Paul Volcker explains how to fix big banks and financial system

In David Brodwin's must read US News column, he looks at Paul Volcker's explanation of how to fix big banks and the financial system.

Mr. Volcker observed:

The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can't be healthy for markets or for the regulatory community....

Regular readers know that transparency is the foundation for confidence and trust in the financial world.

The global financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Confidence and trust is one the end results of implementing this framework.

This end result occurs because market participants have confidence and trust in their decisions when they have access to all the useful, relevant information in an appropriate, timely manner to independently assess the risk of and value an investment so they can make a fully informed decision.

Confidence and trust are shattered when there is opacity in large corners of the financial system and financial authorities insist on substituting their judgement for each market participant's independent analysis.

Volcker sees two main threats to our banking system: first, our ongoing failure to regulate it adequately in the wake of the subprime mortgage crisis, and second, the development of unrealistic and dangerous expectations for the role of the Fed. 

Volcker begins by affirming that modern financial markets have lost the ability to self-regulate, and that "market discipline alone" fails to "restrain episodes of unsustainable exuberance before the point of crisis." 

Your humble blogger disagrees with Mr. Volcker that modern financial markets have lost the ability to either self-regulate or exert market discipline.

For either of these to occur, there must be transparency because without transparency it is impossible to assess risk.

How can markets exert discipline and restrain bank risk taking when they do not have access to a bank's current global asset, liability and off-balance sheet exposure details?

How can markets exert discipline and restrain bank risk taking when the regulators, who have an information monopoly on the current exposure details, say banks are low risk?

No one should expect markets to exert discipline and restrain bank risk taking when bank disclosure regulations allowed them to be "black boxes" and regulators out of concern for the safety and soundness of the financial system misrepresent the riskiness of the banks.

It is not surprising that confidence and trust in the financial system and financial authorities are eroding.  Market participants have reason to believe they are being lied to.

If the banks are in the great financial condition that the financial authorities claim, then the authorities should insist that the banks provide transparency so market participants can independently confirm this fact.

By not requiring the banks to provide transparency 6 years after the financial crisis began, the financial authorities are effectively waving a large red warning flag.

Yet, the so called Dodd-Frank Act does not solve the problem, he says. It provides both too much regulation and too little.... 

Despite the extensive regulation in Dodd-Frank, the bill is badly compromised by loopholes that prevent it from being fully and effectively implemented. Volcker writes: 

"The present overlaps and loopholes in Dodd-Frank and other regulations provide a wonderful obstacle course that plays into the hands of lobbyists resisting change. The end result is to undercut the market need for clarity and the broader interest of citizens and taxpayers."...

The Dodd-Frank Act uses complex regulations and regulatory oversight as a substitute for transparency and market discipline.

Unfortunately, we are in our current financial crisis because complex regulations and regulatory oversight does not prevent a financial crisis like transparency and market discipline does.

Your humble blogger likes to cite in support of this statement the simple fact that the financial crisis occurred in all the opaque corners of the financial system (think banks and structured finance securities).  In these opaque corners the financial system froze (think unsecured interbank lending).

By contrast, the transparent parts of the financial system continued to operate (think stock and corporate markets excluding banks).  For every seller, there was a willing buyer.  The price might not have been what the seller really wanted, but there was a private buyer.

Your humble blogger has frequently said that most of the Dodd-Frank Act should be repealed (with the exception of the Volcker Rule and the Consumer Financial Protection Bureau).  It should be replaced with a requirement that the SEC implement the Securities Acts of the 1930s and require banks to disclose their current exposure details.

As JP Morgan showed with the London Whale trade, when a bank's exposure details are known, it quickly exits any risky position.

It is remarkable what transparency and the resulting clarity it brings can do.

We can't simply return to the rules of the past, says Volcker. 

The world has changed too much. Financial markets and institutions are larger, more complex, more interconnected and "more fragile." Hedge funds and other non-banks play a much larger role in the system and regulated commercial banks play a proportionally smaller role. 

The old regulatory structures will not give us the stability we need in the system and its major institutional components.

Actually, we can return to the rules of the past when the rules concern ensuring transparency in the financial markets.

Please recall that under the FDR Framework's principle of caveat emptor market participants are responsible for all losses on their exposures.  It is this responsibility that ends financial contagion and fears of interconnectedness.

Quite simply, since they are responsible for losses on their exposures, market participants have an incentive to limit their exposures to what they can afford to lose.  This goes for investors and for banks too.

When all market participants are responsible for their losses, there is financial stability.  A bank can fail without any worries about financial contagion because market participants have limited their exposure to what they can afford to lose.

However, this doesn't work when banks are opaque black boxes that financial authorities say have a low risk profile.  In this case, market participants over invest as they did in the run-up to our current financial crisis.

Fixing the big banks and the financial system is simple: bring back transparency.

Who should bear the pain?

In his Bloomberg column, Matthew Klein examines the question of "who should bear the pain" when it comes to absorbing losses on the excess debt in the financial system.

For the global financial system, which is based on the FDR Framework, losses are the responsibility of the market participants who have exposure to the investment.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all useful, relevant information is disclosed in an appropriate, timely manner.  Market participants are responsible for all the losses on their exposures under the principle of caveat emptor (buyer beware).

Because market participants know they are responsible for losses, they have an incentive to independently assess the risk of any investment and limit their exposure to any one investment to what they can afford to lose.

The result of market participants assessing risk and limiting their exposure is they charge more and reduce the amount of their exposure as the risk of an investment increases.  This is very important as it is the mechanism by which market discipline is exerted.

Regular readers know that under the FDR Framework, banks are responsible for the losses on their exposures just like any other market participant.

Banks do have one unique feature, since the 1930s banks have been designed so that they can absorb upfront the losses on the excess debt in the financial system and still continue to operate and support the real economy.

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


Please note, under the FDR Framework, taxpayers are not responsible for bailing out market participants including banks for their losses.  This is particularly true of banks because a bailout is simply making explicit what is already the implicit role of taxpayers being the banks' silent equity partners when they have low or negative book capital levels.

So why is Mr. Klein asking the question of who should bear the pain?

Because bailing out the banks has proved irresistible to policy makers and regulators.

If banks are designed to absorb losses upfront to protect the real economy and the social contract, why did bailing out the banks at the beginning of our current financial crisis prove irresistible to Paulson, Geithner, Bernanke et al?

Mr. Klein provided the answer in a tweet when he observed about the banks' ability to recognize losses that it:

Only works if they are sufficiently capitalized to absorb the loss.

Please re-read Mr. Klein's tweet as it highlights an artificial constraint imposed by financial regulators and economists that was not put in place by the designers of our financial system: the myth that banks need positive book capital to operate.

Bank book capital is an accounting construct and by definition can have a positive or negative value.  It is the account through which any losses taken by the bank flows.

Since it is an accounting construct, it is easy to manipulate.

For example, regulators can manipulate it by engaging in regulatory forbearance and letting banks practice extend and pretend to turn non-performing loans into zombie loans.  The result is no losses flowing through the book capital account.

The fact that the losses are not flowing through the bank's book capital account does not mean that the losses do not exist.

The fact that existing losses are not flowing through the bank's book capital account also does not mean that market participants are unaware of these losses.

The losses on loans to Less Developed Countries is a classic example of investors knowing losses exist and regulators working with the banks to keep the losses from flowing through the book capital accounts.

The activity by regulators was unnecessary.

Market participants simply adjusted each bank's reported book capital level for an estimate of the bank's losses on its loans to Less Developed Countries.  This adjustment showed a number of large banks had very low or, in Security Pacific's case, negative book capital levels.

When Citi finally acknowledged and took the loss on the loans to Less Developed Countries through its book capital account, market participants reacted positively because the level of losses was consistent with their estimate.  Market participants didn't care what the level of Citi's book capital was.

Despite its negative adjusted book capital level, there wasn't a run on Security Pacific by either depositors or wholesale investors.

The reason there wasn't a run is that for banks the critical measure of a bank's viability is whether its income (from performing assets plus fees) exceeds its expenses.  If this measure is positive, the bank can continue to operate as it has the ability to generate earnings and rebuild its book capital level.

Why should it make any difference to market participants if a bank absorbs losses and has to rebuild its book capital level from a negative level rather than a slightly positive level?  It doesn't.

What does make a difference is if a bank has to disclose its current global asset, liability and off-balance sheet exposure details.  With these details, market participants are able to assess whether the bank has recognized all of its losses and to exert restraint on its risk taking.

Without ultra transparency, market participants have no idea if a bank has recognized all the losses that regulators have allowed the bank to hide on and off its balance sheet.

Barclays disclosure of size of its capital shortfall highlights need for banks to provide transparency

At the same time that Barclays disclosed it was planning on raising capital by issuing more shares, it also disclosed that it faced a far larger capital shortfall than the market anticipated.

Regular readers know that bank capital is an easily manipulated accounting construct.  As an accounting construct, it is the balance sheet account through which losses incurred by the bank flow.

Barclays' disclosure reveals just how easy it is for a bank to manipulate its book capital level by deferring the recognition of losses.  

Since the beginning of the financial crisis on August 9, 2007, financial regulators have let banks like Barclays defer recognition of losses.  First, there is the policy of regulatory forbearance that allows the banks to engage in extend and pretend and turn non-performing loans into zombie loans.  Second, there has also been the suspension of mark-to-market accounting so securities are held on the balance sheet at acquisition cost and not their current value.

From Jill Treanor at the Guardian,

The size of the cash call on investors – in the form of a rights issue, which will be launched in September – is bigger than expected and follows a request by the Bank of England that it meet a new measure of financial health, known as the leverage ratio. Barclays shares were volatile in early trading, falling around 6% to 290p after the larger-than-expected rights issue was announced. 

"After careful consideration of the options, the board and I have determined that Barclays should respond quickly and decisively to meet this new target. We have developed a bold and balanced plan to do so," said Jenkins, who was promoted to chief executive only 11 months in the wake of the Libor-rigging crisis. 

The size of the capital gap identified by the Bank of England of £12.8bn is almost double the amount the City had been expecting ....

By disclosing that it has a far larger capital shortfall, Barclays raises the question of what other losses are hidden on and off its balance sheet?

The only way for the market to know for sure is if Barclays discloses its current global asset, liability and off-balance sheet exposure details.  Without this level of disclosure, Barclays is effectively waving a big red flag in front of the market and announcing that it is still hiding losses.

Confirmation of this comes from a Bloomberg report,

“If you’re doing a rights issue, then you have to clear the decks and present investors with a clear balance sheet,” said Mike Trippitt, a London-based analyst at Numis Securities Ltd. who downgraded Barclays to sell this month in anticipation of a rights offering. 

“You can’t do a rights issue and then follow it up with additional provisioning in the next quarter. My only concern is that they haven’t done enough.”

Did capitalism fail?

Almost 6 years after the beginning of the financial crisis, economists and political scientists are trying to answer the question: did capitalism fail?

Their response was no.

According to the economists, what failed was relying on the idea of a mechanistic rational market in the presence of imperfect knowledge.  According to the political scientists, what failed were the institutions that were suppose to oversee the market.

While both the economists and political scientists are on the right track, neither appears to understand the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware) and on which most of the global financial system is based.

As a result, their recommendations for how to prevent future crisis are unlikely to work.

Economist Roman Frydman said in his keynote address to the European Financial Congress

“I would like to pin a significant share of the blame on economists,” Frydman said. “It was their ideas concerning the role and functioning of financial markets in capitalist economies that provided the supposedly scientific underpinning for policy decisions and financial innovations that made the crisis much more likely, if not inevitable.”... 

These theories created a faith in the mechanistic rational market that was a key cause of the crisis, Frydman suggested, deriding the ”unsuccessful – and largely American – experiment in viewing the macroeconomy and financial markets as machines.” 

This view failed because it doesn’t account for imperfect knowledge... 

This conclusion as to the cause of the financial crisis resulting from imperfect knowledge would lead a reader to think that Mr. Frydman would champion the need to bring transparency to all the opaque corners of the financial system.

However, this was not his conclusion.

Instead, he offered up the theory of imperfect knowledge economics.  This theory

relates risk to participants’ perceptions of the gap between an asset price and its range of historical benchmark levels: as asset prices rise well above or fall well below most participants’ perceptions of these levels, those who are betting on further movement away from the benchmark should perceive an increased risk in doing so. 

Despite its name, this is a theory of reversion to the mean in pricing of financial assets that makes the government responsible for limiting how far an asset's price can vary from its historic mean so that when price does revert to the mean there isn't a systemic financial crisis.

But is the government up to this task?

Political scientists Nolan McCarty and Keith Poole would say no.

In their book, Political Bubbles: Financial Crises and the Failure of American Democracy, they explain why government is not up to the task.

Three I’s: ideology, institutions and interests.... the effects of ideology, interests and institutions are pro-cyclical. 

By political bubble, they mean a set of policy biases that foster and amplify the market behaviors that generate financial crises. Rather than counteract the actions of private economic actors, these factors complement and exacerbate their effects. The political bubble is an intrinsic part of answering what went wrong.... 

Political will to do the right thing has to swim against an onrushing tide of Wall Street contributions and the ever-present temptation to “monetize” public service. 

Where does belief in ideology end and the effect of green-colored glasses begin? Using former Senator Phil Gramm (who went on to make millions of dollars at UBS) as an example, the authors confess that, “Somewhat sadly, it can be difficult to disentangle the political influence of ideology from the influence of venality and greed.” 

What happened after the 2008 crisis? 

Widespread illegality was left unpunished. 

Congress passed the Dodd-Frank Act, but that legislation only tinkered at the margins of the existing banking regulatory framework, left Wall Street banks structurally all-but-untouched, and for the most part kicked the can back to the very regulators who had failed to prevent the crisis in the first place.

Regular readers will recall that this is exactly the same conclusion as the Nyberg Report on the Irish Financial Crisis reached.

In absence of transparency, banks and insurers wary of Freddie Mac risk sharing deal

Reuters reported that banks and insurers are wary of Freddie Mac's inaugural risk sharing deal.

Banks and insurers had good reason to be wary of this deal because it provides the same level of transparency that opaque, toxic sub-prime RMBS deals offer:  none.

This lack of transparency means that investors in the deal are blindly betting on the contents of a brown paper bag.

This lack of transparency is ironic because under the guidance of the FHFA Freddie Mac and Fannie Mae are constructing a securitization platform.  The purpose of the securitization platform is to provide disclosure to market participants.

So in theory, Freddie Mac is aware that it needs to provide observable event based disclosure under which any activity like a payment or delinquency involving the underlying collateral is reported to market participants before the next business day.

Perhaps Freddie Mac chose to not provide transparency because doing so would have highlighted the fact that there is already an existing securitization platform, the EU Data Warehouse, that is fully capable of doing everything the Freddie Mac/Fannie Mae joint venture would do.

Since a securitization platform that is endorsed by the ECB already exists, why is the joint venture building another one at taxpayer expense?

Why is the FHFA not requiring that Freddie Mac and Fannie Mae use the EU Data Warehouse and bring disclosure to the US RMBS market sooner rather than allowing them to delay and build their own?  After all, the FHFA could regulate the EU Data Warehouse's activities in the US as easily as regulate the joint venture's securitization platform.

Perhaps Freddie Mac chose to not provide transparency because doing so would have also highlighted the fact that the EU Data Warehouse has set the global price for any securitization platform providing this type of service.  The EU Data Warehouse set its price at a break-even level.

If the EU Data Warehouse is willing to operate at effectively a break-even level, where are the earnings to repay the US taxpayer for building the securitization platform?

Perhaps Freddie Mac chose to not provide transparency because doing so would have also highlighted the fact that a securitization platform can be a stand-alone business.  There is no reason it needs to be owned by Freddie Mac and Fannie Mae.

Perhaps Freddie Mac chose to not provide transparency because doing so would have highlighted to Congress, where there is bi-partisian support for a securitization platform as shown in the House and Senate bills, that given the existence of the EU Data Warehouse there is no real justification for building another securitization platform.

Truth of transparency and liquidity

In an excellent column, Dan Collins looks at a study done on the CFTC's Swaps Execution Facilities rules and finds that the biases of the different market participants drive their responses.

For example, he finds that Wall Street objects to transparency and prefers opaque, over the counter markets.

Please note, this study only looks at one form of transparency: pricing transparency.  There is a second, much more important form of transparency: valuation transparency.

To understand the relationship between the two forms of transparency, it is necessary to look at the investment process that separates investing from gambling.

1. Independent assessment of all the useful, relevant information about an investment by market participants so they can understand the risk of and value the investment.  Doing this assessment requires valuation transparency.
2. Collection of the price Wall Street is willing to buy and/or sell the security at. Accessing this information requires pricing transparency.
3. Comparing the independent valuation to the price shown by Wall Street to make a buy, sell or hold portfolio management decision.

In the absence of valuation transparency, it is impossible to complete Step 1 of the investment process.  Simply buying or selling based on prices shown by Wall Street without having completed Step 1 is gambling on the contents of brown paper bag.

When it comes to liquidity in a market, markets with transparency are naturally more liquid as there are more investors than there are gamblers.

Mr. Collins also finds in the CFTC study that Wall Street objects to transparency claiming it will reduce liquidity.  A claim that he thoroughly debunks.

The whole point of the Dodd Frank Act as it relates to swaps was to move this opaque over-the-counter trading on exchange or at least into a clearinghouse and executed through an electronic facility so there is a clear and transparent paper trail....

It is too early to tell if the CFTC got it right and the results of the study correctly point out that its respondents based their responses on their self-interest. For example, of the respondents that think the CFTC did not go far enough, 90% said there were “too many holes” in the rules; of the respondents who though the CFTC went too far , 92% said rules had “excessive transparency.” 

The report states “Reasons for discontent are broad and contradictory — ranging from those who feel the final rules are prone to gaming, to those who think excessive transparency will damage liquidity.” 

There is a lot to take in here but let’s hone in on the above statement: “excessive transparency will damage liquidity.” 

This sounds counterintuitive. How can seeing more prices and quotes harm liquidity? 

Transparency should always help liquidity unless what that transparency shows is a gamed market. 

Transparency provides confidence that a counterparty can see definitively where price is at in a particular market and how liquid the market is so he knows his risk. 

When the Chicago Board of Trade launched interest rate futures in the late 1970s it harmed the liquidity in the cash treasury market  because end users could all of a sudden access a more efficient market with narrower bid/ask spreads. 

It is not nearly as complex as the investment banking lobbyists would have you believe. It is about competition. 

Just think of shopping for a car and going into a dealership where the salesman offers you the sticker price. Now imagine that you can go online and see every price that this car is offered at in a competitive marketplace. 

The fact that this has been such a struggle is testament to the lobbying efforts of the major investment banks who have basically been able to run a rigged game....

We pointed out recently the irony that the same folks who berated the industry and regulators over making the regulated futures world more transparent with electronic trading have fought that same transparency in the OTC markets they controlled. 

As I mentioned above, it is not that complicated. 

In fact it is simple; excessive transparency will hurt the liquidity of an inefficient market but help the liquidity of a more efficient market.

How much capital should banks have?

In a Vox EU column, the IMF's Lev Ratnovski tries to answer the question: "how much capital should banks have?".

His conclusion after studying the level of non-performing loans and then estimating losses in prior economic crises: 9% on a simple leverage ratio basis and 18% under Basel III.

Of course, Mr. Ratnovski assumes that regulators will actually require banks to recognize the losses on their exposure to excess debt.  History shows that this is not the case.

In addition, regular readers know that the amount of capital that each bank should have is the amount of capital that the market requires given the riskiness of each bank's exposures.

So that the market can assess the riskiness of each bank's exposures and exert discipline on each bank to achieve an appropriate level of capitalization, each bank must disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

During the early 1900s when banks were required to disclose their exposure details, market discipline on the banks resulted in an average simple leverage ratios that exceeded 10%.  A level that is consistent with Mr. Ratnovski's analysis.

Setting the gold standard for judging quality of country's financial regulations

In his Reuter's blog, Felix Salmon establishes the standard for judging the quality of a country's financial regulation.

Here’s a quick and dirty way of judging the quality of your country’s financial regulation: to what extent do you create and impose tougher-than-international standards? 

By their nature, international standards are the lowest-common-denominator. 

Individual countries can and should extend them and create their own rules; when those rules turn out to work well, sometimes the international community will start adopting them more broadly....

Please re-read Mr. Salmon's standard for judging the quality of a country's financial regulation and his observation about how rules that work well are copied.

In the 1930s, the US adopted the FDR Framework as the basis for its financial system.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

US adoption of the FDR Framework was best exemplified by the 1930s Securities Acts that created the SEC and required that all publicly traded securities disclose all the useful, relevant information in an appropriate, timely manner so that market participants could independently assess this information and make a fully informed decision.

As a result of the Securities Acts, the US had the highest regulatory standards and became know for having the most transparent financial markets.

And why wouldn't your want to have the most transparent markets?

Finance is based on the idea that when market participants have all the useful, relevant information in an appropriate, timely manner they can do a better job of assessing the risk of a security and assign it a higher cost than a similar security that is opaque.  So why would any country want to put itself at a disadvantage by having its participants in the real economy pay more to access funding?

The financial crisis exposed the "myth" that US markets were still transparent.

Rather than continue to set tougher than international standards, over the last 30 years the US regulators decided in areas like derivatives to join the race to the bottom.  As a result, large areas of the financial system became opaque.

While this opacity was very good for bank profitability and banker bonuses, this opacity was very bad for all the other market participants.

Overall, I’d say the US is not doing a great job on the regulatory front. 

Dodd-Frank created a lot of noise, but ultimately was much less important than Basel III; what’s more, the banks are now driving the rule-making process so as to effectively neuter most of it. 

Confirmation of your humble blogger's observation about the true intent of the Dodd-Frank Act.

Meanwhile, in lots of other corners of the regulatory universe, you can see the forces of capture at work: one prime example is the way in which the FHFA — the regulator for Fannie Mae and Freddie Mac — has hired a prominent insurance-industry lobbyist to help it regulate the very insurers he not only used to represent, but still represents. 

The fact is that regulation is one of those things that doesn’t have a natural political constituency: rich banks are good at lobbying against it, while there are no effective or well-resourced lobbyists on the other side....

Please re-read the highlighted text as Mr. Salmon makes a very important point about the lack of a permanent, effective lobby for regulation and transparency.

However, a permanent lobby for regulation should not be needed.

Please recall that under the FDR Framework, it is the government's responsibility for ensuring transparency.  It was well recognized at the time the FDR Framework was adopted that a lack of transparency resulted in a systemic financial crisis, the Great Depression.

Under the Securities Acts, the government must ensure that all the useful, relevant information is disclosed in an appropriate, timely manner.

Please note the Securities Acts do not say most of the useful, relevant information.  The Acts say "all" the useful, relevant information.  Government is told to error on the side of disclosing too much information.

Please note the Securities Acts do not say useful, relevant information to all market participants.  They say all the useful, relevant information.  This ensures that information that experts could use as part of their assessment of the risk of a security is made available.  Again, government is told to error on the side of disclosing too much information.

Please note the Securities Acts do not say that the government should perform a cost/benefit analysis when it is ensuring that all the useful, relevant information is disclosed in an appropriate, timely manner.

It was known at the time the Securities Acts were passed and has been shown with the current financial crisis that the cost of a systemic financial crisis is far greater than the cost of providing all the useful, relevant information in an appropriate, timely manner.

The benefit of having transparency and not having another systemic financial crisis far outweighs the cost of providing transparency.  This is why there is no need for a permanent lobby to tell the government that it needs to ensure there is transparency.

Swallowing the bankers' line

Earlier this month, Robert Jenkins, former external member of the Bank of England's financial policy committee, observed:

I fear that the banks have bamboozled government into believing that society must choose between safety and growth, between safer banks and bank shareholder value, and between a safer financial framework and a competitive City of London. These are all false choices.

Please re-read the highlighted text and ask the question of how could this have come to pass.

In his Project Syndicate commentary, Professor Simon Johnson offers a series of potential explanations for how banks have bamboozled government.

There are three possible explanations for what has gone wrong. 

One is that financial reform is inherently complicated. But, though many technical details need to be fleshed out, some of the world’s smartest people work in the relevant regulatory agencies. They are more than capable of writing and enforcing rules – that is, when this is what they are really asked to do. 

Your humble blogger wonders when the regulators within the SEC decided that they were not really being asked to ensure transparency in the financial system?

Regular readers know the SEC was ground zero for the financial crisis and it was the failure of the SEC to ensure transparency that created the conditions for the financial crisis.  Specifically, the SEC allowed opacity for both banks and structured finance securities.

For banks to be transparent, they must disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This was the law in the UK since the 1870s and the standard in the US in the 1930s when the SEC was created.  Clearly, by the start of the financial crisis in 2007, this was no longer true.

For structured finance securities to be transparent, they must disclose on an observable event based basis.  Every observable event like a payment or delinquency involving the underlying assets must be reported to all market participants before the beginning of the next business day.  Clearly by the start of the financial crisis in 2007, this was not true as opaque, toxic sub-prime RMBS deals report on a once per month basis.

The second explanation focuses on conflict among agencies with overlapping jurisdictions, both within and across countries. Again, there is an element of truth to this; but we have also seen a great deal of coordination even on the most complex topics – such as how much equity big banks should have, or how the potential failure of such a firm should be handled. 

Another source of conflict is the regulatory race to the bottom.

That leaves the final explanation: those in charge of financial reform really did not want to make rapid progress.  

In both the US and Europe, government leaders are gripped by one overriding fear: that their economies will slip back into recession – or worse.  

The big banks play on this fear, arguing that financial reform will cause them to become unprofitable and make them unable to lend, or that there will be some other dire unintended consequence. There has been a veritable avalanche of lobbying on this point, which has resulted in top officials moving slowly, for fear of damaging the economy.

Professor Johnson has nicely explained that fear is why the banks were successful in bamboozling government leaders.

But did the government leaders actually have anything to fear?  After all, the first response to the financial crisis was to put the banking system on life support.

Regular readers know that the answer has always been no  There was nothing to fear, but fear itself.

Our financial system was designed to survive even the failure of the SEC to ensure transparency.  Our financial system was designed to survive a massive credit bubble with the creation of excess debt that was well beyond the borrowers' capacity to repay.

Our financial system was designed to survive because it has a safety valve to release its excesses while protecting the real economy.

This safety valve is the ability of banks to absorb upfront the losses on the excess debt in the financial system and continue to operate and service the real economy.

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

Of course, because government leaders swallowed the bankers' line, we have never used the safety valve.

Instead, we have protected bank book capital levels and banker bonuses while at the same time burdening the real economy with servicing the excess debt.  The result has been economic stagnation, an unwinding of the social contract and an increase in inequality.

Old-fashion regulators miss the foundation of finance

In his Bloomberg column, Clive Crook asks is the financial system any safer now than in 2008?

His answer is no because regulators miss what is new in finance because they are trapped in the old model of the financial system.

Insurance prevents bank runs, but encourages risky lending because depositors no longer care whether their bank is prudent or reckless. Once you insure deposits, therefore, you also must regulate banks more strictly (setting rules for bank capital, among other things). 

That’s the old model for systemic safety in finance: deposit insurance plus bank regulation.

Please re-read Mr. Crook's old model for systemic safety in finance because that is not actually the old model.  Mr. Crook leaves out transparency.

Regular readers know that our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  The FDR Framework model for systemic safety is deposit insurance plus bank regulation plus transparency (an equivalent way to describe the FDR Framework model for systemic safety is deposit insurance plus regulatory discipline plus market discipline).

Because of the presence of transparency and the market discipline transparency enables, the FDR Framework model for systemic safety is vastly different from the model suggested by Mr. Crook.  It also leads to vastly different conclusions about how to interpret the financial crisis and fix the financial system.

Under Mr. Crook's model, there was a different kind of bank run that brought down the financial system.  In support of this different kind of bank run he cites the academic work of Yale Professor Gary Gorton.

As Mr. Crook explains, a new form of finance emerged that the old model of deposit insurance plus bank regulation could not handle.

The archetype of the new form of non-deposit bank funding is “repo.” 

In a repurchase transaction, a bank or other borrower sells a security in return for cash, promising to buy it back later at a higher price. The transfer of cash is akin to a short-term deposit; the price difference is the repo equivalent of paying interest. In addition, the loan is “collateralized,” because the bank or other borrower loses the security if it breaks its promise to repurchase. There’s an extra margin of safety because the collateral is typically worth more than the loan -- this margin, called the “haircut,” serves a purpose similar to capital for a deposit-taking bank. 

So what’s the problem? 

Essentially, when fear gripped the capital market, securities deemed safe when they were pledged as collateral suddenly looked unsafe. The market for collateralized short-term funding therefore seized up. Borrowers couldn’t borrow and had to liquidate assets instead. As forced sellers, many lost money; with too little loss-absorbing capital, some faced insolvency. Fear spread, further driving down the prices of securities, adding to the panic. 

It was a run, but not one that traditional financial regulation could have stopped.

This is a wonderful story and entirely consistent with a model for systemic safety in finance that leaves out transparency.  It also leads to the wrong conclusion: a need for more regulation.

When you use the FDR Framework model for systemic safety in finance that has actually been in place since the 1930s, you realize that the "run on the repo" was in fact a reflection of opacity.  Opacity in the structured finance securities being pledge and opacity in the borrowing bank.

Opacity in the structured finance security being pledge meant that the security could not be valued.  Opacity in the banks meant that it was impossible for any bank (or investor) with funds to lend to tell which of the other banks was solvent and which was insolvent.

This ability to distinguish solvent from insolvent banks is important, because when you engage in a repo with an insolvent bank you expect to end up with the collateral.

So let me see, we have opaque banks trying to raise money against opaque securities.  Is there any surprise that this form of financing collapsed?

When you apply the FDR Framework model for systemic safety in finance that has existed since the 1930s, your conclusion is we need to bring transparency to both structured finance securities and banks.

To date, we have made no progress on transparency.  Instead, we have pursued a bunch of meaningless regulations that would not prevent the same crisis from recurring in the financial system.

Wall Street wins its bet on loss of political will for serious financial reform

The Wall Street Journal reports that U.S. financial regulators are considering relaxing, if not eliminating, the need for skin in the game by firms that originate and distribute mortgage-backed securities.

This is a clear sign that Wall Street has won its bet that 6 years after the beginning of the financial crisis there would be a loss of political will for serious financial reform.

Wall Street won its bet because it understood how to manage the legislation and subsequent writing of regulations so as to minimize the chances for any substantive financial reform.

From your humble blogger's perspective, Wall Street's winning was completely predictable.  I predicted it and cited the Dodd-Frank Act as being an impediment to reform.

The Dodd-Frank Act, with the exception of the Consumer Financial Protection Bureau and the Volcker Rule, was quite literally written by the bank lobbyists for the benefit of the banks.  It was designed to use the regulatory rule making process as a blunt instrument to kill the political will for serious financial reform.

No surprise, it succeeded.

But its very success in killing the political will for serious financial reform is also its achilles heel.  It didn't end the "lynch mob" desire to get the bankers.  The bankers made sure this desire was frequently flamed as each instance of their bad behavior behind the veil of opacity has come out.

We have seen the bankers manipulate global benchmark interest rates (Libor, Euribor,...) for personal benefit.  We have seen bankers sell interest rate swaps to unsophisticated borrowers.  We have seen bankers engage in swaps to hide the indebtedness of entire countries so they could gain admission to the EU.  We have seen bankers in the UK sell loan payment insurance products that quite literally could not be collected on.

The list goes on and on and on and with the latest being the revelations about how bankers are currently manipulating the commodity markets for aluminum, electricity, oil and ....

So if there is no political will for serious financial reform and the lynch mob desire is growing with each new report of bankers engaging in conduct that was detrimental to society for their own benefit, how is this going to play out.

What I think you are likely to see is the pressure will be put on the regulators to actually do their jobs.

You can see this with the discussion of banks being required to maintain a higher level of capital against their exposures.

You will see this as pressure is applied to the SEC to do its job and restore transparency to all the opaque corners of the financial system.

In the case of structured finance securities, the pressure will result in observable event based reporting where any activity like a payment or delinquency involving the underlying collateral is reported to all market participants before the beginning of the next business day.

In the case of banks, the pressure will result in ultra transparency where banks are required to disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

Bankers use ignorance to avoid "lynch mob" while pulling big bonuses

The Guardian reports on the Archbishop of Canterbury's struggle with the bankers' use of ignorance.

On the one hand, bankers used ignorance to avoid the "lynch mob" trying to assign blame.

On the other hand, this very ignorance of what was going on calls into question what bankers were paid for if they were not responsible.

A benefit of requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is that it ends willful blindness and makes readily apparent the individuals who should be blamed.

There is a reason that sunlight is the best disinfectant of bad banker behavior.

The archbishop of Canterbury, Justin Welby, has described blaming individuals for the banking crisis as "lynch mobbish". 

But the archbishop, a member of the parliamentary commission on banking standards, also said top bankers had avoided responsibility by ensuring they did not know what was going on in their banks. 

"Certainly one of the trends that has been very unfortunate, to put it mildly, is that in some financial services companies there was a clear policy of not telling the top people. They made sure they weren't told things, because then they could plead ignorance, and that's just unacceptable. 

"But this business of somehow saying that one individual bears the whole blame as opposed to simply the accountability – it feels lynch mobbish."... 

It also accused senior bankers of evading their responsibilities by closing their eyes to what was happening on the front line.

Bank earnings have never been more complicated

In his Fortune column, Allan Sloan asks the simple question of how can Washington regulate the big banks when the earnings release of a large bank like Citi is a 100+ page opaque document.

As shown by our current financial crisis, Washington cannot successfully regulate the big banks.

One of the reasons for requiring the banks to provide ultra transparency is it subjects the big banks to market discipline.  Market discipline that links a bank's cost of funds to the risk it is taking.

This market discipline also strengthens Washington's regulatory discipline and improves the chances that it is successful by allowing Washington's regulators to tap the market for analytical expertise in understanding exactly what the banks are doing.

After all, who better to analyze Citi than JP Morgan and visa versa. 

Happy Birthday Dodd-Frank: a law that was designed not to and isn't working

In his Huffington Post column, former Senator Ted Kaufman looks at how the Dodd-Frank Act was designed not to address the causes of our current financial crisis and fails to make a future financial crisis less likely.

Failure was built into Dodd-Frank from the beginning. Instead of writing laws that addressed the abuses that led to the crisis, it nearly always kicked the can down to agencies, instructing them to write new regulations.

Regular readers know that by definition Dodd-Frank could not address the causes of the financial crisis because it was completed prior to the conclusion of any inquiry into the actual causes.

Instead, Dodd-Frank, with the notable exception of the Consumer Financial Protection Bureau and the Volcker Rule, was written by the bank lobbyists for the benefit of the banks.

The US is not alone in pursuing bank friendly reform legislation.

In the UK, Parliament is just taking up financial reform legislation almost 6 years after the financial crisis began.  There have been two commissions that looked into the crisis: the Vickers Commission and the Commission on Banking Standards.  By and large, the proposed financial reform legislation either ignores or adopts a weakened version of the recommendations made by the commissions.

By and large, those regulatory agencies have been overwhelmed by a combination of congressional underfunding and a massive lobbying effort by the megabanks that increasingly seem to control Washington....

When Dodd-Frank was being drafted, the bank lobbyists knew that the regulatory rule making process favored their positions.

Regulatory rule making favors the banks for 3 reasons: money, known by regulators, and act together.

Supporters of financial reform tend not to have the same financial resources, tend not to be known by the regulators and tend to focus only on the financial reforms of interest.

So making the regulators work on a large number of rule makings was intentional.

Here are just a few examples of Dodd-Frank's failure: 

• The banks still are gambling with FDIC-insured money. The JPMorgan Chase "London Whale" fiasco was just the latest proof that there has been no change in the casino speculation of Wall Street banks. 

• There is still a giant loophole in derivatives trading. Although there are new regulations curbing the kind of derivatives trading that was a key element in the crisis, those regulations do not cover the foreign subsidiaries of megabanks. Banks can easily move trading activities into different offices. He wasn't called the "London Whale" because he worked in Philadelphia. 

• No one has gone to jail. And no one will. There are many examples of criminal behavior during the meltdown, but not one megabank executive has been jailed. Without that deterrent, white-collar crime is not just profitable but inevitable. 

• Reform of the credit-rating agencies is a long way off. "Essential cogs in the wheel of financial destruction," as the Financial Crisis Inquiry Commission described them, the credit-rating agencies still operate as they always have, bought and paid for by the entities they rate. 

• Fannie Mae and Freddy Mac have not been fixed. In fact, they weren't even mentioned in Dodd-Frank, despite the fact that everyone agrees they played a role in the meltdown.

Regular readers know that brining transparency back to the financial system would fix four of these failures.

It would end banks making proprietary bets.  JP Morgan showed with its closing out the London Whale trade when it became known to the market that transparency ends proprietary betting.

It would end concern over where derivatives are traded.  With transparency, banks must disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  So derivatives traded in London would still be disclosed and investors could adjust the cost of the bank's funding to reflect these derivatives.

It would reform the credit rating firms by making them just another voice offering their views on an investment.  When market participants have access to the same data as the credit rating firms, market participants can independently assess the risk and value an investment or hire a third party to do it for them.  They don't need to have any reliance on the credit rating firms.

It addresses the reform of Fannie and Freddie by restarting the private label mortgage securitization market.  With the private label market unfrozen, Fannie and Freddie's portfolios can be run off.

There were lots of heated debates before passage of Dodd-Frank, but no disagreement from anyone in the administration or Congress about one thing. The bill had to end the possibility that American taxpayers would ever again have to bail out a big bank because its failure would have a severe impact on the entire economy. 

You would think that by now at least that problem would have been addressed. But it hasn't been. 

Eliminating the need for taxpayer bailouts won't occur until banks are required to provide ultra transparency and disclose their exposure details.  It is only with this data that market participants can limit their exposure to each bank to what they can afford to lose given the risk of each bank.

Wall Street and the potential to manipulate commodity markets

Bloomberg's Bob Ivry looked at the potential for Wall Street to manipulate commodity markets and highlighted the key issue: opacity.

Because of opacity, market participants cannot see and help the financial regulators assess the extent to which Wall Street is manipulating commodity markets through its participation in the physical markets.

“When Wall Street banks control the supply of both commodities and financial products, there’s a potential for anti-competitive behavior and manipulation,” [US Senator Sherrod] Brown said in an e-mailed statement. Goldman Sachs, Morgan Stanley and JPMorgan are the biggest Wall Street players in physical commodities.... 

Now, “it is virtually impossible to glean even a broad overall picture of Goldman Sachs’s, Morgan Stanley’s, or JPMorgan’s physical commodities and energy activities from their public filings with the Securities and Exchange Commission and federal bank regulators,” Saule T. Omarova, a University of North Carolina-Chapel Hill law professor, wrote in a November 2012 academic paper, “Merchants of Wall Street: Banking, Commerce and Commodities.” 

The added complexity makes the financial system less stable and more difficult to supervise, she said in an interview. 

“It stretches regulatory capacity beyond its limits,” said Omarova, who is slated to be a witness at the Senate hearing. “No regulator in the financial world can realistically, effectively manage all the risks of an enterprise of financial activities, but also the marketing of gas, oil, electricity and metals. How can one banking regulator develop the expertise to know what’s going on?”

An example of "Trying to pierce a Wall Street fog"

In her NY Times column, Gretchen Morgenson looks at the credit default swap market and finds that because of opacity the market is not acting in a competitive manner and Wall Street's informational advantage enables it to extract a much higher profit margin.

Regular readers are not surprised by this finding.  As Yves Smith said, nobody on Wall Street is compensated for developing low margin, transparent products.  Credit default swaps are an example of a high margin, opaque product.

BACK in 2009, the Justice Department said it was investigating the large Wall Street banks for possible collusion in the huge and opaque credit default swaps market. The question was whether the big financial institutions had worked to keep transactions in these insurance-like instruments closed to competitors and more profitable for themselves....

On July 1, the antitrust division of the European Commission announced that its investigators had come to a “preliminary conclusion” that the banks and two entities controlled by them had infringed European antitrust rules. These entities colluded, the commission said, “to prevent exchanges from entering the credit derivatives business between 2006 and 2009.” 

Credit default swaps were at the center of the financial crisis. These instruments allow holders of bonds or other debt to hedge their risks in those positions. But the swaps also let speculators bet on a debt issuer’s default. ... 

But the market for these swaps has been conducted in the shadows. Trades were made over-the-counter — between private parties and not on an exchange. This meant that participants’ positions were not disclosed to regulators. 

Wall Street likes the fog of over-the-counter markets because the profits generated by executing customers’ trades in them are far greater than in more transparent arenas. 

Think of the way you might shop for a mortgage: if mortgage rates were not publicly available, it would be hard to know whether the rate one banker offered was competitive. Customers that dealt with only one banker on their credit default swaps almost certainly did not get the best prices. 

The 13 banks under the microscope on credit default swaps include Bank of America Merrill Lynch, Goldman Sachs, JPMorgan Chase, Morgan Stanley and UBS. Two associated entities controlled by the big banks are also being scrutinized — the International Swaps and Derivatives Association, a lobbying organization, and Markit, a data service provider....

“There was no question the banks did not want the C.M.E. to make the market more liquid and transparent,” said one person briefed on the banks’ internal discussions who asked for anonymity because he was not authorized to speak publicly. “This was their cash cow, and they didn’t want to give it up.”...

The banks have pushed to keep the market for credit default swaps in the dark. 

Three years ago, the Dodd-Frank legislation aimed to bring more competition by pushing trading onto exchanges and swap execution facilities. Wall Street tried to beat back regulators’ efforts to write tough rules after the legislation’s lead. They won some and they lost some. For instance, dealers now have to report swap transactions to regulators. 

There was a reason for the banks’ pushback: money. The Deloitte study cited a 2010 analysis by Citigroup showing that the big banks’ trading in over-the-counter derivatives generated revenue of $55 billion, or 37 percent of the total at these institutions. Such profits will fall as more swaps trade on swap execution facilities under the new rules.... 

“When you have markets that are .... opaque and where market players don’t have access to the same information, the markets are not functioning in a competitive fashion. Those that have the information can take advantage of that fact and extract anticompetitive leverage over those that lack the information.”

Please re-read the highlighted text as it nicely summarizes why transparency needs to be brought back to all the opaque corners of the financial system.

The Volcker Legacy: Too Big to Fail

Most people associate Paul Volcker with his role as the chairman of the Federal Reserve when inflation was defeated in the early 1980s.  For that, he deserves all the kudos he receives.

Few people associate Paul Volcker with his role as the chairman of the Federal Reserve and through his leadership of bank supervision and regulation creating the concept of Too Big to Fail banks.

However, it is the creation of Too Big to Fail banks that our current financial crisis has shown is his most important, lasting legacy.

In a very interesting American Banker article, Francine McKenna discusses how Continental Illinois was the first Too Big to Fail bank.  The collapse of Continental Illinois was the result of opacity that hid from the market what a combination of irresponsible lending, self-interest, hot money and lack of restraint by the Fed was allowing to be done to a bank that faced no market discipline.

In a related article, Ms. McKenna lays out the lack of regulatory restraint on banks and the adoption of the Too Big to Fail policy.

“The Congressional testimony of the OCC’s Conover in September 1984 also mentioned that the OCC had considered earlier whether it should have taken action much sooner to stop Continental from growing so quickly and, in hindsight, so recklessly.  

Conover testified that he believed such action would have been inappropriate but that the OCC could have placed “more emphasis on . . . evaluation and criticism of Continental’s overall management processes.” 

Federal Reserve Board Governor Charles Partee is quoted in William Grieder’s 1987 book “Secrets of The Temple” saying: “To impose prudential restraints is meddlesome and it restricts profits. If the banking system is expanding rapidly, if they can show they’re making good money by the new business, for us to try to be too tough with them, to hold them back, is just not going to be acceptable.” 

If that’s not enough foreshadowing of the policy prescription the Federal Reserve would deliver during the 2008 financial crisis, here’s Conover again during his testimony explaining to Congress why everyone but shareholders was made whole in the Continental Bank bailout: 

“…had Continental failed and been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international, financial crisis, the dimensions of which were difficult to imagine. None of us wanted to find out…” 

The day after Conover’s testimony, the Wall Street Journal published an article by Tim Carrington, “U.S. Won’t Let 11 Biggest Banks in Nation Fail—Testimony by Comptroller at House Hearing Is First Policy Acknowledgement”.

By the mid-1980s, Too Big to Fail had become the policy of the Federal Reserve and other bank regulators.


Regular readers know that I have written extensively about the Loans to Less Developed Countries crisis as it was the next step on the evolution of the concept of Too Big to Fail banks.  This crisis was very important for two reasons:

1. It cemented into the regulatory culture the notion that if the regulators and the Too Big to Fail banks "hid" the true extent of the losses at these banks, the market would go on as if the losses did not exist.
2. It drove monetary policy as the Fed, after informing the banks, chose to cut interest rates in an effort to generate earnings that could be used to recapitalize these institutions.

A little background is necessary to understand these conclusions.

Walter Wriston, a former chairman and CEO of Citicorp, said that "people go bankrupt, but countries don't".  Based on this observation, the large US banks plunged into lending to Less Developed Countries.

Of course, Mr. Wriston was wrong.  Countries do go bankrupt and this point had become obvious by the mid-1980s.  

Unfortunately, by the time this point was obvious, the exposure of the large US banks to the Less Developed Countries was multiples of their book capital levels.  A fact that was well known to market participants as banks disclosed the level of their exposures to the Less Developed Countries.

In fact, the general magnitude of the losses on these loans was also known to the market as predecessors to Bloomberg reported the prices at which the Loans to Less Developed Countries traded. When a Less Developed Country's loans trade at fifty cents on the dollar, it was a pretty safe bet that the value of the loans held by the banks reflected this pricing.

So the question that the Fed as the lead regulator for the Too Big to Fail banks faced was do we require the banks to write down their loans to Less Developed Countries upfront to reflect current market valuations or do we engage in regulatory forbearance and let the banks engage in extend and pretend and bring the losses slowly through their income statement as they generate earnings?

The Fed chose regulatory forbearance and the idea of "hiding" the actual magnitude of the losses from the market.

Please note, the market had a very good idea of the size of the losses, it just did not know the exact amount of the losses.

When John Reed at Citicorp eventually recognized the losses on the Less Developed Country loans, the market responded by bidding up Citicorp's price.  The write-off confirmed the market's conclusion about the size of the losses.

The Fed mistakenly believed that the fact the market had not collapsed when it became obvious the banks were insolvent and the subsequent positive reaction by the market was an endorsement of its policy choice.

The market didn't collapse because there was sufficient transparency into each of the Too Big to Fail banks to determine a) the general magnitude of loss and b) whether the bank's net interest income was greater than its ongoing operating expense after adjusting for the income actually generated by the loans to Less Developed Countries.

The Fed's policy response set another precedent.

Is Wall Street winning or because of its high profits losing the long-war against regulation

Approximately one month ago, in her Guardian column, Heidi Moore described why Wall Street is winning the long-war against regulation.

Feeble as it was, Dodd-Frank was a high point of reining in abuses. Thanks to financial lobbying, it's business as usual.

Today, in his NY Times column, Peter Eavis describes why Wall Street's high profits set them up to lose the long-war against regulation.

In recent weeks, the Treasury Department, senior regulators and members of Congress have stepped up efforts intended to make the largest banks safer. 

The banks have warned that more regulation could undermine their ability to compete and curtail the amount of money they have to lend, but the strong earnings that came out over the last week could undercut their argument. 

Which view is right?

Ms. Moore described how Wall Street wins the long-term war against regulation.

It will surprise no cynic that there is a financial connection between the members of Congress who approve these measures and the industry they are supposed to regulate.... 

It's no surprise, of course – given the well-known influence of Wall Street in writing and influencing the bills that regulate Wall Street. Citigroup lobbyists infamously drafted 70 lines of an 85-line amendment that protected a large acreage of derivatives from regulation.... 

Wall Street is keenly interested in weak regulation and weak regulators.... 

Think of derivatives – these complex securities that render ignorant and bewildered even the CEOs of the finance firms that engineer them – and think about whether a newcomer has a chance against the slick bankers and lobbyists armed with intimidating jargon. 

No matter how strong the personality, knowledge matters, and it takes years to understand the Wall Street fast-talking game....

All of this is part of the process of killing off the one flailing, pathetic attempt at financial reform: the Dodd-Frank Act. 

Dodd-Frank, bloated and vague from the beginning, was never a threat to Wall Street. 

Big banks thought they could wait out the outrage, then start undermining the intent of the law. 

They were right, this time. 

Mr. Eavis counters.

The most pressing concern for banks is a relatively tough new rule that regulators proposed last week that could force banks to build up more capital, the financial buffer they maintain to absorb losses.

Relatively tough might be overstating the new rule.  Many regulators, like the FDIC's Thomas Hoenig, and Economists, like Anat Admati, would like to see rules that require twice the amount the regulators proposed last month.

By setting the proposed level of bank capital where the regulators set it, the banks have already effectively won when it comes to capital regulation.

But the banks did not demonstrate any difficulty in meeting the proposed rules, and the banks now appear to have fewer allies in Washington than at any time since the financial crisis.

This was highlighted on Wednesday when the Treasury secretary, Jacob J. Lew, effectively issued an ultimatum to Wall Street, calling for the swift adoption of rules introduced through the Dodd-Frank financial overhaul law, which Congress passed in 2010.... 

“If we get to the end of this year, and cannot, with an honest, straight face, say that we’ve ended ‘too big to fail,’ we’re going to have to look at other options because the policy of Dodd-Frank and the policy of the administration is to end ‘too big to fail,’ ” Mr. Lew said.... 

In Congress on Thursday, Ben S. Bernanke, the Federal Reserve chairman,... said that if the measures already planned did not remove the risks posed by large banks, “additional steps would be appropriate.”

Still, some analysts remain skeptical that the Fed and the Treasury would really lend their weight to the sort of aggressive measures some lawmakers are contemplating. The recent comments may be an attempt to gain some political benefit from looking tough on the banks. 

And the remarks may be aimed at reducing any momentum that the more draconian pieces of bank legislation are gaining in the Senate.... 

Still, the stronger words from government officials could shift the balance of power away from the banking industry. 

“I sense a sea change in this,” Sheila C. Bair, a former chairwoman of the Federal Deposit Insurance Corporation, a primary bank regulator, said. “It’s not moving with the banks, it’s moving against them.” 

The resurgence in bank profits appears to have been an important factor in persuading regulators to do more....

“The regulators are doing this because they can,” Michael Mayo, a banking analyst at CLSA, said. “And they can at this time of relative stability.”....

Excuse me, but the argument that stability was needed before the banks and the financial system could be reformed is pure and utter garbage.

By late 2008, governments around the globe had put the financial system on life support.  This support was the equivalent of putting a patient on a heart/lung machine so that the patient's heart can be operated on.

While the financial system was on life support it would have been easy to pass and implement the necessary changes to fix the financial system and end Too Big to Fail.

Global policy makers and financial regulators did not do so.  They couldn't even be bother with taking the time to set up the equivalent of a Pecora Commission to discover what caused the crisis in the first place, opacity.

Instead, they rolled out the Dodd-Frank Act which was effectively written by and for the banks by the banks' lobbyists.

Still, Mr. Mayo and others question how healthy the banks are.... 

Mr. Mayo and others are going to continue questioning how healthy the banks are until such time as the banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Without this level of disclosure, there is no telling what risks and losses are hidden on and off the banks' balance sheets.

Still, some banking experts think the banks are bluffing when they say more regulation could hamper lending. 

“They can’t see that it is in their long-term interests to have a credible regulatory process,” Ms. Bair said.

The banks understand that they have already captured the regulatory process.

The only way for the regulators to re-establish any credibility is by giving up their monopoly on all the useful, relevant information about banks and requiring the banks to provide ultra transparency.

Retirement savings: the million-dollar myth explains why consumer demand not rebounding

In her Guardian column, Helaine Olen discusses how in today's low interest rate environment, $1 million in savings is inadequate for retirement.

This is a very important point because it triggers what your humble blogger has called the Retirement Plan Death Spiral.

Individuals saving for retirement or in retirement understand the million-dollar myth and are reducing their current consumption in response so they don't run out of money while they are retired.

This creates the interesting situation where central banks are trying through low interest rates to get individuals to loosen their purse strings and spend while at the same time individuals are cutting back their consumption to offset the loss of income while they are retired on their retirement savings.

As Japan passes the 2+ decade mark and the EU, UK and US pass the half decade mark, it is clear that individuals preference for not running out of cash when they retire overwhelms their urge to spend because central bankers keep rates low.

Is Economics a science or religion? Religion.

In his Bloomberg column, Mark Buchanan asks a terrific question: is economics a science or religion.

Science is based on facts.  Theories are proven or disproven based on their ability to explain all the facts.

Religion, on the other hand, allows you to believe something in the absence of any supporting facts.

A strong case can be made that economics is a religion based on the unwillingness of economic professionals to actually look at the facts.

The unwillingness to consider inconvenient facts isn't surprising as the standard economic analysis starts off by making a series of assumptions.  Assumptions that the economic professionals consider so basic that they don't bear repeating.

Unfortunately, they are assumptions that the facts frequently show to be wrong.

For example, the economics community has championed the call for banks to hold more capital.  The core argument that the economists make is that if banks have a higher level of book capital, this will reduce if not eliminate the amount of or need for a taxpayer bailout.

On the surface, this argument seems perfectly reasonable.  By definition, if the bank has a higher level of book capital, it has a greater capacity to absorb losses before it reduces its book capital to a level where it presumably needs to be bailed out.

However, if we scratch the surface, we find out that this argument has several assumptions embedded within it.  The first of these embedded assumptions being that regulators will require banks to recognize their losses upfront and not protect bank book capital levels out of fear for the safety and soundness of the financial system.

But is there any evidence to support this embedded assumption.  If we look at the US Savings and Loan crisis, the answer is no.  If we look at our current global financial crisis, the answer is no.

There is absolutely no evidence on a global basis that regulators will require banks to recognize the losses hidden on and off their balance sheets.

Instead, as the Bank of England's Andrew Haldane elegantly said it, there is evidence that regulators have an irresistible urge to bailout the banks.

Oops.

Believing that banks holding higher levels of capital won't need to be bailed out or require as large a bailout is simply a religious belief as there are no facts to support it.

Hence, the observation that economics is a religion.

Being a universal banking means participating in all of bankings misdeeds

In his Rolling Stone column, Matt Taibbi catalogs all the fines and legal fees that JP Morgan has paid as a result of its involvement in all types of misbehavior.

It is not surprising the breath or depth of JP Morgan's involvement in all the sordid aspects of banking, it is simply a reflection of the current universal bank business model.

As you read through the list, please note how many of these activities would not have occurred if JP Morgan had been required to report on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

On the other hand, most of these activities would not have been prevented by either the complex regulations spelled out by the Dodd-Frank Act or the need for banks to hold more capital.

It really is true that sunlight is the best disinfectant.

For sheer curiosity's sake, I thought I'd list, in capsule form, some of the capers Chase has been caught up in in recent years: 

They were fined $153 million for the infamous "Magnetar" fund case, another scam in which a bank allowed a hedge fund to create a "born-to-lose" mortgage portfolio to bet against. Very similar to the Abacus case that's at the heart of the ongoing "Fabulous Fab" trial; 

Chase paid $228 million for its role in the egregious municipal bond bid-rigging case we wrote about in Rolling Stone in 2011; 

Chase paid $297 million to the SEC last November for fraud involving mortgage-backed securities; 

Chase paid $75 million in cash and generously agreed to forego $647 million in fines in the Jefferson County, Alabama mess, in which a small-town pol was bribed into green-lighting a series of deadly swap deals; 

In two separate orders this spring, Chase was reprimanded by the OCC and the Fed for money-laundering behaviors similar to the infamous HSBC case, and also for regulatory failures and fraud in the London Whale episode. There was a separate FBI investigation into the London Whale probe in which they allegedly lied to customers and investors about the loss; 

They're under investigation for allegedly failing to disclose Bernie Madoff's trading activities to authorities; 

They were one of 13 banks asked to pay up in this year's $9.3 billion robosigning settlement; 

They were one of four banks last year to settle for a total of $394 million with the OCC for improper mortgage servicing practices; 

They were ordered by the CFTC to pay $20 million last year for improper segregation of customer funds (this was part of the Lehman investigation). The CFTC also fined Chase $600,000 last year for violating position limits in the cotton markets; 

Last year, Chase paid a $45 million settlement to the federal government for improperly racking up fees for veterans in mortgage refinancings. Hey, if you're going to steal from everyone, you can't leave out those veterans overseas! 

In 2010, Chase paid $25 million to the state of Florida for selling unregistered bonds to a state-run municipal money-market fund; 

The bank last year was convicted in Europe along with several other banks for fraudulent sales of derivatives to the city of Milan. A total of about $120 million was seized from Chase and three other banks. 

There have been so many settlements with so many agencies around the world (I'm in a hurry and can't get to Chase's messes in Britain, Japan and elsewhere) that they're almost impossible to count. Some papers are reporting that Chase is being investigated by as many as eight different agencies in the U.S. alone. 

There are some other civil actions left out, too, like the $110 million class-action settlement for improper charging of overdraft fees, or their part in the gigantic $6 billion settlement completed last year involving Visa, MasterCard and other credit card providers for manipulating card service rates. And states like California have only just begun crawling up Chase's backside for its role in the lunatic filing of erroneous credit card collection lawsuits, a scam outed by whistleblower Linda Almonte. 

Chase is turning into the Zelig of the corruption era. In virtually every corruption scandal, the bank is in the background somewhere. The HSBC money-laundering mess? Chase was reprimanded for similar abuses. The Madoff story? They're under investigation there. MF Global? As banker to Jon Corzine's notorious firm, they were part of a $546 million settlement to return money to MF Global's outraged customers. Jefferson County? That was them. And again, you might have heard of Abacus, but Magnetar was just as bad. Not that anyone's counting or anything.

Not on the list yet of course is manipulating Libor.

Bernanke's epitaph: "We had to do something"

In his testimony before the US House of Representatives, Fed Chairman Ben Bernanke provided his own epitaph when he observe "we had to do something" in response to the financial crisis.

Remarkably, since the moment he appeared in panic before Congress to testify on the need for TARP, the self-described Great Depression expert hasn't been unable to come up with a better thought through strategy for ending the financial crisis than "we had to do something".

Actually, as Mark Twain would say, you only have to pay taxes and die.  Everything else you do is optional.

Mr. Bernanke's testimony confirmed that either he a) didn't understand that he was dealing with a bank solvency led financial crisis and the solution is adoption of the Swedish Model or b) he understood that pursuing the Japanese Model would not work and he is trying to defend his legacy.

Bernanke's defensiveness can probably be chalked up to the one thing he could plausibly be afraid of: watching his legacy go the same way as that of former Treasury Secretary Tim Geithner, who left while excoriated for his seeming friendliness toward big banks.

The Geithner Doctrine doesn't "seem" friendly to big banks.  It is designed to be friendly to big banks.

The Geithner Doctrine is don't do anything that will harm the profitability or reputation of big and/or politically connected banks (hat tip Yves Smith).

Bernanke has done more than Geithner did, and took on the economic job left undone by a dysfunctional Congress and a distracted president as well. He became a one-man economic Mr Fix-it, not by choice but by necessity.

Mr. Bernanke told everyone who would listen that he is an expert on the Great Depression.  Hence, he was a logical person to lead the response to our current financial crisis.

The one problem as pointed out by Anna Schwartz, Milton Friedman's co-author and a noted expert on the Great Depression too, is that Mr. Bernanke learned the wrong lessons (see here and here) about the Great Depression.

When faced with a bank solvency led financial crisis, ending the crisis requires having the banks recognize upfront their losses on the excess public and private debt in the financial system.

Until banks recognize the losses, monetary policy is not going to end the crisis.

A fact that should be apparent to all as we approach the six year mark on August 9, 2013 of the beginning of the financial crisis.

Now, facing the end of his term, he is fighting an uphill battle to get the credit for the work laid at his door. 

He wasn't often right – in fact, in forecasting, often wrong – but his Fed did more than any other government or private entity to tackle the country's economic problems. 

That's something.

Your humble blogger would give Mr. Bernanke a significant amount of credit for trying and doing something were it not for one small fact: he didn't use all the tools at the Fed's disposal from the beginning of the financial crisis.

As he testified before Congress, he talked about not being successful at ending the crisis and the need for the Fed to have additional tools if it were to successfully end the crisis.  However, he completely ignores the fact that the Fed has an entire toolkit from its role as lender of last resort and responsibility for bank supervision that he chose not to use.

The Fed could have used both of these tools to end the financial crisis by requiring the banks to recognize their losses upfront on the excess public and private debt in the financial system and protect the real economy and the social contract.

Mr. Bernanke elected not to do so.

He chose to pursue zero interest rate and quantitative easing policies that Walter Bagehot, who invented the modern central bank in the 1870s, said would create economic headwinds that render these policies ineffective.  Turns out Bagehot was right. The economic headwinds existed in the form of the Retirement Plan Death Spiral as both individuals and companies cut back current consumption to fund the shortfall in earnings on retirement assets.

He chose to allow bankers to continue to pay themselves large cash bonuses at the same time the Fed engaged in regulatory forbearance and let the banks transform their non-performing loans through 'extend and pretend' into 'zombie' loans.

He chose to put the real economy into a downward spiral by placing the burden of the excess debt on the real economy where it diverted capital needed for reinvestment, growth and supporting the social contract to debt service.

Update:
In his testimony, Bernanke also observed that

Fed didn't have a way to oversee the shadow banking system.

As regular readers know, the inability to see what is going on in shadow banking should have been a less than subtle hint that there was a need for transparency.