Too Big to Fail and Too Big to Manage

In his Guardian column, Joris Luyendijk does a wonderful job of outlining the issues with the Too Big to Fail and Too Big to Manage global financial institutions.

The Lloyds and RBS press conferences were strikingly similar and, as they wore on it became hard not to think of them as dull, rather sophisticated but above all extremely effective rituals.

Given that these banks do not provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, earnings releases are simply elaborate rituals.

With the information provide by ultra transparency, there is no way to know if anything represented about a bank's financial condition is true.

As the Bank of England's Andrew Haldane says, banks are "black boxes".

Other than the financial regulators, nobody knows what is lurking on and off their balance sheets.

On one side of the table were men (Lloyds had one woman, who said nothing) in suits projecting an image of control. 

Yes, they were presiding over banks with tens of thousands of employees engaged in very different and often wildly complex activities across the globe. Yes, they had been caught out by scandal after scandal somewhere in their vast empires and yes, in the past their books had given a wildly inaccurate picture of the risks they were running. 

Without ultra transparency, there is no way of knowing what risks they are currently running.  So the critical issue is why trust what the bankers have to say?

But all of this was now in the past and firmly under control, they implied, as they fired off endless numbers and percentages and ratios, and said things like "We remain very confident of our capital position," or "Our strategy remains centred on taking into account the interests of all of our stakeholders", or some other cardboard PR phrase CEOs learn to use when they want to deflect a question they know can't be followed up.

Here is one of the dangers of the easily manipulated Basel III capital ratios, because the financial regulators are blessing them it is easy for banks to hide their true condition.

Their vocabulary had been sanitised to a startling degree, with PPI and other schemes that cheated tens of thousands of trusting Britons out of their money becoming "legacy issues" requiring "customer redress". (HSBC referred to its huge fines in the US for massive drug money-laundering as "regulatory and law enforcement matters".)...

The PPI scandal continues to grow.  Last year, the UK's Financial Ombudsman saw its case load of PPI claims grow by almost 300,000.

The ability of the banks to use vocabulary to sanitize their past actions is directly related to how the financial regulators are reaching settlements with the banks.

As regular readers know, financial regulators have adopted the policy of financial failure containment and its corollary the Geithner Doctrine (do nothing that hurts the profitability or reputation of big or politically connected banks).

The pursuit of these policies results in settlements where the banks do not have to admit quilt for their actions.

It is not surprising when banks reach an agreement where they don't have to admit guilt to ripping off their customers that they would choose to try to sanitize and gloss over their activities.

What if bonuses and privatisation are diversions and the real issue is "too big to fail" in combination with too big to manage? 

If you believe that CEOs knew nothing about the scandals taking place under their watch, what reason is there to believe that this time they are on top of things? 

Over the past 18 months I have interviewed more than 150 people working in finance in London, most of them in junior functions. Many of them believe that the top of their organisation has no idea what's really going on. 

They are equally scathing about the regulators.

This is the debate Britain [and the rest of the world] refuses to have.  

Please re-read the highlighted text as Mr. Luyendijk captures the problem presented by Too Big to Fail and Too Big to Manage who operate behind a veil of opacity.

Opacity prevents market participants from knowing what is going on inside these banks.  As a result, the banks are subject to regulatory and not market discipline.

Regulatory discipline that is lacking for a number of reasons.  This includes the ability of the regulators to actually assess what is going on.  The bigger problem with regulators is that even if they do properly assess what is going on, they are designed to make it virtually impossible to communicate this to other market participants or to get the regulator to take action.

The top of the shop for financial regulators are political appointees.  This means they are susceptible to lobbying efforts by the banks.

The upper levels of the financial regulators tend to experience the revolving door between regulator and industry.  As a result, there is a tendency to give the banks the benefit of the doubt.

Your humble blogger has repeatedly said that the only way to truly address the problem presented by Too Big to Fail and Too Big to Manage is to require them to provide ultra transparency.

With this information, market participants can exert discipline on these global financial institutions.  This discipline takes several forms including linking each bank's cost of funds to the risk they are taking.

Naturally, banks that are more complex because of thousands of subsidiaries will be perceived as riskier.

Naturally, banks that engage in proprietary bets will be perceived as riskier.

It is these banks that will face a higher cost of funds and pressure to simplify their organizations and reduce their risk exposure.

The timing and conditions of the privatisation of Lloyds and RBS are vital to the British government's financial health, and it makes for powerful and simple-to-produce stories, especially if these banks continue to pay high salaries and bonuses. 

But Lloyds' and RBS's return to private ownership is ultimately a question of secondary importance when both banks continue to be too big to fail – and so effectively remain a public liability.

Today, the banks are a public liability because they are opaque.  As a result, market participants are dependent on the regulators who have access to all the useful, relevant information in an appropriate, timely manner for properly assessing this information and accurately communicating the risk to the market.

When regulators fail to do this and they will whenever there is concern over the safety and soundness of the financial system, there is a moral obligation to bailout the investors.  After all, the investors relied on the regulators who had better information.

One of the benefits of ultra transparency is that it ends the banks being a public liability and the moral hazard caused by reliance on the financial regulators.

With ultra transparency, investors know they are responsible for all losses on their exposures to these banks as they have the information they need to independently assess the risk and solvency of each bank.

It is this responsibility for losses that will drive investors to exert market discipline.

While this idea persists, Britain remains hostage to the health of banks over which it has only very limited influence. Knowing that your vital interests are affected by factors beyond your control is a recipe for stress. It's not what democracies should be about. 

But it has become the new normal. The big issue today is not whether British taxpayers get their money back. It's whether British citizens get their sovereignty back.

Getting their sovereignty back simply requires the banks to provide ultra transparency.

Any bank that is unwilling to disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details is not a bank that the British citizens would want to support in any fashion.

After all, an unwillingness to provide ultra transparency is the equivalent of waving a giant red flag and announcing to the world that the bank has something to hide.

British citizens would be better off asking banks that are unwilling to provide ultra transparency to leave and become some other country's headache.  Why should British citizens be responsible for the losses of a bank that refuses to disclose the risks it is taking?