Sunday, June 30, 2013

Bank "Living-Wills" fail to reduce their risk or odds they won't be bailed out in future

A Bloomberg article confirmed your humble blogger's observation that complex regulations and regulatory oversight fail to provide the same benefits as transparency and market discipline.

The article focused on how bank "living-wills" failed to either reduce the risks the banks are taking or reduce the odds that they would be bailed out in the event of a systemic crisis in the future.

If banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, they would reduce their risks and make it unnecessary to bail them out in the event of a systemic crisis.

Proof that disclosure would result in banks reducing their risks was provided by JP Morgan and its London "Whale Trade".

JP Morgan tried to keep the trade secret.  This included not providing regulators with information on the trade when they requested it.  When it became obvious that the market knew the trade existed, JP Morgan closed the position as quickly as possible.

Why did JP Morgan want to keep the trade secret? JP Morgan wanted to avoid market discipline.  If the market knew about the trade, many market participants would trade in such a manner as to reduce the upside potential of JP Morgan's trade and maximize the downside risk.

Since transparency reduces the amount of risk that a bank takes, it also reduces the need to bailout banks in the future.

An increasingly vocal chorus of current and former U.S. regulators says the biggest banks still have not provided adequate plans to safely wind down in bankruptcy and may need to be restructured to reduce the risk they pose to the financial system.... 
Banking experts and some regulators speak openly about the impossibility of putting a bank such as JPMorgan -- commonly perceived as being “too big to fail” -- into bankruptcy court without destabilizing the rest of the financial system. Some advocate changes to the banks, and others changes to the bankruptcy code to make it easier to resolve large institutions....

One or more of the largest banks is ’’likely to be required to restructure’’ after their October submissions as regulators seek to give the process more credibility, said Karen Shaw Petrou, managing partner of Washington-based Federal Financial Analytics, an independent banking consulting firm.... 
The 'living-will' process is not made more credible because banks are made to restructure some of their operations.
H. Rodgin Cohen, a lawyer at Sullivan & Cromwell LLP (1147L) who represents large banks, said the living-wills process has already encouraged some banks to begin restructuring, “getting rid of businesses they shouldn’t be in.”...
Banks can claim any restructuring to exit poorly performing businesses is the result of the living-will process.
Even as more living wills are filed, it will be difficult for anybody outside the agencies to measure their worth. 
One reason is that the documents -- running into the thousands of pages -- are mostly off-limits to the public, said Sheila Bair, who ran the FDIC when the agency first proposed the living-wills approach in 2011. 
Unless there is transparency, there is no reason to believe that any aspect of the living-will process is reducing the risk of the banks or altering their status as Too Big to Fail.

Saturday, June 29, 2013

Opacity allows derivatives to be used for deception

In his NY Times column, Floyd Norris looked at how Italy used derivatives to hide the true size of its budget deficits (something that Greece also did).

The reason that Italy could do this is because derivatives are opaque.  Neither the government nor the bank counter-party have to disclose the derivative and its terms.
Derivatives are not always “financial weapons of mass destruction,” as Warren Buffett famously called them. 
But they are often weapons of mass deception. 
For some derivatives, a desire for deception is the only reason they exist. That deception can allow those who own derivatives to evade taxes or accounting rules. It can allow activity that might otherwise be illegal, were it not called a derivative, or that would face regulation if it were labeled what it truly is. 
Sometimes, banks use derivatives they create to help their clients deceive the public. Other times, they enable the banks to deceive those clients.
Please re-read the highlighted text while recalling that all of this is made possible because derivatives are deliberately opaque.
The latest revelation of deception by derivative came in Italian government documents leaked this week to two European newspapers, La Repubblica and The Financial Times. 
The Financial Times said it appeared that Italy had used derivatives in the 1990s to allow it to make its budget deficit seem smaller, thus enabling it to qualify for admission to the euro zone. The report said it appeared those derivatives, now restructured, might be exposing Italy to a loss of 8 billion euros ($10.4 billion). 
La Repubblica noted that the director general of the Italian Treasury Department at the time, Mario Draghi, is now running the European Central Bank. 
Italy’s economy minister, Fabrizio Saccomanni, said it was “absolutely baseless” to say that the country used derivatives to lie its way into the euro zone. ...
What seems to have happened in Italy is similar to something that we already know Greece did. Rather than borrow money — which would increase the reported budget deficit — the country entered into a derivatives contract that called for the banks to make large upfront payments in return for larger payments later from the government. 
And how did that differ from a loan? Functionally, not very much, in all probability. But if you call something a derivative you can often get away with keeping it off your balance sheet — or putting it on the balance sheet in a misleading way.... 
Calling something a derivative can help a company get around inconvenient laws and regulations. ....
The current accounting rules in the United States go so far as to say that banks can hide obligations that are classified as derivatives. 
Your humble blogger wonders what percentage of derivative transactions would go away if transparency was brought to this corner of the financial system.

Transparency that should be part of banks disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Friday, June 28, 2013

J. Bradford DeLong: Is financial sector draining life blood of real economy?

In his Project Syndicate column, Professor DeLong asks the question of whether the financial sector is draining the life blood of the real economy.

To answer this question, he observes

Back in 2011, I should have read Keynes’s General Theory a little further, to where he suggests that “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” 

Regular readers know that the capital development of all the developed countries has become a by-product of the activities of a casino because the financial regulators, like the SEC, allowed the financial industry to bring opacity to large areas of the financial system (examples include black box banks and brown paper bag structured finance securities).

Our financial system is based on the FDR Framework. This framework combines the philosophy of disclosure with the principle of caveat emptor.

The primary role of government is to ensure that all useful, relevant information is disclosed in an appropriate, timely manner.

Market participants have an incentive to use this information as under the principle of caveat emptor they are responsible for all losses on their exposures.

The FDR Framework supports the three step investment process:

  1. Use the disclosed information to independently assess the risk and value a security.
  2. Solicit prices from Wall Street for buying and selling security.
  3. Make investment buy, hold or sell decision by comparing independent valuation of security with price being shown by Wall Street.
Where there is opacity, market participants cannot go through the investment cycle.  Instead, the act of buying or selling a security is nothing more than blindly betting (Mr. Keynes' casino).

Professor DeLong wonders why there has been no "obvious economic dividends" from the growth in the financial industry.

The reason, I proposed, was that “[t]here are two sustainable ways to make money in finance: find people with risks that need to be carried and match them with people with unused risk-bearing capacity, or find people with such risks and match them with people who are clueless but who have money.” 
Over the past year and a half, .... evidence that America’s financial system is less a device for efficiently sharing risk and more a device for separating rich people from their money – a Las Vegas without the glitz – has mounted....
The first sustainable way to make money in finance relies on transparency.  The second sustainable way to make money in finance relies on opacity.

As Yves Smith observed, nobody on Wall Street was compensated for developing transparent, low margin products.  Hence, Wall Street focused on making money by relying on opacity.

An argument could be made that opacity is not a sustainable way to make money in finance.  After all, opacity caused the financial crisis that began on August 9, 2007.

The counter to this argument is that the bankers used the opacity of their own institutions to their advantage and managed to a) convince policymakers and financial regulators to use taxpayer money to bail them out and b) continue to pay themselves large bonuses.

Four years ago, during the 2008-9 crisis, I was largely ambivalent about financialization. 
It seemed to me that, yes, our modern sophisticated financial systems had created enormous macroeconomic risks. But it also seemed to me that a world short of risk-bearing capacity needed virtually anything that induced people to commit their money to long-term risky investments.
In other words, such a world needed either the reality or the illusion that finance could, as John Maynard Keynes put it, “defeat the dark forces of time and ignorance which envelop our future.” 
Your humble blogger disagrees with Professor DeLong that illusion is needed to induce people to commit their money to long-term risky investments.

For over 5 decades since the FDR Framework was put in place during the Great Depression, the economy had adequate access to capital for risky investments that contributed to growing the real economy.

It is only after illusion was introduced into the financial system through the use of opacity that the financial sector's percentage of GDP increased.  The financial sector made much more money because investors didn't have the information they needed to properly assess risk and over-paid for the risk they took on.
Most reforms that would guard against macroeconomic risk would also limit the ability of finance to persuade people to commit to long-term risky investments, and hence further lower the supply of finance willing to assume such undertakings.... 
I disagree with this statement.  People are willing to commit to long-term risky investments when they have access to all the useful, relevant information in an appropriate, timely manner.  The reason people are willing to commit is that they trust their own assessment of this information.
At that point, it is time either for creative thinking about how funding can be channeled to the real economy in a way that bypasses modern finance, with its large negative alpha, or to risk being sucked dry.
I agree with Professor DeLong that we need to bypass where modern finance siphons off excess return.

The straightforward way to do this is to bring transparency back to all the opaque corners of the financial system. Then the financial system can operate as intended under the FDR Framework.

Thursday, June 27, 2013

Sign of desperation: UK officials think bank lobby needs "ground rules" to prevent another crisis

In his last testimony before Parliament, the Bank of England's Mervyn King whined about banks lobbying government officials to put pressure on bank regulators to limit the amount of capital that the banks were required to hold.

To paraphrase Casablanca, "I am shocked, shocked, to hear that banks would lobby politicians to put pressure on bank regulators to limit their regulatory efforts".

Regular readers know that the Nyberg Report on the Irish financial crisis detailed both how and why this lobbying is effective.  It is and always will be effective because the bank regulators are political appointees who have to report to the politicians.

The clear implication of the banks being able to undermine the bank regulators by lobbying the politicians is that the financial system must be designed in such a way that it is not dependent on the bank regulators.

Fortunately, the financial system is designed to not be dependent on the bank regulators.

Unfortunately, there is a gap between the design of the financial system and how the system is currently being practiced.

The system was designed to not be dependent on the bank regulators because banks were suppose to provide transparency to all market participants into their exposure details (something they did in the 1930s as a sign of a bank that could stand on its own two feet).

The system has become dependent on the bank regulators because the SEC and similar regulators in the  EU, Japan and UK failed to ensure that the banks provided transparency to all market participants reasoning that the financial regulators with their 24/7/365 transparency would be enough.

Your humble blogger has been advocating stripping the financial regulators of their information monopoly.  This monopoly makes the financial regulators a single point of failure in the financial system.  A point of failure that failed in the run-up to our current crisis.  And a point of failure that will fail in the run-up to the next financial crisis.

Stripped of their information monopoly, market participants don't have to fear banks lobbying politicians to pressure bank regulators to restrain their regulatory efforts causing another crisis.  Market participants can proactively discipline the banks and restrain the risk taking that leads to a financial crisis.

Sunday, June 23, 2013

BIS: Monetary stimulus is not answer

Four plus years after Anna Schwartz said that the policies being pursued by the Fed were wrong, the Bank for International Settlements (BIS) has come out with its conclusion that monetary stimulus is not the answer to fix the financial system and restore growth in the global economy.

Regular readers know that your humble blogger has been saying that monetary stimulus won't work since the beginning of the financial crisis (several months before Anna Schwartz, the pre-eminent economist on the Great Depression and Milton Friedman's co-author, made her observation in an interview with the Wall Street Journal).

The problem we face is bank solvency.  Specifically, the unwillingness of policymakers and financial regulators like the Fed to admit that the banks are insolvent and that they need to absorb upfront the losses on the excess public and private debt in the financial system.

As I predicted in late 2007, the underlying path for the real economy is a downward spiral until such time as the banks perform the function for which they are designed and absorb the losses on the excess debt.

The failure to use the banks as they are designed hurts both the real economy and the social contract.

The real economy is hurt because capital that is needed for growth and reinvestment is diverted to debt service on the excess debt.  In addition, capital is misallocated due to the distortion in prices caused by regulatory forbearance that lets assets continue to be tied up in 'zombie' loans.

The social contract is hurt because governments cut back on benefit programs to offset their increasing debt service burdens.

Fortunately, there is an answer to the bank solvency problem we face.  The answer is the Swedish Model.  Implementing this model was built into the global financial system during the Great Depression.

Under the Swedish Model, banks are required to recognize upfront the losses on the excess debt.  This protects the real economy and the social programs.

Banks are able to absorb these losses and continue operating because of the combination of deposit insurance and access to central bank funding.  When banks have low or negative book capital levels, deposit insurance effectively makes the taxpayers the banks' silent equity partner.

The Guardian's summary of the BIS report,

Central banks have done as much as they safely can to rebuild the world economy, and the onus is now on politicians to create the conditions for a stronger recovery, according to the Bank for International Settlements, the central bankers' club. 
In its annual report, published on Sunday, the bank, based in Basle, Switzerland, warns that with unprecedented stimulus already in place, fresh action from central banks to kick-start growth may do more harm than good, by distorting financial markets and jeopardising stability. 
"Unfortunately, central banks cannot do more without compounding the risks they have already created. Monetary stimulus alone cannot put economies on a path to robust, self-sustaining growth, because the roots of the problem preventing such growth are not monetary," said Stephen Cecchetti, head of the bank's monetary and economic department, presenting the report. 
The bank's intervention comes at a critical time, as the Federal Reserveis preparing the US public for the end of the quantitative easingprogramme under which it bought $85bn (£55bn) of bonds every month. In total, central banks in the world's major economies, including the US, UK and Japan, now own assets worth 25% of those countries' GDP. 
Stock and bond prices plunged across the world last week after Ben Bernanke, chairman of the Federal Reserve, announced that he planned to begin "tapering" quantitative easing by the end of the year. 
The regulating bank in Basle believes it is the right time for central banks to reconsider their role. "We are past the height of the crisis, and the goal of policy has changed – to return still sluggish economies to strong and sustainable growth. Can central banks now really do 'whatever it takes' to achieve that goal? As each day goes by, it seems less and less likely." 
Instead of more central bank stimulus, the bank would like to see governments take immediate action to repair public finances, finish the job of re-regulating the fragile banking sector and make markets work better. 
It warns that record low interest rates and quantitative easing on a huge scale have dulled the imperative for politicians to act. "After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change," the report says. 
However, the bank does express concern about the knock-on effects of central banks withdrawing their emergency measures, including on emerging market economies, many of which have seen their currencies appreciate and their stock markets boom as investors have used the cheap money to invest in riskier assets. 
As the stimulus is withdrawn, and bond prices start to fall, interest rates – which move in the opposite direction – could jump. "An outsize increase in interest rates could lead to volatile capital flows and exchange rates, with corresponding adverse implications for global macroeconomic and financial stability," the report warns. 
The International Monetary Fund also expressed fears in a recent paper that interest rates could rocket as quantitative easing comes to an end if investors "run for the door". 

Saturday, June 22, 2013

Liam Halligan: true bank reform stymied by lack of political will

In his Telegraph column, Liam Halligan identifies why six years into a financial crisis that rivals the Great Depression there has not been true bank reform anywhere globally: lack of political will.

Why has there been no political will to reform the banks?

Because as one US senator put it: the banks own the place.

Writing about the Parliament's Commission on Banking Standards' report, Mr. Halligan notes that the report contributes valuably in describing just how bad bank behavior was leading up to and since the beginning of the financial crisis.

However, he notes that the report pulls its punches when it comes to making recommendations that would bring about true reform of the banks.

When it comes to mounting a genuine domestic recovery, nothing is more important than “fixing” our banks. When it comes to preparing the UK for the next “systemic moment” on global markets – for there will be one, of that we can be sure – then, once again, our banks are centre-stage. 
Last week saw the publication of an exhaustive final report by theParliamentary Commission on Banking Standards. ... 
Yet having been through all 571 pages, I’ve sadly concluded this report will change very little. 
That’s because it fails to promote the one reform, above all others, that really must happen if we’re to defuse the “too big to fail” time bomb and prevent the UK’s banking sector, once again, from doing serious damage to its host economy.
Regular readers know that the one reform 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.

This was the standard for bank disclosure in the 1930s and is entirely consistent with the global securities laws that were passed to ensure that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could independently assess this information and make a fully informed decision.
A major strength of this report is its account of the extent to which existing bank practices work against consumers. Going through it makes the reader angry and, when it comes to the descriptions, the commission has pulled no punches. 
“Given the misalignment of incentives in banking, it should be no surprise that deep lapses in standards have been commonplace,” the report booms. While that’s obvious, for a high-powered Parliamentary body to say so still represents progress.
What allowed these deep lapses in standards to take place was opacity.  Opacity hid bad behavior by the bankers that was similar, if not identical to, what bankers did in the run-up to the Great Depression.

Everyone knows that sunlight is the best disinfectant and only ultra transparency shines enough sunlight in to disinfect the banking system.
Many of the commission’s 80 recommendations make sense. A new “Senior Persons Regime” could make it harder for boss-class bankers to avoid punishment by claiming responsibilities were delegated and bad decisions collectively taken. Requiring senior managers to sign up to a code of conduct may also help focus minds....
In a display of how far we are from true reform of the banks, all 80 of the commission's recommendations substitute complex regulations and regulatory oversight for transparency and market discipline.

What’s needed is political will – and for the regulators to be sure the political classes will back them if they turn the screw on high-finance white-collar crime. 
Such will has been thin on the ground. 
A Parliamentary commission’s proposal for a new offence, even if eventually enshrined in law (a big if), will do nothing to change that....
Please re-read the highlight text as Mr. Halligan has nicely summarized the conclusion of the Nyberg Report on the Irish Financial Crisis.  Regulators, who are political appointees, will not enforce bank regulations unless they are supported by the politicians.  Unfortunately, the politicians have chosen to support the bankers rather than citizens who vote and pay taxes.
So, while the commission’s report is a descriptive tour de force, and is good in parts in policy terms, I don’t believe it will live up to its title and succeed in “Changing Banking For Good”.
The only thing that would change banking for good is requiring banks to provide ultra transparency.

A bank that is unwilling to provide ultra transparency is a bank that is saying it has something to hide.  If a bank has something to hide, it should not be eligible for deposit insurance.  Without deposit insurance, if the bank fails, there is no need for the taxpayers to bail it out.
I don’t necessarily blame its members for that. They’re working in shark-infested political waters, after all. And radical reforms, while relatively easy for a newspaper columnist to advocate, can unsettle financial markets if proposed by a weighty Parliamentary commission.... 
Actually, advocating for transparency settles the financial markets.  Transparency is the foundation of market confidence.

It is not as if market participants don't know that the banks are hiding losses on and off their balance sheets.  What market participants don't know is if their estimate of these hidden losses is higher, lower or approximately the same as the true level of these hidden losses.

The result of call for and adopting transparency is to provide market participants with the data they need to determine if their estimates of the losses was accurate.
In his final speech as Bank of England Governor last week, Sir Mervyn King said “it is vital, as memories of the 2008 crisis fade, that the audacity of pessimism is not lost”. 
That’s entirely correct. 
So I don’t apologise for being downbeat about our economic prospects as long as our banking sector remains moribund and fundamentally unreformed. 
And I don’t apologise for refusing to pretend that this Parliamentary commission’s proposals amount, as has been billed, to a “radical overhaul” of our banking sector – when that is so clearly far from the truth.
Only requiring the banks to provide ultra transparency will truly reform the banks.  This would be a radical change.

Friday, June 21, 2013

Restoring trust in bank capital

The Lex column of the Financial Times reviewed the bank capital debate between simple leverage ratios and complex, easily manipulated risk weighted asset ratios and concluded that something must be done to restore trust in bank capital.

Regular readers know that the foundation of trust in the financial system is disclosure.  Disclosure is the foundation because without it market participants cannot Trust, but Verify.

For banks, the required level of disclosure is ultra transparency.  Under ultra transparency, banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With these details, market participants can assess the risk and value of each bank's exposures.

With this assessment, market participants can adjust a bank's book capital level for the difference between the market value of its exposures and the book value of its exposures.  The result is a realistic estimate of a bank's current capital position.

Market participants can then use this realistic estimate of a bank's current capital position if they want to look at simple leverage ratios or a risk-adjusted capital ratio and compare it to what the banks are reporting.  Trust in bank capital and its related ratios is restored when what the banks report matches up to the market participants independent assessment.

Thursday, June 20, 2013

Reform of banking needs to go much further

In his Financial Times column, Martin Wolf lays out a compelling case for why banking reform needs to go much further than what is currently being proposed.
An industry that has taken the public for a ride must be made to change its ways. 
The financial crisis has imposed economic and fiscal costs upon the British economy and public finances that rival those of a world war.
This is also true in the EU and US.
This brutal fact must inform the response. 
It is why it has to be radical. Business as usual will not do because that could lead to national ruin. 
No industry can be allowed to operate in such a way. 
As Sir Mervyn King, outgoing Bank of England governor, noted this week: “It is not in our national interest to have banks that are too big to fail, too big to jail, or simply too big.”
Please re-read the highlighted text as Mr. Wolf has nicely summarized what the problem is with the global, financial institutions.
It is quite likely that the crisis will cost the UK a sixth of gross domestic product, in perpetuity. 
How is this disaster possible? 
The answer is that we have entrusted a private industry with the provision of three public or near public goods: the supply of money; the payments system; and the supply of credit. 
But credit is risky, while money and payment have to be safe. 
For this reason governments have provided ever stronger safety nets. 
Profit-seeking bankers have responded by making their institutions increasingly fragile: the desire to make banks safer allows bankers to take more risk.
Unfortunately, Mr. Wolf stops before looking at the role of regulators in setting and enforcing the rules so that banks do not take on excessive risk.

Regular readers know that your humble blogger has been saying that banks must be subjected to market discipline if they are going to restrain their risk taking.  The only way to subject them to market discipline is by requiring them to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is the regulators responsibility under the FDR Framework to ensure that banks provide this level of disclosure.  Unfortunately, regulators have not done so and as the Bank of England's Andrew Haldane says, banks are "black boxes"where the bankers can take on excess amounts of risk and not be subject to market discipline.
It is only against this background that we can assess the proposals of the report by the Parliamentary Commission on Banking Standards, out this week. It is a depressing, but impressively radical, document. It lays bare the malfeasance and incompetence that characterised UK banking before the crisis.
Malfeasance and incompetence that also characterized EU and US banking before the crisis.
The report is wide-ranging. It has much to say, for example, on competition. 
But soundness of the system is the heart of the matter. 
Unbridled competition over who can run their bank more irresponsibly offers only a transitory benefit to customers. 
Sound competition is possible if, and only if, the risks are fully internalised by decision makers. They were not, as the report shows.
The only way risks are fully internalized by decision makers is if market participants have the data they need so they can assess the risk of each bank and link its costs of funds to its level of risk.

The only way market participants can have the necessary data to do this assessment is if banks provide ultra transparency.
Bankers who ran their institutions into the ground left with great wealth, leaving the public, in general, and taxpayers, in particular, to pick up the pieces. 
So what is to be done? The answer, in essence, is to focus on structure and incentives. 
The beauty of transparency is that it focuses on both structure and incentives.

With transparency, bankers will have to make their money by providing the services that society needs and not by betting with taxpayer money.

Surprise, banks are still a danger to the real economy

In his Financial Times column, Chris Giles looks at the reasons that banks are still a danger to the real economy.

Unfortunately, he leaves off his list the number one reason banks are a danger to the real economy: politicians and financial regulators who do not use a modern banking system as it is designed to protect the real economy by requiring banks to recognize upfront the losses on the excess debt in the financial system.

This failure to use banks as they are designed shifts the burden of the financial crisis from the banks onto the real economy.

This burden hurts the real economy in several ways.

For example, it diverts capital needed for reinvestment, growth and supporting the social contract to debt service payments on the excess debt.

For example, it makes it virtually impossible to get a loan as valuing the collateral being offered becomes extremely difficult.  This is particularly true of real estate collateral where the price of real estate is being artificially propped up through banks not foreclosing, banks engaging in 'extend and pretend' and turning non-performing loans into 'zombie loans', and central banks pursuing zero interest rate policies.

When the authorities intervene in banking, their aim is to protect the economy from the banks rather than the banks from the economy.
Please note that authorities intervening in banking was done based on advice from the bankers.

The banking system is designed so that authorities do not need to intervene, particularly to protect bank book capital levels and banker bonuses, as they did and still do.
This turn of phrase, borrowed from Sir Mervyn King, the outgoing Bank of England governor, should be the yardstick for progress. 
On the morning after the annual Mansion House speeches by the BoE governor and the chancellor, the question is whether George Osborne is correct to say that the UK has reached a turning point from “rescue to recovery”? Is the economy now protected from banks?... 
The simple answer is No. 
The move from rescue to recovery is a question of degree and there is quite some way still to go. Sir Mervyn talked about “the work of a generation”....
Well Sir Mervyn should talk about the "work of a generation" as the EU, UK and US borrowed their policy response from Japan which had a similar banking crisis and is still trying to work its way out of that crisis a generation later.
Much progress has nevertheless been made since 2007. 
The crisis at Co-operative Bank demonstrates that parts of the new regulatory mechanisms are working in the way ultimately intended. ....That new arm of the BoE stood its ground and insisted the Co-op plug a £1.5bn hole in its capital buffers. With the authorities demanding action and no taxpayer money on the table, the wider Co-op group has been forced to inject money from other parts of the business and extract a significant, but still to be determined, contribution from bondholders. 
There was no knock-on distress to other banks’ funding costs or lending. This was banking recovery in action, a regulatory intervention much preferable to the resolution of a dying bank or a taxpayer bailout.
This is the way that a modern banking system has been designed to operate since the 1930s.  This is simply an example of the regulators using the bank as it was designed.
But what is true for the Co-op or for other small financial entities still would not apply to the big boys. If RBSLloydsBarclaysHSBC, Nationwide or Santander UK got into difficulties, the authorities could not stand back. 
Authorities could stand back.  Authorities will not stand back.  After all, they have to consider their post political or regulatory careers.
Nor will we know, ultimately, how healthy Britain’s banks are until monetary policy returns to something approaching normality. The eventual return to interest rates near 4 or 5 per cent contains many hidden dangers for banks if their customers cannot cope with higher borrowing costs. 
Before a new world of normality can be achieved, action is still needed on many fronts to make banks and bankers a more normal part of the British economy.
There is no reason to ever expect monetary policy to escape the ZIRP/QE trap.  These policies are designed to artificially inflate asset prices and hope that the wealth effect will spur economic growth to support the inflated prices.

The problem is that the wealth effect has been shown to be virtually non-existent.
Four “Cs” are especially relevant in removing the special tag from banking and bankers. 
As the parliamentary commission makes clear, the first is the conduct of the industry. Perverse incentives with enormous rewards for success and insufficient sanction for failure must be addressed, especially when the distinction between both depends so much on luck. Deferred bonuses, clawbacks and the mere hint of criminal penalties will help, but can be successful only if banks and bankers embrace a new culture. Success is far from guaranteed....
As regular readers know, conduct of the industry is easily addressed by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is well known that sunlight is the best disinfectant of bad banker behavior. Effectively, sunlight introduces a new culture into banking based on providing services society needs rather than betting with taxpayer money.
Third comes the more difficult area of capital. While banks are far better capitalised than in 2007 and in the long run the BoE is right to argue that higher capital levels do not impede lending, the transition is difficult and gives banks the incentive to reduce lending in the process of becoming safer.
Capital is another area that is easily handled by ultra transparency.

First, with this level of disclosure, banks are subject to market discipline to recognize all the losses currently hidden on and off their balance sheets.

Second, with this level of disclosure, market discipline is exerted on banks to rebuild their book capital levels while restraining their risk taking.  In the 1930s when ultra transparency was seen as the sign of a bank that could stand on its own two feet, banks carried much higher levels of book capital.

Monday, June 17, 2013

Heidi Moore: Wall Street is winning the long war against regulation

In her Guardian column, Heidi Moore looks at how Wall Street is winning the war against post-financial crisis regulation.

Regular readers know that this is just a minor skirmish in the much larger war Wall Street has been waging against the regulations it was subjected to following the stock market crash of 1929.

In the aftermath of the 1929 crash, but not the 2007/2008 meltdown, Wall Street's behavior was investigated.  What the Pecora Commission uncovered was that everyplace there was opacity in the financial markets, Wall Street engaged in unsavory conduct.

As a result, the FDR Framework became the basis for the global financial system.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

The FDR Framework makes governments responsible for ensuring that market participants have access to all useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Please note that the governments are made responsible for ensuring "valuation" and not price transparency.  This is intentional as valuation transparency is the starting point for the investment cycle and differentiates investing from gambling.

The FDR Framework also provides an incentive for market participants to engage in the investment cycle and independently assess the disclosed information as it makes market participants responsible for all losses on their investment exposures.

The three steps of the investment cycle are as follows:

  1. Independently assess the disclosed information to determine the risk and valuation of an investment;
  2. Obtain prices from Wall Street at which it would buy or sell the investment;
  3. Compare the independent valuation to Wall Street's prices and make portfolio management decision to buy, hold or sell.  

Market participants gamble when disclosure does not provide them with all the useful, relevant information in an appropriate, timely manner.  Without this information, market participants cannot start the investment cycle and independently determine the risk and valuation of an investment.  Rather, they are simply blindly betting on the contents of a brown paper bag when they buy or sell the investment.

When all there is valuation transparency, knowing they are responsible for losses, investors limit their exposures to any investment to what they can afford to lose.  This builds market discipline into the financial system as investors link what they need to be compensated for making an investment to the risk of the investment.  This also builds stability into the financial system and eliminates concerns about financial contagion.

The only exception where market participants are not responsible for losses is for deposits at banks that are less than or equal to the level guaranteed by the government.

As demonstrated in the 1920s and again in the run-up to our current financial crisis, Wall Street prefers opacity.  Wall Street prefers opacity because it makes it impossible for investors and other market participants to properly assess the risk of and value an investment.

Wall Street particularly likes opacity when it has access to all the useful, relevant information in an appropriate, timely manner and investors and other market participants do not.  Examples of this would be opaque, toxic structured finance securities or the banks themselves.

Wall Street also likes opacity because it can hide behind the veil of opacity and manipulate markets.  Examples of this include all the benchmarks like Libor and foreign exchange.

Obviously, Wall Street's preference for opacity runs into the government's responsibility for ensuring valuation transparency.  This is a war without end.

Unfortunately, as shown by our current financial crisis, it is a war where periodically Wall Street wins a  battle.

If you look, you will see that large portions of our financial system are opaque.  Examples include structured finance and banks.  It is these corners of the financial system that froze at the beginning of the financial crisis and have not unfrozen.

Ending our financial crisis requires bringing valuation transparency to all the opaque corners.  One of the results of bringing valuation transparency to banks will be to subject Wall Street to market discipline (not just regulatory oversight where Wall Street can capture the regulator).

Sunday, June 16, 2013

Thomas Hoenig calls attention to well known fact: banks operating without much capital

Thomas Hoenig created a ruckus by pointing out that Deutsche Bank is "horribly undercapitalized".  Naturally, Deutsche Bank responded that in the make believe world of Basel capital requirements Mr. Hoenig was wrong.

To settle the matter, Zero Hedge weighed in and noted that EU banks, including Deutsche Bank, needed upwards of 500 billion euros of capital.  Citing the work on EU banks by Benink and Huizinga, Zero Hedge noted
Banks are already saddled with ample unrecognised losses on their assets, estimated by many observers to be at least several hundreds of billions of euros and mirrored by low share price valuations...
This whole debate highlights two important facts about our current financial crisis.

  1. Everyone knows that the banks are hiding losses and the extent of their hidden losses exceeds their current book capital levels.
  2. Banks are holding policymakers and central bankers hostage by threatening that disclosure of these losses and the related lack of capital will result in financial instability.
Please note that if everyone already knows the banks have low or negative capital, then revealing the exact amount should not result in financial instability.  Revealing the exact amount simply confirms what market participants already know and lets market participants know how close their estimates of the losses were to reality.

Your humble blogger is confident in his statement that revelation of the losses won't result in financial instability for several reasons including: market participants might have overestimated the extent of the losses and we have 6 years of experience that show that banks can continue to operate with what in reality is low or even negative book capital levels because of the combination of deposit insurance and access to central bank funding.

If revelation of the exact amount of losses is not going to result in financial instability, then policymakers and central bankers don't have to remain hostages of the banks.  And if policymakers and central bankers don't have to remain hostages, then there is no reason to continue to pursued the failed Japanese Model and preserve bank book capital levels and banker bonuses at all costs.

Friday, June 14, 2013

Jeremy Warner: this crisis proves that capitalism works

In a very interesting Telegraph column, Jeremy Warner makes a very important point: this crisis proves that capitalism works.

Where Mr. Warner and your humble blogger differ is in how we come to this conclusion.

I look at the stock market which continued to function throughout the most hectic early days of the financial crisis.  Yes, prices did decline, but there were private buyers who were willing to buy at these prices if the sellers were willing to sell.

Compare and contrast the stock market with the interbank lending market or structured finance market.  The latter two markets froze.


Because of opacity.  Opacity that prevented buyers from having valuation transparency.

The first step in the investment process is to independently assess all the useful, relevant information disclosed in an appropriate, timely manner under valuation transparency to determine the risk and value of an investment.

The second step in the investment process is to solicit the price Wall Street is willing to buy and sell an investment at.

The third and final step in the investment process is to compare the independently determined value with the prices from Wall Street to make a buy, hold or sell decision.

If the first step of the investment process cannot be completed due to opacity, then financial markets effectively freeze except for gamblers who are willing to bet on the contents of a brown paper bag or a black box.

It is the observation that financial markets with transparency function during times of stress and the financial markets with opacity freeze that leads me to the conclusion that capitalism based on the FDR Framework works.

Thursday, June 13, 2013

Robert Reich: lack of accountability by Wall Street creating huge problems

On his blog, Robert Reich looks at the problems that are created by not holding Wall Street accountable.

Regular readers know that the only way to hold Wall Street accountable is with transparency.  Sunlight is the best disinfectant because it makes the bankers and their financial regulators responsible for their actions.
The second center of unaccountable power goes by the name of Wall Street and is centered in the largest banks there. 
If we trusted that market forces kept them in check and that they did not exercise inordinate influence over Congress and the executive branch, we would have no basis for concern. 
However, market forces can not keep them in check because market forces do not operate where there is opacity.  Market forces require transparency to exert influence.
We wouldn’t worry that the Street’s financial power would be misused to fix markets, profit from insider information, or make irresponsible bets that imperiled the rest of us. 
Fix markets like the benchmark interest rates (Libor). Profit from insider information like structured finance products (ownership of servicers allows Wall Street to have tomorrow's news today and legally trade on it). Place bets like JP Morgan's London Whale CDS trade.
We could be confident that despite the size and scope of the giant banks, our economy and everyone who depends on it were nonetheless adequately protected.  
But those banks are now so large (much larger than they were when they almost melted down five years ago), have such a monopolistic grip on our financial system, and exercise so much power over Washington, that we have cause for concern. 
The fact that not a single Wall Street executive has been held legally accountable for the excesses that almost brought the economy to its knees five years ago and continues to burden millions of Americans, that even the Attorney General confesses the biggest banks are “too big to jail,” that the big banks continue to make irresponsible bets (such as those resulting in JP Morgan Chase’s $6 billion “London Whale” loss), and that the Street has effectively eviscerated much of the Dodd-Frank legislation intended to rein in its excesses and avoid another meltdown and bailout, all offer evidence that the Street is still dangerously out of control. 
Dodd-Frank was effectively written by and for the Too Big to Fail banks.  The banks were so confident in their writing of the legislation that they even created the Office of Financial Research so that transparency would have a place to go to die.

The only elements not approved of by Wall Street were the Consumer Financial Protection Bureau and the Volcker Rule.
It is rare in these harshly partisan times for the political left and right to agree on much of anything. But the reason, I think, both are worried about the ... depredations of “too big to fail or jail” Wall Street banks on our economy, is ...: It is this toxic combination of inordinate power and lack of accountability that renders ... them dangerous, threatening our basic values and institutions. 
Ultimately policymakers will have to make a choice: bankers or society.

Dani Rodrik on Europe's way out of the financial crisis

In his Project Syndicate column, Harvard Professor Dani Rodrik lays out his plan for how Europe could end its current financial crisis and and restore economic growth.

Regular readers will immediately recognize that Professor Rodrik's plan is essentially your humble blogger's blueprint for economic recovery with one difference.

Professor Rodrik thinks that banks need to be recapitalized immediately by their sovereigns when in fact they are designed so that they can be recapitalized over several years using retained earnings.

Letting the banks recapitalize themselves through retained earnings frees up the sovereigns to use their resources pursuing stimulative economic policies.

The eurozone periphery suffers from both a stock problem and a flow problem. It has too large a debt stock, and too little competitiveness to achieve external balance without significant domestic deflation and unemployment. 
What is required is a two-pronged approach that targets both problems simultaneously. 
The prevailing approach – targeting debt through fiscal austerity and competitiveness through structural reform – has produced unemployment levels that threaten social and political stability.
So, what can be done differently?
The most direct way to address the debt problem is a write-down, coupled with recapitalization of those banks that will suffer large losses as a result. This may seem extreme, but it simply recognizes the reality that much of the existing debt will not be paid back without new flows of official financing. 
As the IMF now acknowledges, it might have been better to restructure Greek debts from the outset than to engage in a “holding operation.” 
Debt reduction by itself clears the way for growth, but does not directly trigger it. 
Policies that directly target expenditure rebalancing within the eurozone and expenditure switching within the peripheral economies are also needed. 
These include: policies to boost eurozone-wide demand and stimulate greater spending in creditor countries, especially Germany; policies that aim to reduce non-tradable prices; income policies to reduce the peripheral economies’ private-sector wages in a coordinated fashion; and a higher ECB inflation target to allow room for movement in the real exchange rate via nominal changes.
These policies would require Germany to accept higher inflation and explicit bank losses, which assumes that Germans can embrace a different narrative about the nature of the crisis. And that means that German leaders must portray the crisis not as a morality play pitting lazy, profligate southerners against hard-working, frugal northerners, but as a crisis of interdependence in an economic (and nascent political) union. Germans must play as big a role in resolving the crisis as they did in instigating it.
France will most likely play a critical role as well. France is big enough that if it threw its support fully behind the peripheral countries, Germany would be isolated and would need to respond. But, so far, France remains eager to separate itself from the southern countries, in order to avoid being dragged down with them in financial markets.

Small problem with Fed policies, it is real wages, not wealth effect, that drive US consumer spending

As Pedro da Costa reports in his Reuters blog, a survey shows that it is real wages and not the wealth effect that drive US consumer spending.

This is important because the Fed's monetary policy, including zero interest rates and quantitative easing, is reliant on the wealth effect to drive growth in demand.

Did this reliance ever make sense in anything other than an economic model?


There is no reason to believe that the wealthy dramatically increase or decrease their spending because of the level of interest rates rather than base their spending on what they earn as income each year.

If your humble blogger had to guess why economists believe in the wealth effect it is that they confuse correlation with causation.

Specifically, they saw consumption pick up over the last 30 years as both stock and house prices increased and said "aha, there must be a wealth effect as an increase in wealth is correlated with higher consumption".

In reality, what was really happening is that Wall Street became quite proficient at letting Main Street tap the equity in their houses and Main Street needed to tap this equity because growth in income was insufficient to support the lifestyle they had from previous years.

Federal Reserve officials have touted the ‘wealth effect’ from higher stock prices and rising home values as a key way in which monetary policy boosts consumer spending and economic activity. 
But according to the results of a recent survey from the Royal Bank of Canada, that ethereal feeling of being richer on paper is no substitute for cold, hard cash.
Here’s how Fed Chairman Ben Bernanke explained the benefits of rising asset prices to the real economy during a press conference in September
The tools we have involve affecting financial asset prices and those are the tools of monetary policy. There are a number of different channels – mortgage rates, I mentioned corporate bond rates, but also prices of various assets, like for example the prices of homes.  
To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more disposed to spend. If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. So house prices is one vehicle.... 
The issue here is whether or not improving asset prices generally will make people more willing to spend. 
One of the main concerns that firms have is there is not enough demand, there’s not enough people coming and demanding their products. If people feel that their financial situation is better because their 401(k) looks better for whatever reason, or their house is worth more, they are more willing to go out and provide the demand..... 
RBC survey’s findings, explained by the bank’s chief U.S. economist, Tom Porcelli, in a research note: 
That wages and the jobs backdrop matter for consumption is not only borne out in the hard data, but this also came through loud and clear in our June consumer survey. 
When asked about what would embolden them to increase spending, nearly half of respondents noted wage increases while about 1/5 said a better job backdrop. So 65% of consumers think employment dynamics are what matter most. Contrary to popular belief, there was little “wealth effect” from stocks and housing apparent here. 
The bad news: U.S. wages have been stagnant for quite a while.

Wednesday, June 12, 2013

Paul Krugman: Unproductive finance based on knowing something before other market participants

In his NY Times blog, Professor Paul Krugman finally discovers the role of transparency in the financial markets when he discusses unproductive finance which is based on knowing something before other market participants.
More than half a century ago, in his classic paper on the economics of speculation, Paul Samuelson noted the perverse rewards to knowing stuff just slightly before everyone else. 
He asked readers to imagine someone who, somehow, consistently received crucial information one second before everyone else. 
As he pointed out, the social value of that extra second would be minimal; but the private rewards could be huge.
As regular readers know, with private label structured finance securities including CDOs, Wall Street's informational advantage was not an extra second but rather weeks.  Wall Street had this informational advantage because it owned the firms that were servicing the underlying collateral.

Naturally, when the collateral stopped performing, Wall Street was only too happy to "short" these securities before market participants received this performance information.

Your humble blogger has been saying since the very earliest days of the financial crisis that we need to bring transparency to all the opaque corners of the financial system so as to eliminate Wall Street's informational advantages.

It is these informational advantages that give rise to unproductive finance and our current financial crisis.

Bank of England's Andrew Haldane: Central bank created bond bubble threatens financial system

In his testimony before Parliament, the Bank of England's Andrew Haldane made clear that the greatest threat to financial stability was the central bank zero interest rate/quantitative easing induced bond bubble.

Regular readers know that Mr. Haldane is accurate in his assessment and that the pursuit of ZIRP and QE was totally and completely unnecessary as a response to the bank solvency led financial crisis.

As your humble blogger has been saying since before the financial crisis spiraled out of control in 2008, the way to deal with this crisis is to adopt the Swedish Model and require banks to absorb upfront their losses on the excess public and private debt in the financial system.

Please note, the only way to end Mr. Haldane's concern about unwinding ZIRP and QE and triggering financial instability is to adopt the Swedish Model with a twist.  The twist being that the banks "pay" for their having been bailed out by "donating" their holdings of government securities to the issuing sovereigns.

Will this make the vast majority of banks have low or even negative book capital levels?

Yes, but modern banks are designed because of the presence of deposit insurance and central banks to be able to continue operating and supporting the real economy when they have low or negative book capital levels.  They can do so because with deposit insurance the taxpayers act as the banks' silent equity partners.

A key Bank of England policymaker has warned of the risks to global financial stability when "the biggest bond bubble in history" bursts. 
In a wide-ranging testimony to MPs, Andy Haldane, Bank of England director of financial stability,... told the Treasury select committee that the bursting of the bond bubble – created by central banks forcing down bond yields by pumping electronic money into the economy – was a risk "I feel acutely right now"....

But he described bond markets as the main risk to financial stability. 
"If I were to single out what for me would be biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally." he said. 
There had been "shades of that" in recent weeks as government bond yields have edged higher amid talk that central banks, particularly the US Federal Reserve, will start to reduce its stimulus. 
"Let's be clear. We've intentionally blown the biggest government bond bubble in history," Haldane said. "We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted."

Tuesday, June 11, 2013

Sheila Bair asks "Does anyone have a clear vision of the desirable financial system of the future"

Since Sheila Bair asked "does anyone have a clear vision of the desirable financial system of the future" and responded by providing a variant of the financial system that collapsed at the beginning of the current financial crisis, I thought I should answer her question.

Ms. Bair's response fails because it substitutes complex rules and regulatory oversight for transparency and market discipline.

The number one lesson of the financial crisis is that a financial system that is reliant on complex rules and regulatory oversight is prone to failure.

It is a myth that more complex regulation and regulatory oversight would have prevented the financial crisis that started on August 9, 2007.

The reason it is a myth is that a financial system that relies on complex regulations and regulatory oversight is dependent on the regulators to a) do their jobs, b) properly assess what is happening in the financial system and c) accurately communicate their findings to market participants.  Because of concern about the safety and soundness of the financial system, regulators will never accurately communicate their findings.

The financial system of the future is the same financial system that was designed in the 1930s and based on the FDR Framework.  This financial system incorporated the philosophy of disclosure with the principle of caveat emptor (buyer beware).

It assigns a very specific role to the financial regulators. They are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Fulfilling this responsibility means the financial regulators have to eliminate opacity in all the large areas of the financial system where it currently exists.

For example, regulators need to require that banks adopt that 1930s standard of disclosing all of their current global exposure details.  This includes assets, liabilities and off-balance sheet exposures.

For example, regulators need to require that structured finance securities disclose when an observable event occurs with the underlying collateral, like a payment or delinquency, before the beginning of the next business day.

The FDR Framework also assigns responsibility to the market participants.  They are responsible under caveat emptor for all gains and losses on their exposures.  Responsibility for losses gives market participants an incentive to independently assess the disclosed information.  Market participants use this independent assessment to limit their exposure to what they can afford to lose given the risk of the exposure.

By limiting their exposures to what they can afford to lose, market participants build robustness and resiliency into the financial system and make it so it is not prone to failures.

Unlike Ms. Bair's, my proposed financial system for the future has 6+ decade track record of successful performance.

Ms. Bair's proposed financial system that allows opacity and relies on complex rules and regulatory oversight  has already shown that it is prone to failure within a decade.

ABC's Alan Kohler on casino banking: banks create risk and gamble on it

ABC's Alan Kohler makes the case for requiring banks to provide transparency when he talks about casino banking and how banks create risk that they subsequently gamble on.

Almost all financial derivatives trading adds nothing but risk to the world and should be banned. It won't be, but that doesn't mean the debate is academic. 
Regulators are attempting to bring derivatives into the light through mandatory exchange execution and clearing and "Legal Entity Identification" rules, but progress is slow and fragile. It can be filed under "B" for believe it when we see it.
Please note that derivatives could easily be brought into the light if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Disclosing their exposure details would disclose their derivative positions.
But is there any reason to allow financial derivatives at all? 
New York hedge fund manager James Rickards says they should simply be banned because the benefits are illusory and the effect is that risk is created out of thin air and then multiplied....
Most derivatives trading involves swaps or contracts for difference, where two people bet on movements in an underlying asset or income flow without actually trading in it. It's a bit like betting on flies crawling up a wall, without having to buy the flies.... 
Credit default swaps are bets on whether a country or company will go broke; interest rates swaps are bets on movements in interest rates; contracts for difference are bets on movements in a share price or other asset; and so on....

In fact, derivatives caused the 2008 global financial crisis because banks and investment banks vastly multiplied the leverage on their balance sheets by betting through derivatives and then losing control. 
I wouldn't say that derivatives caused the 2008 global financial crisis.  Derivatives clearly contributed to the magnitude of the crisis.
Since then, the amount of derivatives outstanding has actually grown, and now stands at more than $700 trillion....
Requiring the banks to disclose their derivative positions would have an immediate impact on restraining growth in the amount of derivatives outstanding and would give banks an incentive to shrink their derivative exposures.

Disclosure of their derivative books means that banks are subject to having their cost of funds linked to the risk they are taking.  The more risk in their derivative book, the higher their cost of funds.

This form of market discipline restrains growth in derivative exposures and provides an incentive to reduce the risk of the derivative exposures.
Nevertheless, regulators are grinding their way through consultation and report production with a view to eventually dragging OTC derivatives trading into the open, where the players at least have to say who they are.
The US Dodd-Frank legislation, passed in 2010, requires non-US banks to register as swap dealers with US regulators from next year if they want to trade derivatives there. 
Guess what? Reuters reported last week that Asian banks are cutting their relationships with US banks so they don't have to register, and US banks themselves are restructuring so they can keep going. 
Proving that complex rules and regulatory oversight are not a substitute for transparency and market discipline.
Let's be clear: basically, we're talking about a casino where the gamblers are banks. And banks aren't just any old punters: they also take deposits and lend money, underpinning the financial system on which society rests. 
As with all casinos, someone always loses their shirt occasionally - LTCM in 1998 (US$4.6 billion), UBS in 2011 ($2 billion), AIG 2008 ($18 billion), Barings in 1995 ($1.2 billion), Societe Generale in 2008 ($7.2 billion), and so on. 
The losses of shirts don't always cause a general financial crisis, but there's always a wobble, and in 2008, the combination of AIG, Merrill Lynch and Lehman Brothers and a few others did cause a global recession and is still causing widespread misery....
The only way to restrain bankers' desire to gamble is by requiring they disclose their exposure details.

As Jamie Dimon and JP Morgan showed with the London Whale trade, if banks are forced to disclose their positions, fear of the market trading against them will cause them to exit the position as soon as possible.

Monday, June 10, 2013

Telegraph's Jeremy Warner: 6 years into financial crisis, time to consider radical reforms

In his Telegraph column, Jeremy Warner looks at the failure of current reforms to satisfactorily address the problems in the financial system and suggests that it is time to consider more radical reform.

He proposes that we consider adopting 100% reserve banking.

Regular readers were first exposed to this idea a couple of years ago with the discussion of Boston University Professor Kotlikoff's call for limited purpose banking.

As your humble blogger noted at the time, we already have 100% reserve banking/limited purpose banking.  It is known as mutual funds.  A mutual fund operates with no leverage.  All gains and losses on its investments are absorbed by its investors.

Mr. Warner described the advantages and disadvantages of such a mutual fund only financial system.
In a system of 100pc reserve banking, none of these problems arises. As the term implies, all deposits are held on reserve, or in cash. The deposit bank is thereby deprived of its money creating privileges, but there is no risk of a run. Credit is instead provided by intermediaries that compete for these deposits and marry them directly with borrowers. 
Simple. The credit cycle is abolished, and many of the things that so much concern regulators today – capital and liquidity requirements, risk weighting, how to get rid of the too-big-to-fail problem – would cease to be an issue. 
What’s more, there would be no need for deposit insurance or oversight, beyond a framework for simple fraud prevention. Credit banks could be allowed to fail without risk of wider systemic damage. 
Under the original Chicago plan, the transition from the current to the new system would also allow the Government to cancel its debts, though obviously at the current level of spending, these debts could quickly re-accumulate. 
When something looks too good to be true, it generally is. 
One of the most obvious drawbacks is that there would plainly be less credit and less leverage in such a system. Indeed, to the extent that credit existed, it would look much more like high-risk equity. For all the social and economic scarring the credit cycle can inflict, it is also a key part of the creative destruction of capitalism. 
Without it, you might have a more stable economy, but it is not clear that you would have as much innovation, entrepreneurialism, business creation and long-term economic growth. 
The biggest problem of all with 100pc reserve banking is that of transition. Getting from here to there would be a truly revolutionary and potentially highly destabilising process, so much so that it is hard to think of any advanced economy embarking on it. 
Then again, we are not through this present banking crisis yet by any means, and already, many things that were once thought fanciful are now part of our every day language.
I happen to agree with Mr. Warner's motivation for reform as returning the banks to where they were pre-August 9, 2007 is of no benefit to society.
The only thing everyone agrees on – from bankers to bank bashers – is that the reform agenda as it stands is far from satisfactory. 
In the sense that the thrust of banking reform to date has been essentially to return the system to the way it was, with a little more discipline and transparency than before...
I disagree with his solution of 100% reserve banking.  Just like the 1930s, where we need to end up is with transparency so that all market participants have access to all the useful, relevant information so they can independently assess this information and make a fully informed decision.

For banks, this level of transparency is ultra transparency.  It existed and was the global standard in the 1930s.  Under ultra transparency, banks disclosed on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The result of ultra transparency would be to radically reform the banking system.  It would subject the banks to market discipline.

With their risk linked to their cost of funds, banks would have an incentive to a) end proprietary trading, b) shrink by eliminating their subsidiaries that engage in regulatory and tax arbitrage, and c) reduction of excess public and private debt in the financial system as banks would absorb their losses on this debt.

Friday, June 7, 2013

FT's Martin Wolf calls for UK to fix it banks, but not its monetary policy

In his Financial Times column, Martin Wolf calls for the UK to fix its banks, but leave its monetary policy unchanged.

Mr. Wolf bases his call on the observation that
The UK is suffering from a combination of the banks’ unwillingness and inability to lend and potential clients’ inability and unwillingness to borrow. 
The BoE’s easing is “pushing on a string”.
This is an interesting observation as it contains a kernel of truth surrounded by a forest of falsehood.

Regular readers know that a bank's lending function is separate from how it funds the loan.  It is separate because banks have many different ways of funding the loan including on-balance sheet, syndicating the loan to other banks or selling the loan to investors.

Banks have the ability to lend, but they are showing an unwillingness to lend.


Banks are senior secured lenders.  In this role, they require collateral.  When the financial crisis hit, it created doubts about the value of the collateral, particularly the real estate collateral.

These doubts were made worse by the financial regulators adoption of regulatory forbearance.  Under regulatory forbearance, the banks engage in 'extend and pretend' and turn non-performing debt into 'zombie' loans.

The bankers know how much of their portfolio is in 'zombie' loans.  Psychologically, it is difficult to assign a high collateral value to real estate pledged for a new loan when one can see the huge overhang of real estate in the 'zombie' loans.  The result is both the apparent unwillingness to lend and potential clients' inability to borrow (inability reflects a lack of collateral after the bank discounts for 'zombie' loan overhang).

The way to address this problem and restart lending is to have the banks recognize their losses on the excess public and private debt in the financial system.  In recognizing their losses, the banks need to write-down the debt to a level where the borrowers can afford to service the debt.

Debt write-downs should not create equity for the borrower.  Where there is a buyer for the collateral who would pay more than the borrower, the collateral should be sold.

The idea that the BoE's easing, like the other central banks, is "pushing on a string" is totally false.  This policy was known in advance to be good for bankers and bad for the real economy.

It was good for bankers in that it maximized the banks' reported earnings and banker bonuses since the beginning of the financial crisis.  There is nothing like zero cost funds to temporarily boost banks' net interest margin, particularly when the banks are carrying 'zombie' loans.

It was bad for the real economy in that it triggered economic headwinds like the Retirement Plan Death Spiral that crushed current demand.  Under the Retirement Plan Death Spiral, both individuals and companies make up for the shortfall in earnings on their retirement assets by reducing current consumption.

The way to address the problem with monetary policy and support the real economy is to reverse the policy and restore interest rates to a minimum of 2%.

Thursday, June 6, 2013

European Commission cites risk of financial contagion to defend not restructuring Greece debt earlier

The Guardian reports that the European Commission is defending its failure to restructure the Greek (Irish, Portuguese, Spanish, ...) debt at the outset of the financial crisis citing the risk of financial contagion.

And what is financial contagion?

In theory, financial contagion is a domino effect through the banking system where the failure of one banks triggers the failure of other banks.

But does financial contagion exist in our global modern banking system?

No.  Banks have the capacity to absorb significant losses as they are designed to be able to operate with low or even negative book capital levels and still support the real economy.

Banks are able to do this because of the combination of deposit insurance and access to central bank funds.  With deposit insurance, taxpayers effectively become the banks' silent equity partner when they have low or negative book capital levels.

But don't banks need to be recapitalized immediately after they have absorbed the losses on the excess public and private debt?

No.  Again, the taxpayers are effectively backstopping the banks, so it is as if the banks had unlimited equity.  As a result, the banks can rebuild their book capital levels over several years by retaining 100% of pre-banker bonus earnings.

But won't depositors get nervous if the banks have low or negative book capital levels?

No.  There are two types of core depositors.

One type holds deposits that are below the deposit guarantee level and they trust that the government will honor its guarantee.

The second type of depositors is a business that has a reason, like making payroll, for holding deposits with the banks.  They too are insensitive to how much capital the bank has unless policymakers and financial regulators plan on seizing these excess deposit a la Cyprus to bail-in and recapitalize the bank.

So why are policymakers citing the risk of financial contagion to defend themselves against not restructuring excess public and private debt sooner?

Because policymakers were following the advice of the bankers advising them.  As shown by the European Commission, it was easy to succumbed to the irresistible temptation to push the losses onto the taxpayers and "protect" the banks.

In reality, all putting the losses on the taxpayer did was to protect the bankers' bonuses and shift who suffered as a result of the losses from the banks to the taxpayers.

The IMF criticism and the commission's defence of its performance boil down to a dispute over whether Greece's staggering debt level should have been restructured early in 2010 when the troika was fixing the terms for the bailout. 
While the IMF takes the view now that it was a cardinal error not to restructure, the commission argues strongly that there were too many unknowns, the risks were huge, such a move could have unleashed a rollercoaster of panic across the eurozone, and there was not yet any real eurozone firewall or bailout funds in place.
Actually, all the necessary firewalls have been in place for decades.

It would have been armageddon for banker bonuses, but this seems like a reasonable outcome given that the bankers were the ones who took on the risk in the first place.
"Even assuming it was inevitable and the only solution, the risks associated with an early Greek debt restructuring were huge," according to the commission. 
The European Commission is confirming that it knew what the only solution to end the financial crisis was (adopt the Swedish Model and require the banks to recognize the losses upfront) and that it instead chose to protect bank balance sheet and banker bonuses at all costs (the Japanese Model).
"The whirlpool in the financial markets in early 2010 was only beginning to subside, the banking system was extremely fragile and it was not possible to estimate financial and psychological effects of the largest bond restructuring in history or its potential ripples to the real economy of the euro area. Against this background, later restructuring allowed for time to build firewall capacity. An earlier restructuring would have also entailed risks of systemic contagion."
By 2010, governments around the world had put the financial system on life support.  Recognizing the losses that everyone knew were on the bank balance sheets would not have triggered panic.  In fact, it would have triggered relief.

Later restructuring allowed the banks time to offload their losses onto the taxpayers while the bankers continued to pocket their bonuses.  Not a good outcome for the taxpayers.