Friday, October 26, 2012

Bank of England's Andrew Haldane calls for 'curbing King Kong banks'

The Bank of England's Andrew Haldane in his speech 'on being the right size'  became the latest regulator to call for cutting the Too Big to Fail banks down to size.

Besides Mr. Haldane's typical insightful analysis, his speech reiterated many of the observations made by Paul Volcker on why the regulations proposed since the beginning of the current financial crisis are not going to be effective at dealing with the Too Big to Fail banks.

Regular readers know that there is only one way to right size these banks:  require the banks to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency harnesses the market in shrinking these global financial institutions.

For example, the market shrinks these banks by charging the banks more for their complexity.  It is one thing to say these big banks have 14,000+ subsidiaries, it is another to make these banks disclose the intimate details of each subsidiary so the market participants can assess their risk.

In addition, the market shrinks these banks by restraining proprietary trading.  Management and traders know that disclosing their positions limits how much can be earned from proprietary trading.  At a minimum, market participants can use programs similar to IBM's Watson to identify trades that appear to violate the Volcker Rule and call these trades to the regulators' attention.

More importantly, ultra transparency ends contagion in the financial system.  With ultra transparency, market participants have the information they need to independently assess the risk of each of these banks and adjust the amount of their exposure to what they can afford to lose given the risk assessment.

As reported by the Telegraph,
Andrew Haldane, the Bank’s executive director for financial stability, claimed that current bank reforms – including the Government’s plans to ringfence retail banks – do not go far enough and further measures should be considered. 
To address properly the “too-big-to-fail” problem, he said regulators should consider doubling banks’ loss-absorbing capital buffers to around 20pc, “placing limits on bank size”, or imposing a “full separation of investment and commercial banking” rather than a ring-fence.
Each of these alternatives has problems.

The OECD observed and your humble blogger has fully documented why the accounting construct known as bank capital is meaningless.  It bears repeating that bank capital is meaningless because it is easily manipulated by both banks and their regulators.

Limiting the size of banks sounds nice in theory, however, the question is whether it is size that makes the Too Big to Fail problematic or the risk that if they fail it will cause damage to the rest of the financial system.  The way to mitigate this risk is to require the banks to provide ultra transparency.

Ring-fencing or full separation of investment and commercial banking sounds nice in theory, but the reason that Glass-Steagall fell was banks and their regulators had discovered that banks were bad holders of credit, interest and liquidity risk.  It was far more sensible for banks to originate and service loans and distribute these loans to investors who were better able to hold the loans.

The freezing of the structured finance market is a reflection of the failure to require that each deal provide observable event based reporting so that investors could know what they own.  The fact that the market froze does not say that it is a bad idea to have banks reducing their credit, interest and liquidity risk.
He added that the evidence pointed to the optimal size for a bank to be as small as $100bn (£62bn). ... 
Although banks claim to be more efficient the larger they are, Mr Haldane said the analysis ignored the cost of the implicit taxpayer guarantee that he calculated was worth $70bn a year for the world’s largest banks between 2002 and 2007, and $300bn a year now. 
Without the subsidy, “there is no longer evidence of economies of scale at bank sizes above $100bn. If anything, there is now evidence of dis-economies which rise with bank size, consistent with big banks becoming ‘too big to manage’,” he said. 
“Subtracting this subsidy, removing the state crutch, would suggest a dramatically lower socially-optimal banking scale. Like King Kong and Godzilla, these giants would arguably then be physiological impossibilities ... the weight transfer associated with a single step would have shattered their thigh bones.”
Mr. Haldane does have a wonderful way with words.

I know what his analysis suggests, but it is not clear to me that a bank that provides ultra transparency and operates as a utility doesn't have economies of scale when it gets larger than $100 billion.
Mr Haldane was warning that, despite regulators efforts to build regimes that allow banks to fail without taxpayer support, the risk is that – in the practical event of a giant lender’s imminent collapse – the government would discard the theory and step in. 
“Consider that trade-off when a big, complex bank hits the rocks,” Mr Haldane said. “On the one side is a simple, but certain, option – state bail-out. On the other is a complex, and less certain, option – resolution. If governments are risk-averse ... then bail-out may look attractive on the day. 
“The history of big bank failure is a history of the state blinking before private creditors.”
Please re-read the highlighted text as the point that Mr. Haldane makes is extremely important.

Our modern banking system is designed not to require government bailouts of the banks, however, there is a long tradition of bank regulators urging governments to bailout failing institutions (think Savings & Loans for example).
In his speech at the Institute of Directors, he argued that “one way of lessening that dilemma, and at the same making resolution more credible, is to act on the scale and structure of banking directly”....
The most direct way to act on scale and structure of banking is to require the banks to provide ultra transparency.  It would be amazing how much the banks would change by simply shining the bright light of transparency on them and letting it act as the best disinfectant.
Mr Haldane warned of potential loopholes in the structure. “Today’s ring-fence [can become] tomorrow’s string vest,” he said. He also questioned whether banks would properly separate “cultures and capital” as long as the two operations remained under one roof.
Both of these loopholes were identified by Paul Volcker in his testimony before Parliament prior to Mr. Haldane's speech.

As I learned when working for Mr. Volcker, what he says might not be the word of god when it comes to banking, but it does come from closer to god given his 6'7" height.
Although he welcomed the progress made on bank reforms so far, he added: “Claims that they have solved the too-big-to-fail problem appear to me, however, premature, probably over-optimistic. Worse, they risk sending a false sense of crisis comfort.”
His comments were released shortly after Christine Lagarde, managing director of the International Monetary Fund, spoke out against the “vested interests” in banking and said that unfinished reforms were hampering economic recovery. 
“There are many vested interests working against change and push-back is intensifying,” she said. “It is interesting how some banks say the new regulations will be too burdensome, but then spend hundreds of millions of dollars lobbying to kill them.”
The leading unfinished reform that is hampering economic recovery and that is being strongly resisted by the banks is requiring them to provide ultra transparency.

The banks know if they provide ultra transparency the market will force them to recognize upfront the losses on the excess debt in the financial system.  This will take the burden of supporting this debt off of the real economy and, as shown by Iceland, result in the economy growing again as capital that was used for debt service is now used to buy goods and services.

The banks know if they provide ultra transparency they will be forced to shrink dramatically.  Gone will be the subsidiaries to arbitrage rules and regulations.  Gone will be proprietary trading.  Gone will be behavior like manipulating Libor.
She added that progress was needed on resolution regimes to allow banks to fail and for regulators to coordinate and align their rules, particularly over new rules on bank structures such as ring-fencing or proprietary trading bans. “We need a global level discussion of the pros and cons of direct restrictions on business models,” she said.
Actually, we need to stop talking and simply implement ultra transparency.

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