economist at Sweden's central bank [and a member of the Basel Committee for Banking Supervision], said last week it wouldn't "take much for the interbank market to collapse", bringing a fresh credit crunch
A Bloomberg article discussed this phase of the credit crisis.
Four years to the month since the global credit crisis began, European lenders remain dependent on central bank aid, plaguing markets and economies worldwide. 
Emergency steps such as unlimited loans from the European Central Bank are keeping many banks in Greece, PortugalItaly and Spain solvent and greasing the lending of others, while low interest rates and debt-buying are containing borrowing costs. Such aid is needed as concerns about slowing economic growth and sovereign debt prompt banks to curb lending, stockpile dollars and hoard cash in safe havens. 
“I’m not sleeping at night,” said Charles Wyplosz, director of the Geneva-based International Center for Money and Banking Studies. “We have moved into a new phase of crisis.” 
Central bankers rescued financial firms after the collapse of Lehman Brothers Holdings Inc. in 2008 by providing limitless funding of as long as a year. While they treated the symptom -- a lack of ready cash -- politicians, regulators and bankers in Europe have proved unable to cure the root cause: some European lenders are at growing risk of insolvency. 
As noted by Mr. Inman, the issue of solvency is not limited to Europe.

This blog has repeatedly observed that the focus of policy makers from 2008 onward has been to treat symptoms and not to cure the root cause of bank insolvency.
The tremors, the biggest since Lehman’s collapse, were triggered by European governments’ continuing inability to stop the sovereign debt crisis from spreading beyond Greece, Portugal and Ireland to Italy and Spain. Renewed signs of economic weakness globally and the downgrading of U.S. debt by Standard & Poor’s rekindled concern about the quality of all government debt. 
The signs of distress are widespread and mounting: Banks deposited 128.7 billion euros ($186 billion) overnight with the ECB yesterday, more than three times this year’s average, rather than lend the money to other firms. Banks also borrowed 555 million euros from the Frankfurt-based ECB’s overnight marginal lending facility, up from 90 million euros the day before. 
... The extra yield investors demand to buy bank bonds instead of benchmark government debt surged to 302 basis points yesterday, or 3.02 percentage points, the highest since July 2009, data compiled by Bank of America Merrill Lynch show. The cost of insuring that debt against default surged to a record today. The Markit iTraxx Financial Index linked to senior debt of 25 European banks and insurers rose to 252 basis points, compared with 149 when Lehman collapsed.
It was the specter of government debt turning toxic that has revived the liquidity crisis policy makers had tried to stop in 2008. As speculation grew that European banks would have to write down their holdings of more governments’ debt after a Greek default, lenders pulled funding to those banks that held the most peripheral debt. It also raised concern European governments would struggle to afford a further bail out of their banks, because both the state and the lenders had failed to reduce their borrowings since the onset of the crisis. 
“The debt has been transferred from the banks to the sovereign, but it hasn’t actually been eradicated,” said Gary Greenwood, a banking analyst at Shore Capital in Liverpool. “Until the sovereigns get their balance sheets in order, then these concerns are going to remain.” 
Funding markets have seized up as investors speculate that sovereign debt writedowns are inevitable. Banks in the region hold 98.2 billion euros of Greek sovereign debt, 317 billion euros of Italian government debt and about 280 billion euros of Spanish bonds, according to European Banking Authority data. 
The difference between the three-month euro interbank offered rate, or Euribor, and the overnight indexed swap rate, a measure of banks’ reluctance to lend to each other, was at 0.66 percentage point today, within 4 basis points of the widest spread since May 2009. 
“The central bank is the only clearer left to settle funds between banks,” said Christoph Rieger, head of fixed-income strategy at Commerzbank AG (CBK) in Frankfurt. “There is a mistrust between banks in general, between regions and with dollar providers overall.” 
... “Banks are becoming more nervous about being exposed to other banks as they hoard liquidity and become more suspicious of other banks’ balance sheets,” Guillaume Tiberghien, analyst at Exane BNP Paribas (BNP), wrote in a note to clients on Aug. 19. 
Regular readers know that it is only when all financial institutions disclose their current asset and liability-level data that it is possible to end the cycle of banks withdrawing liquidity from the market whenever they become worried about other banks' balance sheets.

With disclosure, banks can properly assess the risk of other banks and set both the amount and price of their exposures.
By contrast, banks in the U.S. are “flush” with liquidity, loan loss reserves and capital, Goldman Sachs Group Inc. analyst Richard Ramsden wrote in an Aug. 6 report. Large commercial banks combined holdings of cash and securities at large have climbed to 30 percent of managed assets, up from 22 percent at the start of the U.S. financial crisis in October 2007, Ramsden wrote, citing Federal Reserve data. 
Bank of America would appear to contradict the Goldman report as the bank is publicly arguing with critics over whether it needs to raise additional capital or not.
... Banks’ woes are again thrusting central bankers to the fore ....  After increasing its benchmark rate twice this year to counter inflation, the ECB this month provided relief for banks by buying Italian and Spanish bonds for the first time, lending unlimited funds for six months, and providing one unnamed bank with dollars to satisfy the first such request since February. In doing so, it’s maintaining a role it began in August 2007 when it injected cash into markets after they began to freeze. 
... The central bank is acting in part because governments have yet to ratify a plan to extend the scope of a 440-billion euro rescue facility to allow it to buy bonds and inject capital into banks. Markets tumbled last week on concern policy makers aren’t acting fast enough. 
... the ECB should eventually try to hand over fire-fighting duties either to governments, who would then inject capital into financial firms, or national central banks, who could provide short-term loans to lenders. 
Longer-term solutions may involve the restructuring the debt of cash-strapped nations in a way that doesn’t roil bank balance sheets, potentially in lockstep with a European version of the U.S.’s Troubled Asset Relief Program. 
Without current asset and liability-level disclosure, the only solutions available are bailouts.

With current asset and liability-level disclosure, other solutions become available.  For example, once the facts of a bank's insolvency are known, it could be allowed to continue operating, but with the requirement that it retain all its earnings until it is solvent again.
Lena Komileva, Group-of-10 strategy head at Brown Brothers Harriman & Co. in London, said the central bank may have no option but to extend the backstop role it is playing for periphery banks to lenders elsewhere. Refusal to do so would risk a European bank default by the end of the year, she said. 
“Markets are back in uncharted territory,” said Komileva. “The crisis is a whole new story now.”

Put up or shut up time for Bank of America

With its stock continuing to decline, Bank of America went on the offensive against its critics.  A strategy that is unlikely to succeed so long as BofA hides its current asset and liability-level data behind its opaque financial reporting.

In fact, the last time I saw financial institutions engage their critics like this was in 2008 with Lehman Brothers and RBS.  These firms also hid their current asset and liability-level data behind opaque financial reporting.

Please note, I do not know whether BofA or its critics are right.

What I do know is that BofA is in possession of facts, its current asset and liability-level data, that are not available to other market participants.  If these facts were made available and they supported BofA, then the critics would go away.  In fact, the mere announcement that these facts were going to be disclosed would tend to silence the critics as the critics would assume the facts would not be voluntarily disclosed if they did not support BofA.

That BofA does not make these facts available strengthens the argument of its critics.  Critics see the failure to disclose all its current asset and liability-level data as confirmation that BofA has something to hide.

Like his predecessors at Lehman and RBS, BofA CEO Brian Moynihan is at that time to either put up current asset and liability-level data or shut up.

In case he elects to put up, BofA knows how to contact your humble blogger for assistance in coordinating this disclosure.

Tuesday, August 23, 2011

FDR Framework and financial markets over-reacting

One of the strengths of the FDR Framework is that adherence to it keeps governments out of making observations about prices in the market.  There is no need to since the market participants have all the useful, relevant information in an appropriate, timely manner.

In the absence of this type of disclosure, governments are prone to talk about prices.  The question is:  do they have any credibility when they do so?

Before the credit crisis, the answer was yes.  Market participants knew they had a monopoly on all the useful, relevant information for financial institutions and trusted that governments knew how to use this data.

After the credit crisis, the answer is no.  The credit crisis showed that relying on the analysis by governments was no substitute for doing your own homework.  This has been confirmed in Europe with the last two stress tests.

According to a Telegraph article, EU president Herman Van Rompuy ventured into the discussion of prices by observing that financial markets are over-reacting.
He said jittery traders had behaved in a “fundamentally disproportionate” manner during the past fortnight, seeking out safe haven currencies and causing global markets to rollercoaster. 
Speaking on Belgian radio station RTBF, Mr Van Rompuy also ruled out issuing common eurobonds until what he described as “genuine budgetary convergence” within Europe. 
“Markets aren’t always right,” he said in the interview. “We could have eurobonds on the day...when everyone is in balance or virtually in balance.” 
Mr Van Rompuy cited the overvalued Swiss franc, which has soared by 14pc in value since the start of the year, as an example of investors’ insecurity. 
He said unwarrented panic had sparked the mass selloff of Italian and Spanish government bonds, which prompted the intervention of the European Central Bank earlier this month. 
“If the Swiss franc becomes a safe haven currency, it’s because something fundamentally disproportionate is going on in the world’s markets,” he said. 
Regular readers know that it is a lack of disclosure that is behind the market's reaction.  Without current asset and liability-level data, the market cannot tell who is solvent and who is insolvent.  As a result, the market is assigning a higher risk to everyone.
... The EU president said a better solution could be found in last month’s plan to give more flexibility to the eurozone’s €440bn (£384bn) rescue fund, which he urged governments to ratify as quickly as possible. 
While European growth slowed during the first half of this year, the region still shows signs of a healthy recovery and is likely to avoid recession, the EU president added. He said the risk of economic break-up within Belgium or the eurozone was “fiction”. 
Mr Van Rompuy said a six-part package of laws to strengthen European rules on national deficits is expected to be passed next month, with emphasis on an improved communications policy to boost investor confidence and dampen disagreements between governments. 
“We have to try to give the same message. It’s inevitable that there will be several voices. But everyone has to convey the same message,” he urged.
It is far easier to get everyone on the same page on disclosure.