Wednesday, November 7, 2012

Bank of England's Andrew Haldane: traditional banking model, R.I.P.

In his testimony before a Parliament committee, Reuters reports that the Bank of England's Andrew Haldane observed that banks need a new business model.
Banks need a new business model and the threat of forced separation of investment and retail banking should be put into law to help curb risky behaviour... 
The question is what should the new business model be?

The financial crisis confirmed for all time that banks are bad holders of risk.  This includes credit, interest rate and liquidity risk.

This should come as no surprise given past financial crises:  Loans to less developed countries (credit), US Savings and Loans (interest rate) and the Great Depression (liquidity).

It was this recognition that banks were bad holders of risk that drove the creation of the 'originate to distribute' model.  Under this business model, banks were suppose to transfer these risks to other financial market participants who were better able to hold these risks.

Clearly, the 'originate to distribute' model failed in the run-up to the Great Recession.  The key question is why?

It failed along two correctable dimensions.

First, it failed because of a lack of transparency in the securities that were sold to transfer the risk.  Structured finance securities from covered bonds to securitizations are brown paper bags where buyers are blindly betting on the value of the contents.

This is correctable by simply requiring observable event based reporting on all activities like payments or delinquencies involving the underlying collateral before the next business day.  With this information, market participants can know what they are buying (which exerts market discipline on the pricing of the underlying collateral) and, on an ongoing basis, know what they own.

Second, it failed because of a lack of transparency into the banks themselves and the risks that they were taking on.  Banks are, in Mr. Haldane's words, 'black boxes.'  As such, they are not subject to market discipline as market participants cannot figure out how risky the banks are.

Instead, the financial system is dependent on regulators to both correctly assess and communicate the risk of the banks.  The failure by regulators to do both correctly (and regulators are biased to not properly communicate the riskiness of the banks over concerns about "safety and soundness") results in the potential for financial contagion as market participants have too much exposure given the real risk of the banks.

This too is correctable by simply requiring ultra transparency and having the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The new business model should be the 'originate to distribute' model with transparency.

This business model restrains risk taking by banks while assuring that the economy has the access to credit it needs for growth.
Andrew Haldane, director of financial stability at the Bank of England, told a panel of lawmakers that Britain's Vickers plan to impose extra capital on the deposit-taking arms of banks by 2019 to make them safer, may not be enough to protect the taxpayer.... 
Haldane urged them to consider inserting a "backstop" so that if the "ring fence" leaked or was hard to police, regulators could forcibly split up the banks into retail and investment units. 
"That could be a clever way of ensuring Vickers is implemented faithfully and achieves what it is meant to achieve," Haldane said. 
Regular readers know your humble blogger is not into "clever", particularly when it involves financial regulation.  Clever is what drives the creation of complex rules/regulations like ring-fencing as a replacement for transparency and market discipline.
The ring-fence will comprise deposits and overdrafts, leaving flexibility on other products, but Haldane said this "grey area" created perilous risks for regulators. 
"There is a case for moving the ring-fence outwards to mandate a broader set of activities that lie within," he said. 
Small business loans, trade finance and mortgages should be inside the ring-fenced arm which should have its own governance, risk management, balance sheet, treasury operations and even human resources to ensure the right culture, he said....
Anything that creates "perilous risks for regulators" by definition is an unacceptable risk for the financial system and therefore should not be part of financial reform.

I say this because the Great Recession showed that regulators are fallible and when they fail it comes at a huge cost to the taxpayer.
The Bank of England's new prudential regulation authority (PRA) ... will aim to move away from the "box ticking" approach of the past and be more judgement led in its approach which Haldane likened to a swat team pursuing "random sampling".... 
Many top banks were also unable to "simply add up the numbers" and calculate risks across the group, he added. 
The risk-based Basel rules forcing banks to hold more capital from January were also built on the "shakiest foundations". 
It would be a thankless task of deciding how much capital banks should hold against each asset, a game of "cat and mouse" that no regulator can win, Haldane said.
By requiring the banks to provide ultra transparency, financial regulators like the PRA can truly move away from a box ticking approach or engaging in no win games like determining capital adequacy.

With ultra transparency, the PRA can ask each bank's competitors and other market participants what they are most concerned about with that bank.  Asking this question harnesses the ability of the market to assess the banks and the risks they are taking.

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