Tuesday, December 4, 2012

Details of HBOS failure highlight need for banks to provide ultra transparency

In reading the articles about the Parliament commission on banking standards' investigation into the failure of HBOS, a UK bank, one is reminded of that old banking truism:  it is illiquidity that brings an end to a bank and not insolvency.

As reported by the Guardian, 
Stevenson, [the former chairman of HBOS], said he "felt awful" that the board had failed to foresee the "protracted" closure of the wholesale markets on which the bank relied for funding....

Stevenson, who grew hoarse during the testy exchanges, irritated members of the commission, who include former chancellor Lord Lawson and the new archbishop of Canterbury, Justin Welby, by his insistence that the main problem was the failure to predict wholesale markets would dry up for a year. 
He told Welby: "We failed to plan for catastrophe … we were not aware until very late in 2008 that we were suffering from a heart attack." 
HBOS's loan-to-deposit ratio – a measure of reliance on markets rather than savers to fund lending – had grown from 140% to 196%. 
"What brought the bank down was the closure of the wholesale markets. The day after Lehman that was it," said Stevenson, who oversaw the takeover by Lloyds three days after the US bank collapsed.
A closure of the wholesale markets that persists to this day with the closure of the interbank lending market and the private label structured finance market.

Both of these markets closed due to opacity.  

In the interbank lending market, banks with deposits to lend could not assess in 2008 and still cannot assess the solvency of the banks looking to borrow.  In the private label structured finance market, investors could not independently assess in 2008 and still cannot independently assess the value of the securities based on the current performance of the underlying collateral.

Re-opening both markets requires transparency.

For banks, transparency means disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

In the case of HBOS, if it had been making this disclosure, the market would have exerted discipline to restrain its lending and funding practices well before the bank failed.  The cost of wholesale funds would have increased as the loan-to-deposit ratio increased.  

This would have provided plenty of incentive to either grow the deposit base or shrink the asset base.

Also, if HBOS had been providing ultra transparency, it would have been possible for the Bank of England to easily step in as a lender of last resort.  A lender of last resort lends a high interest rates against good collateral.  

Ultra transparency would have provided all market participants, including the BoE, the information needed to assess the quality of HBOS' assets, particularly those that could be pledged as collateral.

For private label structured finance, transparency means providing observable event based reporting on the activities like payments and delinquencies on the underlying collateral before the next business day. 

With current information on the underlying collateral performance, market participants can independently assess the risk and value these securities.  This in turn allows them to make buy, hold and sell investment decisions.

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