Bank of England's Paul Tucker warns banks that worse yet to come

The Guardian reports that the Bank of England's Paul Tucker has warned banks that the worse is yet to come and that banks need to end their get-rich-quick culture.

The lead candidate to take over from Sir Mervyn King as governor of the Bank of England, Tucker told a City audience: "There is a tangible probability – not a high probability – that the worst may still be ahead" for banks, which was why they needed to hold more capital....

Regular readers know that your humble blogger feels sick every time I hear another economist or regulator call for banks to hold more capital.

Apparently the economist or regulator did not get the message from the OECD that bank capital is meaningless.

At the top of the list of reasons why it is meaningless is that regulators have engaged in regulatory forbearance which allows the banks to push off recognition of losses on bad debt through the use of extend and pretend.

Next on the list of reasons why bank capital is meaningless is that the accounting profession allowed banks to end mark-to-market accounting on all those toxic securities the banks are holding.  Since there is no deep, liquid market for those securities, nobody knows how much the current book value of these securities overstates what would be realized if the securities had to be sold.

Since losses haven't been realized, bank book capital is overstated.  Hence, it is meaningless.

"I would say that the Bank believes what it always believed: that sound and honest finance is not only essential for the economy, it will be good for the City too."

Regular readers know that at the heart of sound and honest finance is ultra transparency.  It is only when banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details that sound and honest finance occurs.

Without sunlight as the best disinfectant, we have ample evidence that bankers will engage in bad behavior (think Libor manipulation, interest rate swap mis-selling,....).

He said the Financial Policy Committee, on which he sits, was concerned a "tidal wave" could be coming. "We may all be grateful that there is a few billion more of capital here and there in the banking industry, keeping banks in the private sector rather than the dead hand of state ownership."...

Modern banking systems are designed not to require the 'dead hand of state ownership'.

Banks can operate and support the real economy for years even if they have low or negative book capital levels.  They can do so because of deposit guarantees and access to central bank funding.

With deposit guarantees, taxpayers are effectively the silent equity partner for the banks when they have low or negative book capital levels.

Tucker said bankers needed to be paid in subordinated debt and put more focus on customer service rather than sales and on the medium-term success of the firm. 

"Putting it bluntly that would make it less easy to get rich quick irrespective of the quality of the business transacted or the compliance culture in their part of the firm," Tucker said, indicating this would require changes to the codes on remuneration....

As I have repeatedly said, there are two problems with paying bankers with subordinated debt.

First, it takes the regulators' focus off of ensuring that banks provide ultra transparency.  With ultra transparency, the banks are subject to market discipline and as a result a restraint on their risk taking.

Second, this debt does not represent 95% of their compensation.  Bankers will receive other forms of compensation.  For example, bankers are likely to continue to receive stock options.  The reward from taking risk and boosting share price could easily offset the risk of loss on the subordinated debt.

Bottom line:  market discipline made possible by ultra transparency is superior at restraining bank risk taking than compensating using subordinated debt.

While changes are under way, Tucker said that all risk could not be avoided: "We need to find broadly the right balance between, on one hand, safety and, on the other hand, the contribution that sound and honest finance can make to economic prosperity. 

A balance that can only be achieved if banks are required to provide ultra transparency and the invisible hand of the market allowed to work properly.

"We may not be able to abolish the occasional waves of optimism that grip humanity and the tendency to excess when they set off. But we can and must dampen their effects on the financial system and economy. This must include changing the incentives that bankers face."

Without ultra transparency, the financial system is dramatically more unstable as it is dependent on the Financial Policy Committee to dampen the occasional wave of optimism or pessimism that grip humanity.

As the financial crisis showed, when there is a single point of failure in the system like dependence on regulators, the single point of failure will fail.

It is simply unacceptable to have a single point of failure in the financial system.  I am not advocating doing away with the Financial Policy Committee.  I am simply saying that the system needs ultra transparency so that the financial markets are not dependent on the FPC for stability.