An amusing view of the losses banks are hiding

From the Guardian,

Office of Financial Research: looks for advice in all the wrong places

In his ProPublica article, Jesse Eisinger confirms your humble blogger's observation that the Office of Financial Research is a tool of the financial services industry to bury transparency.

Regular readers know that there are two pillars underlying the FDR Framework:

• The philosophy of disclosure; and
• The Principle of Caveat Emptor (buyer beware).

OFR was designed under the Dodd-Frank Act to bring as much opacity to the financial system as possible.  Specifically, OFR can collect data, but it cannot share this data with market participants.  It can only provide summary analyses.

As a result, the ability of the market to analyze the data collected by OFR is never brought to bear on the data.

As Mr. Eisinger observed,

But hardly anyone is paying much attention to the Office of Financial Research. 

This entity was created by the Dodd-Frank Act to conduct independent research on the sweeping risks to the financial system. Ah, right, another group of Washington wonks who will issue reports carrying vague warnings of risks looming sometime in the uncertain future. Yawn. I hadn't paid much attention either. 

But then I spoke to Ross Levine, an economist and specialist in regulation at Haas School of Business at the University of California, Berkeley, and I finally got it. The Office of Financial Research is a great idea.

Indeed it is as it is based on my call since the beginning of the financial crisis to create the "Mother of all financial databases".

And as I grasped it, I felt a minor sense of horror, as when you see a precious ring slip off a finger in slow motion and go down the drain while you are powerless to stop it. 

This was exactly how I felt when I saw the supporters of the National Institute of Finance come bumbling into the space I had defined with the call for the "Mother of all financial databases".

The office is looking as if it will be a tool of the financial services industry, instead of a check on it. 

Which is exactly what the National Institute of Finance and its supporters managed to achieve because they had not the slightest clue about what they were doing.

Its main role is to serve the Financial Stability Oversight Council, providing the systemic risk overseer with data and analysis of where the nukes are buried.

This is where they made there first mistake.  OFR should never have been in the research business.  It should solely have been in the business of overseeing a data warehouse run by a third party that collected, standardized and disseminate data to all market participants.

Everyone knows except the ego maniacs who were part of the National Institute of Finance that the market is better collectively at doing analysis than a handful of economists.

By insisting on doing analysis, the supporters of the National Institute of Finance opened the door for the Wall Street lobbyists to both neuter OFR and protect opacity in the financial system by burying transparency in the form of the "Mother of all financial databases".

But the Office of Financial Research was hobbled from the get-go by a poor design. It is housed in the Treasury Department, while ostensibly being independent of it. It has a small budget. And it has to report to the very regulators it is supposed to report on. 

This month, it announced its advisory committee. Thirty big names charged with giving the fledgling operation direction and gravitas. But these same people have also compromised it. 

A committee that by design substitutes for the market if OFR had been a tool to bring transparency to all the opaque corners of the financial system like I intended that it should be.  Instead...

By my count, 19 of the 30 committee members work directly in financial services or for private sector entities that are dependent on the industry. There are academics, but many of them have lucrative ties to the financial services industry. I noted only one financial industry critic: Damon A. Silvers, the policy director for the A.F.L.-C.I.O.... 

The Treasury Department sees it differently. 

"We were not looking for critics or proponents. That wasn't the goal," said Neal S. Wolin, the Treasury deputy secretary. "We were looking for people with a range of perspectives who understand keenly the systemic risks in the financial system."... 

The world is teeming with expert critics of Big Banking; they just aren't heard from much in the halls of Washington. 

The Federal Reserve Banks of Kansas City and Dallas have candidates. The economist Joseph Stiglitz would make a good choice. The Bank of England houses two prominent banking critics, Andy Haldane and Robert Jenkins. Outfits like Better Markets or Demos could nominate people who would give Jamie Dimon some indigestion. 

Certainly, financiers are not a monolithic lot. Investors often have differing interests from those of banks, and investment banks from commercial banks, and the small from the large. Even in big institutions, there are secret sharers of anti-Wall Street sentiment. ...

Clearly, there is a place for finance professionals. But shouldn't the balance of the committee be tilted in the opposite direction and give greater voice to the critics and the banking skeptics? This is a panel that is supposed to identify giant risks in the system that bankers ignore in their pursuit of profit and bonuses and to spot flaws in regulations that could cost the public and economy trillions....

Imagine how all of these market participants could have been utilized to identify problems in the financial system if OFR were there to foster transparency rather than create opacity by monopolizing information. 

So why does yet another Washington advisory panel of worthies matter? Mr. Levine has a subtle and fascinating answer. He starts by pointing to the mystery of the home-team advantage in sports, which has long puzzled researchers.

It turns out that umpires are biased toward the home team not out of conscious or recognizable bias. Rather, they subconsciously gravitate toward their immediate "community" — in this case, the home-field crowd, especially at crucial moments in a game. (Researchers will next study how this appears to have no effect whatsoever on the New York Jets.) 

To minimize the bias, you can tell the umpires that they are being monitored. Introduce instant replay. With that, you have expanded the community that is watching the umpires to an audience far beyond the home crowd....

Which is exactly what happens when the data is made available to all market participants.

The Office of Financial Research is well on its way to barring the gate. 

Before the crisis, the consensus was that the Office of Thrift Supervision was the regulator most in the pocket of Big Banking. For its efforts, it got shut down as part of the postcrisis regulatory overhaul. 

"Now, the title of ‘Most Captured' is up for grabs," Mr. Johnson said. "And I think we have a contender." 

Bank of England finally gets tough and says banks need to come clean about their exposures

It appears that the Bank of England has finally decided that pursuit of the Japanese Model for handling a bank solvency led financial crisis results in a Japan-style economic slump.  Since they do not want this horrible fate to befall the UK, they are adopting the Swedish Model and requiring the banks to recognize their losses upfront on the excess debt in the financial system.

The Bank of England is achieving this by saying that the banks need to come clean about their losses regardless of the accounting treatment.

Regular readers know that this is what your humble blogger has been calling for since the beginning of the financial crisis.

As described by Larry Elliott in his Guardian column which also applies to the EU and US,

The fear that haunts the Bank of England is that Britain could become the next Japan. Permeating the whole of Threadneedle Street's latest update on the state of the financial sector is the conviction that, as with Japan in the 1990s, the sickness of the banking sector could throttle the life out of the economy. 

With Britain already half way through its own lost decade, the Bank's financial policy committee believes immediate action is needed that will force lenders to improve their financial resilience. 

If the warning sounds far-fetched, then compare and contrast. Britain had a long period of growth that ended with a massive property bubble. So did Japan. 

The UK banks lent far too much than was wise in the 2000s to property companies against too little capital. In doing so they followed a trail blazed by Japanese banks two decades earlier. 

When Britain's party finally ended, the result was an economic wasteland of over-indebted consumers and over-leveraged banks. 

In a repeat of Japan's experience, the credit taps were turned off and growth shuddered to a halt. Japan ended up with a zombie economy in which zombie banks were lending to zombie companies. Firms that would in normal circumstances have gone bust were kept on life support by lenders who themselves were kept in the realm of the living dead courtesy of easy credit and softly-softly financial regulation from Tokyo. 

Worryingly, the UK is showing signs of heading in the same direction. One in 12 companies are able to repay only the interest on their debts and between 5% and 8% of mortgage payers are able to stay in their homes only because lenders are going easy on them. The Bank is particularly concerned about the commercial property sector, which accounts for half of all commercial loans. One third of commercial real estate loans by value are subject to some sort of forbearance, and losses could be higher than lenders are estimating. 

To make matters worse, the Bank thinks accounting rules are allowing lenders to systematically underestimate risks when assessing loans, and that they will eventually face a much higher bill for mis-selling payment protection insurance than they have so far admitted..... 

With investor confidence in banks at a low ebb, drumming up enthusiasm for rights' issues could be tough.

It would be easy if the banks provided ultra transparency.  Then the investors could independently assess the risk of an investment in the banks and invest accordingly.

Bank shares rose slightly yesterday because there had been concern that King would specify what individual banks would have to do and by when. It would be a mistake, however, to believe that the issue of bank capital has been kicked into the long grass. 

The FPC is deadly serious about this because until the banks are sorted out the economy will remain in limbo. Raising interest rates will mean that the policy of "extend and pretend" towards non-performing loans will have to end. Banks will have to be robust enough to cope and at the moment they are not. So, the Bank means it all right. The real question is why it has taken it so long to get tough.

Bank of England to call for banks to provide transparency

As reported by the Wall Street Journal, the Bank of England's Financial Policy Committee will call on banks to provide transparency so that market participants can independently assess the value of each bank's assets and each bank's solvency.

Regular readers know that the only way to accomplish this is if the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The Bank of England is expected Thursday to heap further pressure on U.K. banks to come clean about the value of their assets, a move aimed at rebuilding investor confidence in the sector and freeing up idle resources to make more loans and foster a stronger economic recovery. 

The central bank's Financial Policy Committee, which brings together regulators, BOE officials and finance industry veterans to assess the health of the financial system, warned in September that banks will find it difficult to attract capital as long as investors are unsure of precisely how much bank assets are worth. 

The issue is also causing a headache for regulators--who say the banks' opaque balance sheets mean they can't decide whether lenders are safe or not--and for rate-setters steering U.K. monetary policy....

Please re-read the highlighted text as it appears that your humble blogger's argument for requiring the banks to provide ultra transparency has been both heard and understood.

"Capital needs could be better clarified, and the task of attracting fresh capital facilitated, if steps were taken to reduce uncertainty about valuations of on-balance sheet assets," the committee concluded, according to a record of its September policy meeting. 

Participants noted "market doubts" about the price tags banks currently place on some of their loans and other holdings, and vowed to consider how to tackle the issue this month after assessing the latest data....

Everyone knows that the price tags are wrong because of suspension of mark to market accounting and the adoption of regulatory forbearance that allowed banks to engage in extend and pretend with their bad debt.

Outgoing BOE Governor Mervyn King ... told lawmakers Tuesday there are "fundamental questions" that need to be addressed over whether banks' published balance sheets truly reflect their real-life positions.

 This can only be answered if the banks provide ultra transparency.

BOE officials and bank supervisors at the Financial Services Authority fret that, cheap funds or not, one reason some banks may be unwilling or unable to lend is that their balance sheets may be clogged with bad loans. 

Rather than foreclose and take losses, lenders have instead tweaked loan conditions or given borrowers more time to pay up, tying up capital that could be used to fund loans elsewhere. 

As far back as June last year, the central bank was warning that while such "forbearance" provides a lifeline to struggling homeowners and businesses and can, therefore, enhance financial stability, banks were nonetheless unsettling investors by failing to make adequate provisions for any potential losses.

Meanwhile, officials on the BOE's Monetary Policy Committee, which sets interest rates, worry that banking sector problems mean capital may be stuck in unproductive industries and isn't being shifted to the productive bits of the economy where it is sorely needed, a phenomenon that is severely impairing growth. 

British policy makers are desperate to ensure that the country doesn't succumb to a "lost decade" of stagnation like Japan did in the 1990s. Japanese banks' unwillingness to recognize losses--an endless "evergreening" of bad loans to "zombie" companies that the authorities took too long to tackle--has been identified as one of the key factors that kept Japan's economy in stasis.

 Regular readers have seen this argument presented on this blog in too many posts to count.

Richard Barwell, an economist at Royal Bank of Scotland and a former BOE official, believes policy makers are poised to act. He anticipates the FPC will Thursday set out fresh guidance on how best to ensure banks are valuing their assets prudently. 

"It is hard for investors to be sure which banks are weak and which are strong, and which if any need more capital, given the lack of consistent information. It all boils down to whether there is a difference between how the banks are valuing their assets and what they are really worth."

 And the only way to solve the question that has dogged the banking industry since the beginning of the financial crisis is if each bank provides ultra transparency.

To be sure, demanding banks open up about the true state of their balance sheets is fraught with risk. It may expose banks dangerously short of capital, potentially a big problem when two--Royal Bank of Scotland Group PLC (RBS) and Lloyds Banking Group PLC (LYG)--are largely in the hands of the taxpayer. It could also force banks to call in souring loans, leading to a surge in foreclosures and economic hardship. But policy makers hope that confronting an issue that has been festering since the crisis started may also allow the U.K. economy to finally get back on its feet.

I hope that I have answered the question of capital (not to worry as bank are designed with deposit insurance and access to central bank funding to operate with low or negative book capital levels).

I hope I have also handled the issue under the Swedish Model of banks recognizing their losses upfront.  As Iceland showed, banks can recognize their losses without throwing families out of their houses.

The Tabloid Test: Even bankers understand why sunlight is the best disinfectant

As reported by the Wall Street Journal, Barclays is in the process of putting each of its businesses through the "Tabloid Test".  The test asks the simple question of if the business was in the paper tomorrow, would you be proud.

Barclays' exercise confirms the need for requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, the market can help Barclays by doing a "Tabloid Test" on an ongoing basis.  This is why sunshine is the best disinfectant.

Barclays is looking to rebuild its reputation after it admitted to attempts to rig the London interbank offered rate, or Libor—the rate at which banks lend to one another. Mr. Ricci said the investment bank is now looking at its businesses through a "reputation lens" and deciding whether to keep them going. 

"Would they pass the tabloid test?" asked Mr. Ricci. "If you read about the activity in a newspaper, would you be proud?" 

Secondly, could this activity lead to problems in the future, he asked. To this end, the bank is considering axing several activities, including its tax-advisory and agricultural commodities trading businesses, he said.

Ultra transparency would let the market help with the question of could this activity lead to problems in the future.  As you can imagine, many of the tax-advisory strategies would not past the market smell test if disclosed.

Warren Buffett: Fed has no more bullets to stimulate the economy

Warren Buffett said according to a Telegraph report,

The Federal Reserve has "used up its bullets" to stimulate the US economy, Warren Buffet has said, as he warned that "D-Day" was here for politicians to strike a deal to solve the country's "fiscal cliff" problem. 

The billionaire investor said that it was now up to Congress to help boost America's flagging recovery. 

Speaking in an interview broadcast on Radio 4's Today Programme, he said: "I think [the Fed] has used up its bullets pretty much. When you drive interest rates to zero and when you buy almost a trillion dollars worth of securities and how you start buying longer-term securities -- you've done your part. I mean, Ben has given up the office."... 

"We've kicked it down the road for a long time," said Mr Buffett, "but D-Day is here and that doesn't mean we'll get the fiscal cliff problem solved by December 31. 

"I hope we do, but it may go over into January. But we are going to have to address important policy questions. I think Congress knows it, I think the president knows it, and certainly the American public knows it.

Mr. Buffett is right, the time to stop bailing out the banks under the Japanese Model for handling a bank solvency led financial crisis has come.  The US can no longer afford to protect bank book capital levels and banker bonuses.

The time has come to exit all the policies, like zero interest rates and quantitative easing, that were adopted to protect bank book capital levels and banker bonuses.

The time has come to see what the banks are hiding on and off their balance sheets.

As Iceland has shown and certainly the American public knows, the social safety net can be enhanced during a financial crisis when policy makers focus on protecting the real economy and the middle and lower class instead of the banks and the 1%.

The time has come to recognize that reducing the US debt is best achieved by adopting the Swedish Model and requiring the banks to recognize upfront the losses on the excess debt in the financial system.  This protects the real economy and allows money that is currently being diverted to support the excess debt burden to instead be used for reinvestment and growth.

A better economy means more tax revenue with which to repay the debt.

While we are at it, the time has come for the US banking system to recognize the value of deposit insurance and access to central bank funding and pay for the privilege.  Bankers can show their gratitude for these subsidies by donating their current balance sheet holding of US debt to the US Treasury.

This would dramatically lower the outstanding debt and would show the American public that bankers truly understand that they are there to serve the public and support the real economy and not the other way around.

Spain's retail customers whacked under unnecessary bank bailout

As the final terms of the bailout of Spain's nationalized banks become known, it is clear that the retail customers who were duped into buying hybrid securities in these banks are going to take a sizable loss.

My question is why are they being forced to take a loss?

Regular readers know that banks in a modern financial system are designed not to need to be bailed out.  The combination of deposit insurance and access to central bank funding allows them to continue operating and supporting the real economy even when they have low or negative book capital levels.

Given that the banks don't need to be bailed out, why are retail customers being forced to incur a loss?

From a Reuters article,

Spain's four nationalized banks will more than halve their balance sheets in five years, slash jobs and impose hefty losses on bondholders, under plans approved by the European Commission on Wednesday. 

The measures open the door for nearly 40 billion euros ($52 billion)in euro zone bail-out funds for the state-rescued banks, offering hope for an end to Spain's banking crisis which has pushed the country to the brink of asking for sovereign aid....

There is zero chance that this ends Spain's banking crisis.  Spain has 180+ billion euros of bad debt associated with real estate alone in its banking system.

"Our objective is to restore the viability of banks receiving aid so that they are able to function without public support in the future," said European Union Competition Commissioner Joaquin Almunia said....

By design, banks have public support.  Public support that takes the form of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers become banks silent equity partners when they have low or negative book capital levels.

Therefore, all a bailout does is change a silent equity partner into a shareholder.

Almunia said the nationalized banks would have to close up to half their branches during the five-year overhaul process. 

The biggest of the banks, Bankia, said it would lay off over a quarter of its workforce amounting to over 6,000 staff, reduce its branch network by around 39 percent and aim to return to profitability by 2013.

Neither of these required an "investment" by the taxpayer to accomplish.  Both could have been required by the banking regulators.

Bankia, formed from the merger of seven savings banks in 2010, said holders of hybrid debt would contribute up to 4.8 billion euros to the recapitalization, through losses incurred by swapping their holdings for shares....

Please remember, Bankia "sold" this hybrid debt to its retail customers because there were no institutional buyers for its capital securities.

At the time, your humble blogger observed that nobody would invest in Bankia without ultra transparency and disclosure of its current asset, liability and off-balance sheet exposure details as there was no way to assess the risk of the investment.

This prediction was true.

Many hybrid debt holders at the nationalized banks are retail customers who say they were conned into buying complex financial instruments that buoyed banks' capital levels instead of fixed-term savings accounts.

What was required to find investors was to misrepresent the investment to unsophisticated buyers.  As I recall, the representation was the investment was just as safe as buying a time deposit. Unlike time deposits, these securities were not guaranteed by the government.  An important misrepresentation.

Stifling dissent at financial regulators not unique to Bank of England

To no one's surprise, Bank of England governor Sir Mervyn King denied a report that his organization stifled dissent.

However, the Bank of England is not the first financial regulator to do this.  As the Nyberg Report documented, all of the Irish financial regulators engaged in stifling dissent.

There is a reason why dissent is stifled.  Each financial regulator insists on speaking to the market with one voice.

It is this single voice that dooms financial regulators to being a source of financial instability.

This can be easily shown by looking at the experience of bank examiners.  Leading up to the financial crisis in Ireland, there were a few individuals who saw the problem.

In order for their view that a problem existed to be communicated to the market, they had to convince everyone above them who worked for the financial regulator.  It is only by doing this that the "voice" of the financial regulator would say there was a problem.

There were two significant factors working against them that effectively stifle dissent.

First, the "voice" would be concerned that saying there was a problem would threaten the safety and soundness of the banks.  Even if there were a problem, there is a risk that by saying the problem exists that it makes the problem worse.

Second, the banks themselves would lobby both senior regulators, who are political appointees, and politicians to say there was no problem.  As we know, none are so blind as those whose current or future paycheck is dependent on not seeing.

At a place like the Bank of England or the Federal Reserve, there is a third reason why dissent is stifled.  The economic PhDs at the top of the shop are naturally defensive of their ideas (they learn this behavior as part of preparing for the dissertation defense) and have an incredible "not invented here" complex.

If they did not think up the solution, then the solution is by definition flawed.  They will go to the ends of the earth to come up with a reason it is flawed.

Take ultra transparency for example.  This is the solution to the problem that banks are 'black boxes' and market participants cannot assess the risk of the banks or exert market discipline on them.

I have been told by numerous economists that the problem with ultra transparency is that it would make so much data available it would confuse market participants.

This is not a flaw with ultra transparency, but rather a feature.  If HSBC is confused and unable to assess Standard Chartered after seeing its exposure data, the message is unmistakable, Standard Chartered needs to be shrunk in size until firms like HSBC can understand it.

Will Mark Carney champion transparency?

Ultimately, Mark Carney, the Bank of England governor designate, will be remembered by whether or not he champions transparency and market discipline and rejects the combination of complex rules/regulations and regulatory oversight as a substitute.

As I am using transparency, it refers to the idea of bringing transparency to all the opaque corners of the financial system including banks and structured finance.

• For banks, this takes the form of ultra transparency under which banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

• For structured finance securities, this takes the form of requiring them to provide observable event based reporting under which all activities like payments or delinquencies involving the underlying collateral are reported before the beginning of the next business day.

Regular readers know that if he champions transparency and market discipline, the financial crisis in the UK will quickly be brought to an end and long-term financial stability put in place.

Regular readers also know that if he continues to reject transparency and market discipline in favor of the combination of complex rules/regulations and regulatory oversight there will be no end in sight for the financial crisis.

Based on an interview with Euromoney, it is hard to tell exactly where Mr. Carney will come down.

Carney, who was appointed FSB chairman in November 2011, is tasked with implementing the Basle III accord.

His in-tray is groaning under the weight of the reform agenda and the ostensibly insurmountable challenges: crafting a regulatory system that reduces the prospect of another financial meltdown, but without choking off capital formation in an already depressed global economy. 

Carney is staking his credibility and reputation that Basle III – the third global regulatory effort in around two decades – is the world’s best bet to reduce the risk of another financial Armageddon. 

In his capacity as chairman of the global agenda-setting and co-ordinating body, which works with the Basle Committee on Banking Supervision, he is executing changes to the composition and definition of capital, liquidity and counterparty credit risk, capital buffers and the leverage ratio, while crafting a single rule book, enhanced supervisory measures and sanctions for noncompliance....

This suggests he prefers substituting complex rules/regulations and regulatory oversight for transparency and market discipline.

"The reform agenda is being pursued with a legitimate effort to increase the resilience of the system in the most efficient way possible. We could build capital to the moon and we would not have to worry about an institution failing but the economy would not be there," he tells Euromoney. "The interests of the private financial community should be absolutely aligned with those of the regulatory community to grow the real economy in a sustainable way. And the more enlightened members of the financial community have that perspective."...

Regular readers know that transparency is the most efficient way to make the financial system resilient without negatively impacting growth in the real economy.

So it sounds like Mr. Carney is open to hearing about transparency and market discipline.

Gordon Nixon, chief executive of Royal Bank of Canada, agrees: "He acknowledges the fact that the complexity and over-reach of regulation inflicts economic damage and he is fighting to achieve a better balance between regulation and growth within a very constrained political context. I would rather have him fighting for that balance than anyone else I have ever met in the regulatory or political world." 

Although recent scandals have reintroduced calls to break up the big banks even as they maintain their argument that the universal banking model benefits from diversification of geographic exposures and earnings by business type, Carney’s assessment is more nuanced. 

He principally cites the failings in operational oversight and culture, rather than the inherent structural risks of scale and complexity, in the most recent scandals. 

"In these [recent] episodes there were fundamental issues of conduct, and troubling issues of oversight, be it risk management or operational oversight," he says "It is not truly accurate to say they prove something systemic. A common aspect in several cases is that the people involved did not appear to take into account wider societal norms or the implications between what they did and their institution’s ultimate relationship with the real economy." 

He cites money-centre and deposit banks in the US and elsewhere as evidence that it is possible to run well-managed large, global institutions, although he refrains from naming specific banks.

The common aspect of these cases was they all occurred in the opaque corners of the financial system where sunshine could not act as the best disinfectant of bad behavior.

As I said earlier, it is hard to tell whether Mr. Carney will champion transparency and market discipline or not.  If he does, I would expect a quick resolution of the financial crisis in the UK.  If he does not, I would expect that the next Governor of the Bank of England will be dealing with an economy in far worse shape and a financial crisis that is exponentially worse.

More on how Iceland managed to overcome its financial crisis

No country was hit harder by the financial crisis than Iceland.  Yet, Iceland is the only country that has managed to overcome its financial crisis.  Why?

Regular readers know that Iceland alone adopted the Swedish Model for handling a bank solvency led financial crisis and protected its real economy.

Iceland chose to require its banks to recognize upfront the losses on the excess debt in the financial system that they would ultimately incur if the bad debt was allowed to go through the process of default and foreclosure.  By making the banks take the losses on the excess debt, the burden of servicing this debt was not placed on the real economy.

Please note, while the banks recognized their losses upfront, they did not create equity for the borrowers.  Rather, loans were restructured so that they were affordable to the borrower.

In a der Spiegel interview, Iceland's economy minister talks about out steps Iceland took to address the financial crisis.

SPIEGEL: What can European crisis managers learn from the experience of your small country?

Recognize your losses ....

Sigfusson: We are not going to preach to Europe that we have found the cure all. But it was important that we didn't wait, but that instead we reacted immediately to symptoms of the crisis.

None of this forbearance on bad debt that has been pursued in the EU, UK and US.

In order to remedy the deficit, an increase in taxes to raise revenue was unavoidable, but savings measures were also necessary. We needed a mix of both and the strong conviction in preserving our welfare system. 

Please note that Iceland put preserving its welfare system ahead of preserving its bank's book capital levels and banker bonuses.  Something that the EU, UK and US have not done.

SPIEGEL: What can you recommend to countries in crisis like Greece? 

Sigfusson: First security for society. Then the lower and middle income classes must be protected from austerity measures. Their purchasing power must be maintained so that their consumption can contribute to the revitalization of the economy. Internationally that is often overlooked.

Please re-read the highlighted text as it nicely summarizes why the Swedish Model works for ending a bank solvency led financial crisis and why your humble blogger continues to urge the policymakers of the EU, UK and US to adopt the Swedish Model.

China faces hidden risk of 'shadow finance' led financial crisis

It appears that China is going to experience its version of the 2008 structured finance meltdown that almost brought down the global financial system.  The Wall Street Journal carried an article that highlights how loans made by China's opaque shadow finance sector may be coming back to haunt its banks.

The solution for China, just like it was and is for shadow banking in the EU, UK and US, is to bring transparency to the shadow finance sector.

Specifically, China should require that there be observable event based reporting for all activities like a payment or delinquency involving the underlying loans before the beginning of the next business day.

With this disclosure, investors could independently assess the risk of the loans and would know what they own.

Mr. Wang's case highlights the hidden risks to banks from their links to China's fast-growing "shadow-finance" industry, a term for all types of credit outside formal lending channels. 

Shadow finance in China totals about 20 trillion yuan, according to Sanford C. Bernstein & Co., or about a third the current size of the country's bank-lending market. In 2008, such informal lending represented only 5% of total bank lending. 

China's shadow-finance industry has experienced similar growth to the global shadow banking system in the years leading up to the financial crisis.

The sector is lightly regulated and opaque, raising concerns about massive loan defaults amid a softening economy, with ancillary effects on the country's banks. 

Just like the shadow banking system, China's shadow-finance industry is lightly regulated and opaque.  As a result, no one knows what is going on.

Banks often work with private lenders by selling loans to them or marketing investments on their behalf for a fee. 

"Regular banking and shadow banking are not isolated from each other. Many activities in the two systems feed into each other, and could influence each other if things start to deteriorate," wrote Xiao Gang, chairman of Bank of China Ltd., in an editorial in the China Daily newspaper. 

Although China Credit has the legal responsibility to repay investors, according to Chinese law, "for reputation's sake and potential social stability reasons, a portion of these loans can be banks' contingent liabilities," said David Cui, China strategist with Bank of America Corp.'s BAC -0.66% Merrill Lynch unit. 

Just like the shadow banking system, nobody knows what the exposure of the regulated banks are to the shadow banks.  As a result, nobody knows if the regular banks are solvent or insolvent.  This sets the stage for a systemic financial crisis.

Others agree. "Banks might be held liable if bank representatives didn't adequately evaluate the products' risks for their clients," said Peng Junming, a former official at the People's Bank of China who now runs his own investment firm, Empire Capital Management LLP.

With opacity and a lack of observable event based reporting, it is impossible for the banks to have adequately evaluated the products' risks for their clients.

Just like shadow banking leading up to the beginning of the financial crisis, China's version of shadow-finance is a powder keg ready to blow up.

Did either interconnectedness or contagion cause the financial crisis

Harvard professor Hal Scott and the Committee on Capital Markets Regulation issued a discussion paper in which they looked at the role played by interconnectedness and contagion in the financial crisis.

They found that contagion was the primary cause of the financial crisis and they offered seven solutions to address the problem.

The study engages in a detailed analysis of interconnectedness (i.e., the linkage between financial institutions) in the context of the failure of Lehman Brothers in October 2008 and concludes that interconnectedness was not a major cause of the recent financial crisis. 

The study continues with a discussion of financial contagion (i.e., run-like behavior that spreads from the perceived failure of a financial institution to other financial institutions) and an analysis of possible solutions to contagion. 

The study highlights that a distinguishing feature of contagion is its ability to spread indiscriminately among firms in the financial sector and notes that contagious runs can occur even if there are no direct linkages to the original institution (i.e., even in the absence of interconnectedness).

This finding is in direct contrast to the finding of the Financial Crisis Inquiry Commission (FCIC).  FCIC found that all financial institutions shared a common interconnectedness and source of contagion.

Specifically, due to a lack of transparency, no financial institution (or investor) could determine if any other financial institution was solvent or not.

Without the ability to determine if a financial institution is solvent, banks with deposits to lend or investors with money to invest refused to lend to banks looking to borrow.  The result was the interbank lending market and unsecured bank debt market froze.

The study comes to the conclusion that contagion was the primary cause of the financial crisis and that short-term funding in particular is the primary source of systemic instability. 

In the context of these conclusions, the study engages in a comprehensive and detailed analysis of the possible solutions to financial contagion. The solutions include: (i) capital requirements, (ii) liquidity requirements, (iii) resolution procedures, (iv) money market mutual fund reform, (v) lender of last resort, (vi) liability insurance and guarantees, and (vii) public bailouts. ....

Please note that requiring the financial institutions to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is not included in the list of possible solutions.

If the financial institutions had been required to provide ultra transparency, then the issues of interconnectedness and contagion would have been moot.

With ultra transparency, each market participant can independently assess the risk of each financial institution and adjust their exposure to what they can afford to lose given this risk.  Included in the market participants who would adjust their exposure are a bank's competitors and investors.

References to transparency showed up 9 times in the study including the following

One example widely discussed during the financial crisis is the Swedish banking bailout in the early 1990s. 

The Swedish bailout adopted a typical “good bank-bad bank” approach and was not noteworthy in terms of techniques. 

However, the Congressional Oversight Panel has noted two aspects of the Swedish bailout: maximum transparency and independence. 

The Swedish government created an entity separate from its existing financial regulators to oversee the bailout efforts and granted it both political and financial independence. The bailout authority then required the banks in trouble to open their books and conducted audits to assess their potential capital needs. 

Gee, ultra transparency!

Rogoff and Reinhart: recognizing losses on bad debt speeds recovery

In their interview with Barron's, economists Kenneth Rogoff and Carmen Reinhart effectively endorsed the Swedish Model over the Japanese Model for handling a bank solvency led financial crisis.

Under the Swedish Model, banks are required to recognize up font their losses on the excess debt in the financial system.  This protects the real economy.

Under the Japanese Model, bank book capital and banker bonuses are protected at all costs.  This places the burden of the excess debt on the real economy with the result being a prolonged Japan-style economic slump.

What are your thoughts about the steps taken to foster fiscal and monetary policy? 

Reinhart: We can always go back and figure out a way in which the fiscal and monetary policy could have been made sharper, to do more. But the thrust in a deep financial crisis, when you throw in both monetary and fiscal stimulus, is to come up with something that helps raise the floor. That's why the decline wasn't 10% or 12%. 

However, one area where policy really has left a bit to be desired is that both in the U.S. and in Europe, we have embraced forbearance. Delaying debt write-downs and delaying marking to market is not particularly conducive to speeding up deleveraging and recovery. Write-downs are not easy. On the whole, write-offs have been very sluggish. 

Rogoff: Again and again, policy makers, Wall Street economists, and world leaders have all been overly optimistic about how fast things are going to go. If you think that we are about to get a V-shaped recovery, then you talk yourself into forbearance. 

It helps when the bankers are standing there saying the financial system is going to collapse unless their is forbearance.

If you think, "My gosh, this is going to last 10 years, but how can we make it last seven years?" you say, "This is really painful, but we've got to do it." But they've been very slow coming around to the view that this downturn isn't ending soon, and they can't just hold their breath and have it go away.

Your humble blogger has been making this point since the financial crisis began.  Every day policy makers have to make a decision over whether they would like to end the financial crisis sooner or let it drag on.

Every day that policy makers continue to pursue the Japanese Model and forbearance over the Swedish Model, policy makers are choosing to let the financial crisis drag on.

Look at Europe. A lot of policies are directed at keeping European banks afloat, and it is crippling the credit system. You could have said the same about the U.S., where a lot of policies are about recapitalizing the financial system. The policy makers were very, very cautious about breaking eggs. The thinking was, "We just have got to hold out for a year, and it is going to be fine."

Well, everything is not fine in Europe or the US.

Don't take my word for it, just look at the Federal Reserve's recent adoption of permanent quantitative easing.  Is this a monetary policy consistent with everything is fine in the financial system?

What kind of policy makes sense in the U.S.? 

Reinhart: On the monetary side, which for me is the least ambiguous right now, this is not the time to be an inflation hawk. I would rather see the margin of error favor easing too much, rather than too little, for many reasons. The frailty of the recovery is still an issue. The amount of debt that is still out there for households, the financial industry, and the government is still large. 

The fiscal side is more complicated, because the idea of withdrawing stimulus in what is still a frail environment is not an easy one to tackle. However, over the longer haul, a comprehensive, credible fiscal consolidation is very much needed, because as much as we allude to the level of public debt, the level of private debt, external debt, and so on are even higher. And we also have a lot of unfunded liabilities in our pension scheme, a long-term issue that needs addressing. 

But getting back to the earlier point about helping the deleveraging process, we have a credit system that is still working very poorly. 

Right.  So the policy that makes sense for the US is to adopt the Swedish Model and have banks recognize all the losses on the bad debt hiding on or off their balance sheets.

HSBC chairman urges bankers to swear an oath

The Telegraph reports that the HSBC chairman is urging bankers to swear an oath similar to that sworn by doctors in a bid to restore trust in banks and bankers.

Before taking the oath, every bank needs to begin providing ultra transparency and disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is needed not only because this form of sunshine that is the best disinfectant, but because it is the foundation of the bankers pledge to engage in an honest, fair manner with all of their clients, customers and counter-parties.

Everyone knows that a bank and its bankers that are not willing to provide ultra transparency are hiding something and should never be trusted.

So when is HSBC going to start providing ultra transparency?

Douglas Flint, the chairman of HSBC, is pushing for bankers to take an oath similar to that sworn by doctors as part of radical plans to overhaul the way the profession is viewed in the wake of the financial crisis and successive banking scandals. 

He is calling for the oath to be administered by an independent body designed to police the banking industry and is understood to have discussed the prospect with his counterparts at the UK’s other big banks....

With ultra transparency, all market participants could police the banking industry.  We have already seen with the financial crisis that regulators are not up to the task.

Mr Flint, the bank’s finance director for 15 years before being elevated to chairman in 2011, is working with the British Bankers Association (BBA) on the idea....

The very same British Bankers Association that brought us the opaque mechanism for setting Libor that allowed the banks to manipulate the rate for their own profit behind a veil of opacity.

The first of eight principles sets out the need “to act honestly and fairly at all times when dealing with clients, customers and counter-parties”.

In order to abide by this first principle, the bank must provide ultra transparency.  Without this information, it is impossible for clients, customers and counter-parties to know if the bank and its bankers are acting honestly and fairly.

Tax havens: an example of banks fighting to retain opacity in the financial system

In an interesting article, the Guardian looks at the fight to bring transparency to tax havens so that countries can know if their citizens are paying what they owe in taxes.

Clearly, this is a major issue given the amount of sovereign debt outstanding.

It is another example of why transparency must be brought to all the opaque, corners of the financial system.

Regular readers will not be surprised to learn that leading the fight to block transparency are the banks.

The world is seeing the first stirrings of an emerging new architecture of global transparency in taxation which could, if pushed forwards, help governments for the first time raise serious revenues from the estimated $21-32 trillion sitting offshore. 

Switzerland, in alliance with the tax havens of Luxembourg, Austria and Britain, is leading the charge to derail it.

And who in these countries would be leading the charge to derail transparency?  Why the banks whose private client business model is based on helping their clients defer paying taxes.

The battle now under way hinges on a powerful transparency principle called automatic information exchange. According to this, governments routinely tell each other about the cross-border assets and income of one another's citizens so they can tax them appropriately. 

This is the gold standard of transparency and the basis for a multilateral European scheme, the European Savings Tax Directive, which includes 42 European and other countries. This multilateral scheme is riddled with loopholes, but it is already up and running. Amendments to plug those loopholes are being prepared. 

A second pillar of the emerging architecture is run by the OECD, a club of rich countries that contains several tax havens (including Britain, which partly controls a number of major tax havens, such as the Cayman Islands, the British Virgin Islands and Jersey). 

The OECD scheme runs on a ridiculously weak transparency principle: information exchange on request. Here, you cannot make blanket information requests to a tax haven: you must ask, on a case-by-case basis. That means you effectively have to know the information you are looking for – before you ask for it. Precious little information flows through these narrow pipes....

It is no surprise that the banks oppose automatic information exchange in favor of information exchange on request.

This is yet another example of the veil of opacity allowing misbehavior to occur.  This time the party potentially engaging in misbehavior by not paying their taxes is the client.  However, they are aided and abetted in this by the bankers.

In August last year, Switzerland threw a huge spanner into the works. It signed bilateral tax deals – "Rubik agreements" – with Germany and Britain, based on a very different principle: wealthy people with Swiss accounts can preserve their secrecy and, instead, merely pay a one-off, withholding tax on assets, and a bit of future income. "Trust us," say Swiss bankers – who have centuries of form helping the world's wealthy get around the rules of civilised society.... 

The Rubik project is a Swiss swindle – and a humiliation for this government. If successful it would, in the words of Professor Itai Grinberg of Georgetown University, "stifle the emergence of multilateral automatic information exchange". 

The Swiss Bankers' Association, which designed Rubik, has explicitly admitted that its original purpose was "to prevent" automatic information exchange: in other words, to kill the European Savings Tax Directive. In particular, crucial and powerful amendments to plug the directive's loopholes are now held up because Luxembourg says it won't accept them if Germany and Britain (and now the tax haven of Austria, which has signed its own Rubik deal) get special bilateral treatment from Switzerland. 

This obstructionism was the plan all along. ....

Thankfully, Germany's Bundesrat is widely expected to throw its Rubik deal out in a vote on Friday. ...  A top Green party official called it "a slap in the face for all honest taxpayers"; and the head of the centre-left Social Democratic party, has accused Swiss banks of engaging in "organised crime". 

If Germany rejects the deal, as seems likely, Austria will be easily dealt with, leaving Britain alone as the last big obstacle to progress in the greatest transparency project the world has seen.

European Parliament call for transparency and the creation of the "Mother of all financial databases"

In studying how to balance the risks and benefits of shadow banking, the European Parliament concludes this is best done by enhancing transparency and creating the "Mother of all financial databases".

From a European Parliament press release,

Better prudential oversight is needed to reduce shadow banking's systemic risks, without stifling its benefits to the economy, say MEPs in a resolution voted on Tuesday. 

Shadow banking institutions account for up to 30% of the global financial system, worth over €50 trillion in 2011. In good times, they provide credit to people or entities that otherwise cannot get it and so fund the real economy. But if they make bad investments they have no protection, because they do not hold deposits and have no access to central bank liquidity. 

Risks to regular banks
Shadow banks do not exist on their own. They are interconnected with regular banks, which often use them to get round capital and accounting rules. If they collapse, they can cause a domino effect across other financial institutions and borders, bringing down regular banks and ultimately harming taxpayers across the EU who are obliged to come to the rescue. 

Safeguard alternative funding
MEPs say that shadow banking should be better monitored and supervised, so as to reduce the systemic risks they pose without cutting of the benefits that they provided to the real economy. 

Prudential oversight should reduce the systemic risks that shadow banking may pose due to the lack of data on financial flows and interconnections and the highly complex nature of its financial products....

Identify systemic risks
MEPs also suggest ways to reduce identified systemic risks, such as extending capital requirements to all unregulated entities, imposing limits on the complexity of  financial products or considering whether shadow banking entities linked to a bank should be included in the bank's balance sheet. 

Finally, MEPs call on the Commission to adopt a consistent approach to collecting data centrally, with a view to mapping all financial service transactions in real time so as to capture the riskiest deals.

The first step in mapping financial flows is to collect the data on each financial institution's exposures.  Doing this requires that the financial institutions provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This data should be collected and made available to all market participants through the "Mother of all financial databases".

King vs Osborne: a tussle over meaningless bank capital requirements

Against the backdrop of EU banks asking for a one year delay in the introduction of Basel III in light of the US not implementing Basel III in 2013, we have the spectacle of the Bank of England's Mervyn King fighting with UK Chancellor George Osborne over leverage on UK bank balance sheets.

Regular readers know that bank capital and any ratio involving bank capital is meaningless.

The OECD observed that bank capital is meaningless given the existence of regulatory forbearance that allows banks to engage in 'extend and pretend' with bad debt and the suspension of mark-to-market accounting.  Both directly manipulate bank book capital levels by overstating exactly how much book capital there is.

Capital ratios are an example of the combination of complex rules/regulations and regulatory oversight that are substituted for transparency and market discipline.

The financial crisis showed that this substitution contributes to financial instability and makes the financial system prone to failure.

Regular readers know that what is needed is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants can independently assess the risk of each bank and calculate capital ratios if they want to as part of this assessment.

Indeed, the more important clash is King v Osborne on the vital issue of the degree of leverage on UK banks' balance sheets. 

Vickers' panel was crystal clear: leverage should be capped at 25 times capital. But the chancellor has watered down that proposal, saying the government is happy to tolerate 33 times. 

To most outsiders, it looks as if Osborne has been swayed by the lobbying of the likes of Santander UK, which argues that a mortgage-dominated bank would be constricted by Vickers' harder limits. 

Of course the government is swayed by the lobbying of the industry.  There is no surprise here.

What is left unsaid is that both King and Osborne are swayed by the lobbying.  In particular, both of them are spending time arguing about a meaningless capital ratio when what is needed is to restore transparency to the banking system.

Vickers was unhappy about the watering-down and King sounds furious. 

The governor gave a blistering defence of the more conservative approach. International standards for calculating risk-weighted assets are too inflexible; risk weights move over time; and in major crises risks tend to interact. For those reasons, pure leverage ratios have proved the best guide to the strength of a bank in a crisis. 

As King pointed out, Northern Rock, while fully up-to-date with the Basel banking committee's finely tuned risk calculations, was still operating at 80 times leverage before its collapse. 

The argument over the right amount of leverage is nonsense.

The only relevant issue is how much risk the banks are taking so that market participants can adjust their exposure to each bank based on the risk of each bank and the market participant's capacity to absorb losses given this risk.

Setting sensible leverage ratios should therefore be at the top of the reform agenda. It's more important than the detail of which activities should lie, or be required to lie, within a ring-fenced bank.

Actually, what should be at the top of the reform agenda is requiring transparency.

If King, Vickers (and Tucker?) think 25 times is high enough and that Osborne is being too racy, that's a major concern. Let's hope the commission, which seems to be in a mischievous mood, kicks up a storm about leverage.

I am hoping the commission kicks up a storm about transparency which is what truly matters and is the only sensible reform.

UK financial institution calls for full deposit insurance

Nationwide Building Society, a UK financial institution, answered the question of why was there a run on Northern Rock while calling for full deposit insurance.

As reported by the Telegraph, Nationwide would like full deposit insurance for all financial institutions so as to eliminate the confusion that triggered the run on Northern Rock.

The reason for the run was that Northern Rock depositors knew that their deposits were guaranteed up to a certain level, but were confused over what this level was.

Remember, with deposit insurance, depositors don't care about the performance of the bank.  They only care they can get their money back.

Nationwide Building Society has been lobbying for clearer and more comprehensive protection for depositors for over a year now, and is stepping up efforts ahead of publication of the new Financial Services Bill. 

Under current arrangements, savings are only insured up to a maximum of £85,000 per person per bank or building society. Above that, savers would face losses if the company failed. 

However, Graham Beale, Nationwide’s chief executive, told The Daily Telegraph: “[Protection] should apply to all deposits, not just those less than £85,000.” 

In 2007, confusion over the level of protection sparked the run that brought down Northern Rock, as depositors queued to withdraw their money until the Chancellor promised every penny would be backed by the taxpayer. 

Changes are now being made to the law to enshrine “depositor preference”, which will put insured deposits ahead of other bondholders in the creditor hierarchy to guarantee savers get £85,000 back within days of a bank’s collapse. 

However, Nationwide, the UK’s second largest savings provider with £125bn in deposits, wants the law extended to cover all retail savings to avoid confusion. “The consumer message of full depositor preference is much more powerful and comprehensible,” Mr Beale said.

 Full depositor protection is now implicit based on the government's action in 2007.

The mutual is backed by the Building Societies Association but its position sets it against the banking industry, which does not even back “depositor preference” for the first £85,000. 

Banks claim the £85,000 is protected by the industry insurance scheme so there is no need for a complex legal change that puts other creditors more at risk and may consequently push up banks’ costs. 

“Depositor preference gives customers no added protection and increases substantially the losses of other creditors,” the British Bankers’ Association said in its Parliamentary submission.

It is not surprising that UK banks do not want depositors to have preference.  They know that it is really the taxpayer that is guaranteeing the deposits.

For example, in the US, the FDIC has unlimited ability to draw from the US Treasury to cover losses on its deposit guarantee.

The lack of preference increases the potential for loss on the deposits with the benefit accruing to the other creditors and therefore to the bankers in terms of cheaper funding.  That is why in the US deposit insurance scheme the FDIC has preference over other creditors.

Two Columbia University economists think that raising rates is cure for economic slump

As reported by Bloomberg, two Columbia University economists have adopted your humble blogger's suggestion that raising interest rates will help to cure the economic slump.

Regular readers have seen numerous posts over the last couple of years discussing Walter Bagehot and his rule that central banks never lower rates below 2%.

Mr. Bagehot, the father of modern central banking, laid out this rule in the 1870s.  He did this in full knowledge of Mark Twain's famous observation about being more concerned about the return of his capital than the return on his capital.

Mr. Bagehot understood that as rates drop below 2% they create their own economic headwinds including that savers start pursuing Mark Twain's observation.

The solution to weak economic growth may be higher interest rates. 

That seemingly paradoxical remedy can apply if the cause of the slump is a confidence shock that cheap borrowing costs are failing to reverse, two Columbia University economists said in a report published this week. 

In such a situation, ultra-easy monetary policy risks making fears of deflation a self- fulfilling prophecy as spenders sit tight. 

If low interest rates can’t motivate jittery consumers, then the answer may be the opposite: an increase in borrowing costs. Such a shift “can boost inflationary expectations and therefore foster employment,” said Stephanie Schmitt-Grohe and Martin Uribe in the study published Nov. 19 by the National Bureau of Economic Research in Cambridge, Mass.
“By its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump,” they said. 

The academics said sagging confidence among households and companies has played a part in the recent economic slowdown. Evidence from the U.S. as well as Japan during the last two decades “seems to suggest that zero nominal interest rates are not doing much to push inflation higher.”

At the moment, the Federal Reserve pledges to keep its benchmark interest rate near zero through mid-2015.

While I am not an economist, I suspect that the transmission mechanism for economic improvement from higher interest rates is that savers no longer have to offset the lack of return on their savings through more savings, but can instead use this money for consumption.

Banking can be made honest and fail-safe

In case no one has noticed, everyone who has testified before the Parliament's Commission on Banking Standards has concluded that the combination of complex rules/regulations and regulatory oversight will neither make banks honest nor fail-safe.

This list of high-powered witnesses includes the UK Chancellor, George Osborne, the Governor of the Bank of England, Sir Mervyn King, a leading contender as next Governor of the BoE, Paul Tucker and former Fed Chairman Paul Volcker.

As an example of why the combination of complex rules/regulations and regulatory oversight will neither make banks honest nor fail-safe, each of them looked at the flaws in the proposals to separate investment and retail banking using the Volcker Rule, ring-fencing or complete separation.

Your humble blogger was thrilled that all of these distinguished individuals confirmed what I have been saying all along about the combination of complex rules/regulations and regulatory oversight is not an effective substitute for transparency and market discipline.

Everyone knows that requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details would make the banks honest.

Sunshine is the best disinfectant.

Everyone also knows that transparency makes the banks fail-safe.

With access to the information disclosed through ultra transparency, market participants can independently assess the risk of each bank.  With this risk assessment, market participants can adjust the amount of their exposure to each bank to what they can afford to lose given the risk of each bank.

As a result, a bank is both subject to market discipline to restrain its risk taking and, if it ignores this restraint, can fail without fear of financial contagion.

Hopefully, the commission members will see that substituting the combination of complex rules/regulations and regulatory oversight for transparency and market discipline doesn't work.  And they will conclude that reform needs to focus on bringing transparency to all the opaque corners of the financial system.

BoE's Paul Tucker: splitting retail and investment banking won't make system safe

Speaking to the parliamentary commission on banking standards, the Bank of England's Paul Tucker observed that splitting retail and investment banking won't make the system safer.

His reason for making this statement is that he thinks that investment banks are fully capable of blowing up the financial system.

Combine this with the historic fact that retail banks are fully capable of blowing themselves up (see: US Savings & Loan for example) and it is clear that pursuing regulations that would create a ring-fence or full separation is unproductive.

What is needed is reform that would actually make the financial system safer and financial crises far less likely to occur.

Regular readers know that there is only one reform that achieves this goal:  bring transparency to all the opaque corners of the financial system.

That this works can be easily seen by the simple fact that

• the parts of the financial system characterized by opacity, including complex rules/regulations and regulatory oversight, were the parts that ceased functioning and haven't resumed functioning since the start of the financial crisis.

• the parts of the financial system characterized by transparency and market discipline have continued to function throughout the financial crisis.

As reported by the Guardian,

Paul Tucker, the frontrunner to become the next governor of the Bank of England, has told MPs he does not want to see the full separation of retail and investment banks. 

Speaking to a parliamentary committee on banking standards, Tucker warned that even if the separation of banks was forced by law, the economy would still be at risk of being "blown up" by non-retail banks and other financial institutions.

Tucker said: "The thing that has worried me most about this debate from the beginning ... is that people fall into thinking, 'if only we could make retail banking safe, the financial system will be safe', and frankly I think that is nonsense. I think the financial system and the economy will be capable of being blown up by vast wholesale dealers and non-banks."...

Please re-read Mr. Tucker's comments as he effectively explains why transparency is the solution that works rather than the combination of complex rules/regulation and regulatory oversight.

With transparency, nobody assumes that the financial system is or will be safe.  Rather, all market participants know that they still have the obligation to independently assess the risk of each of their exposures and to not have a larger exposure than they can afford to lose given the risk.

That this occurs is not surprising as the FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Clarity, he said, was crucial to avoid banks lobbying the regulator. "For the regulator to be effective, it has to be able to use judgment. But if judgment ends up simply as a negotiation between the regulator and the regulated bank, there's only one winner in that and I think that will be a very bad outcome."

While Mr. Tucker was talking about ring-fencing, I think his comment is applicable to the entire idea of  substituting the combination of complex rules/regulations and regulatory oversight for transparency and market discipline.

The combination of complex rules/regulations and regulatory oversight is doomed to failure as it ultimately ends up as a negotiation between the regulator (who can be pressured by politicians) and the regulated banks that the regulated banks will win.

Ironically, transparency is all about bringing clarity and avoiding having banks lobbying the regulator.

Take ultra transparency for example.  Under ultra transparency, banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This disclosure brings clarity to all market participants on the risks each bank is taking.

With ultra transparency it is no longer the regulator negotiating with the bank over the riskiness of the bank, but the regulator judging the riskiness of the bank using the analytical capabilities of the market (the regulator can ask other banks how risky they think each bank is for example).

George Osborne defends big banks as good for UK

In his testimony to Parliament, George Osborne not only defended the idea that big banks are good for UK society, but also expressed his wish that the UK had more big banks.

I am confident that Mr. Osborne's statement will generate a number of articles and posts saying:

• Hope he gets his wish and that (fill in the country's name)'s largest banks will all move there so that (fill in the country's name)'s taxpayers will no longer have to bail them out; or

• How could he have offered up that myth about the need for large banks when both the recent financial crisis and academic studies have debunked this idea and shown that banks never need to exceed $100 billion in size.

What I found more interesting is his defense of the big banks rested on the observation that other countries had them so therefore the UK should too.

The fact that other countries have these banks doesn't prove these banks are good for society.

As reported by the Telegraph,

Commission member Justin Welby, the Bishop of Durham and Archbishop of Canterbury in waiting, asked the Mr Osborne why he could not simply break up big banks altogether. 

Mr Osborne said he believed the survival of big banks was good for UK society. 

"If we aggressively broke up all of our big banks, I am not sure that, as a society, we would benefit form it," said the Chancellor. 

"There are still a lot of big banks operating in other countries. I think it is important for the UK that our largest private sector industry thrives, survives and grows, employing very large numbers of people across the UK. 

"I want Britain to be the home of big successful banks. I think it would be a real shame if we were saying to the likes of HSBC that they can't locate themselves in the UK. I think that would be a mistake for us as a country. 

"I think we have to strike the right balance. We want to be a home to successful financial services but we want those services to be safer."

Regular readers know that I don't think that politicians and regulators should get into figuring out how to break up the big banks.

It is far easier to break these banks up by simply requiring them to provide ultra transparency and let market discipline force them to break themselves up.

Under ultra transparency, banks would be required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants could independently assess the risk of each bank and adjust the price of their exposure to reflect this risk.

As riskier banks see their cost of funding increase, they will be under tremendous pressure to reduce their risk.  The easiest way to reduce risk is by getting out of the riskiest businesses.

Mr Osborne also warned the commission against attempting to rewrite the Bill so close to its passage through Parliament. 

"I don't think personally this is the right moment to tear up all the work that's been done over the last two years. That would inevitably delay things and I think we have got to a good place where broadly we have a consensus," he said. 

"You will be unpicking the work that John Vickers and his commissioners did. That work has been accepted, as far as I'm aware, by all the major political parties. We are now on the verge of getting on with it." 

Commission members bridled at the suggestion that Mr Osborne was seeking to limit their inquiry. 

Labour MP Pat McFadden told the Chancellor: "If you are worrying about the freedom and powers of the Commission, perhaps you should have thought about that before establishing it... 

"If you were sitting on this side of the table, you wouldn't take too kindly to a Chancellor saying 'I want you to look at that, but not to look at that'." 

Commission chairman Andrew Tyrie said the members did not find it "very convincing to be told that we should be wary of unpicking a consensus". 

"Just because something has achieved a consensus does not necessarily mean that it is right. It is our job to take a look at it," said Mr Tyrie....

Please re-read the highlighted text as this is exactly what I have been saying about the proposal to substitute the combination of complex rules/regulations and regulatory oversight for transparency and market discipline.

[Mr. Osborne] also said the draft Bill was imposing a lot of cost on banks and a full separation would be an even greater cost. 

"Exactly the same Members of Parliament who say we must screw the banks down are the same ones getting up and saying we have got to get the banks to lend," he said...

Mr. Osborne makes a compelling case for ending the pursuit of complex rules/regulations like ring-fencing.

It is very inexpensive to provide ultra transparency.

Equally importantly, providing ultra transparency does not impede a bank's ability to make a loan.

Mr Osborne said the primary purpose of the legislation was to ensure that, in a future crisis, a Chancellor is able to allow a bank to fail while protecting consumers, rather than being forced to bail it out, as his predecessor Alistair Darling was because of the "inadequate" legislation in place at the time of the 2007-8 banking crash. 

"Ultimately, what this is all about is so that the person doing my job – hopefully not on my watch – when faced at midnight with that decision 'Do you let this very large bank go bust?' has enough confidence to say 'I think we can let it go because the banking Bill has provided me with enough reassurance that we can continue to provide core services, that people can go to cashpoints and get their money out'," said Mr Osborne. 

"My predecessor, when he was faced with that decision, felt he was not confident that people would be able to get their money out of the cashpoint in the morning. 

"If, at the end of all this, the person doing my job is still not confident that people can get their cash out of the cashpoint even if they let the institution fail, then I think we as a Parliament will have failed."

One of the many benefits of requiring the banks to provide ultra transparency is that it ensures that a Chancellor can feel comfortable in the middle of the night allowing a bank to fail.

With ultra transparency, market participants know they will not be bailed out.  The reason they will not be bailed out is that they have access to the information they need to independently assess the risk of each bank and to adjust their exposure to each bank to what the market participant can afford to lose given the risk.

This permanently ends bailing out the banks for fear of financial contagion.

Regular readers also know that in a modern financial system there is no reason to ever bailout a bank.  Banks can continue to operate and support the real economy even when they have low or negative book capital levels because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, the taxpayers become the silent equity partners of any bank with low or negative book capital levels.

Hence, until the financial regulators decide to shut down the bank, it can continue in operations.

Funding for lending and ongoing loan forbearance

Lest anyone forget that there is an unknown quantity of bad loans hidden on bank balance sheets, the Bank of England's report on how the Funding for Lending program is going reminds us.

As reported by the Guardian,

It does appear to be having an impact for customers looking for a mortgage. The Bank of England's closely-watched agents' report says: "Recent reductions in institutions' marginal funding costs appeared to be working through more quickly in the residential mortgage market than corporate lending." 

But the picture still looks for bleak for small businesses. "Some business lenders appeared still to be tightening terms," the agents said. Overdrafts were being restricted and banks demanding "additional personal guarantees" for credit. 

Not exactly what the government intended. 

And even in those instances where lenders are starting to offer loans at lower rates, the demand from small business to borrow money is low. 

The agents' report says that lenders are continuing to show a "significant degree of forbearance" to help businesses in financial difficulty. Helpful for businesses, but not reassuring for anyone worried about the potential bad loans being stored up on banks' balance sheets.