Wednesday, September 4, 2013

Der Spiegel: Bank reform still needed 5 years after crisis began

A must read Der Spiegel article makes the important point that five years after the beginning of the efforts to reform the international banking system the addition of complex rules and regulatory oversight has achieved nothing.

Regular readers know that the only way to fix the financial system is to require the banks to provide transparency.  Specifically, they need to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the risk of each bank and limit their exposure to each bank to what the market participant can afford to lose given the risk of each bank.

When market participants limit their exposure based on the risk of each bank, contagion or the domino effect is ended.  Contagion is ended because each market participant has set their level of exposure to each bank to what they can afford to lose.  This means there is no reason to ever bailout a bank for fear of contagion.

At the same time, the bank's management becomes subject to market discipline.

Management knows if it increases the bank's risk passed a certain level, it will increase the cost of funds to the bank at the same time as it reduces the bank's access to funds.  This is bad for the bank's net income and share price.

Management also knows that if it reduces the bank's risk it will be rewarded.  Lower risk leads to a lower cost of funds.  A lower cost of funds tends to be good for a bank's net income and its share price.

This is how market discipline works.

Market discipline is something that the banks have not been subjected to for over forty years.  Instead, banks have been subjected to complex rules and regulatory oversight replacing transparency and market discipline.

The results have been predictable.  The banks have gamed the system and taken on far greater levels of risk than the markets would have permitted.

Banks were able to do this because regulators do not approve or disapprove of any exposure a bank takes on (they don't do this as it would mean the regulator was allocating capital across the economy).

Instead, the regulators try to estimate the probability of loss if there is a problem with an exposure and the amount of loss should the problem occur.  Regulators then compare this loss to the bank's book capital level to see if it can absorb the loss.

It is not surprising that Der Spiegel sees a need for bank reform.  Adding more complex rules and regulatory oversight does nothing to change the fundamental reason regulators were incapable of preventing the current financial crisis.

It is only when there is transparency that the next financial crisis can be prevented.

When asked whether he believes that the industry and lawmakers learned the right lessons from that tumultuous weekend in September 2008, he concludes soberly: "We would hardly be more effectively protected against a chain reaction today than we were five years ago.".... 
While it is certainly true that bank bailouts no longer have to be ironed out in hectic, nighttime crisis meetings, it is also true that large banks, especially in the United States, are raking in billions once again. 
But the new sheen is deceptive, because banks owe much of their comeback to ongoing support from governments and central banks. Instead of having to launch bailout operations worth billions, they have simply turned to a policy of slowly feeding the financial industry with cheap money.
Please re-read the previous paragraph as it confirms the adoption of the Japanese Model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels and banker bonuses are protected at all costs.

As a result, governments feed money into the banks.  Some of this money is used to absorb losses and some is used to pay bonuses.
"In the euro zone, many banks would have trouble refinancing themselves without the help of the European Central Bank (ECB)," says Christoph Kaserer, a financial expert at the Technical University of Munich. 
According to Kaserer, a number of institutions are not sufficiently profitable to survive on their own in the long term.
Under the Swedish Model, banks are required to recognize upfront their losses on the excess debt in the financial system.

Banks which are capable of generating earnings after recognition of their losses are allowed to continue operating.  Earnings are used to rebuild book capital levels.

Banks which are not able to generate earnings after recognition of their losses are closed.
The euro-zone countries, fearing the potentially uncontrollable consequences of liquidating ailing financial groups, have helped create so-called zombie banks. 
European banks are still burdened with massive bad loans left over from the financial crisis -- amounting to €136 billion ($180 billion) at Germany's Commerzbank alone. 
Analysts with the Royal Bank of Scotland estimate that the banks need to shed about €3.2 trillion in assets in the next three to five years, while at the same time generating €47 billion in fresh capital to be considered stable.
Please note that financial authorities cite fear of uncontrollable consequences, i.e. contagion, as the reason for adopting the Japanese Model and creating zombie banks.

This fear is entirely misplaced as market participants already have some idea of the size of the losses at each bank and which banks do and don't have the ability to generate earnings.

Rather than continue to feed money into banker bonuses, governments should be requiring each bank to provide transparency into their exposure details.  As discussed above, market participants could then assess the risk of each bank and adjust their exposures accordingly.

With the risk of financial contagion removed, regulators could then require the banks to take their losses and clean up the banking system.
If one of these shaky financial giants were to fall, it would likely spell the end of the banking sector's tentative recovery.... 
The banking sector's recovery is all smoke and mirrors.
In the last five years, there have in fact been a significant number of new guidelines, laws, drafts and recommendations. 
The banks were forced to increase the size of their financial cushions, for example, but they still aren't large enough. 
Regulators devised split banking systems designed to shield customer deposits from risky trading activities, but the concepts are half-baked and have yet to be fully implemented.... 
Bankers' bonuses were capped, but then their fixed salaries were increased dramatically. 
Regulators had vowed to rein in the rampant trade in derivatives among banks by requiring it to be conducted on supervised exchanges. Instead, the over-the-counter derivatives market has grown by 20 percent since 2009.
In short, complex regulations and regulatory oversight don't work.
Over the years, lawmakers have lost sight of the most important objectives of regulation. 
Secure savings deposits, a continuous supply of credit and a functioning payment transaction system are as important to an economy as intact water pipes or power grids. 
The point is to ensure that this supply functions properly. 
At the same time, governments and taxpayers cannot allow themselves to be held hostage by the banks, merely because they can guarantee a basic supply of capital. 
"What is needed is fundamental structural change, which, as in other industries, costs money. Lawmakers shy away from that," says Clemens Fuest, President of the Center for European Economic Research (ZEW).
The fundamental structural change needed is to bring transparency to the banks and the rest of the opaque corners of the financial system.

With transparency, banks are subject to market discipline and governments and taxpayers are no longer held hostage by the banks.
Financial industry executives take every opportunity to warn that if regulators take aim at financial groups, then businesses, savers and investors will ultimately suffer.... 
The beauty of requiring banks to provide transparency is it doesn't reduce their ability to provide loans, take deposits or support a functioning payment system.

Transparency addresses the issue of how much risk banks take by using market discipline to restrain risk taking.
At the same time, Jain sends out a warning to lawmakers not to overdo it with new legislation. "If all measures are implemented as planned, it could spell the end of 100 years of universal banking in Europe," Jain said in Frankfurt. His message seems to strike a chord.

Capital rules are a case in point. "Contrary to their political rhetoric, Germany, France and even Japan have blocked the acceptance of tougher requirements in international negotiations," says financial expert Harald Hau of the University of Geneva. Their goal, he adds, is to avoid putting their own, undercapitalized banks under pressure....
Please note that after 2+ decades, Japan is blocking capital rules because of its zombie banks.

This is a clear indicator that the Japanese Model is the wrong policy for handling a bank solvency led financial crisis.  It is also a clear indicator that the EU, UK and US that also adopted the Japanese Model will not do any better.
"So far, this central problem has been neglected in the reform plans," says Jan-Pieter Krahnen of Frankfurt's Goethe University....
The bigger and less transparent the banks, the more reliable their guarantee that the government will bail them out if necessary. "The banks know that if they're complex enough, they'll be bailed out," says ZEW President Fuest.

That is why the solution is to require the banks to provide transparency.

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