Will I be hired as the Chairman of the Board for Common Securitization Solution, LLC?

Given that I literally invented the idea of a common securitization platform and know more about how this business should operate than literally anyone else, I wonder if the executive recruitment firm hired by Fannie Mae and Freddie Mac will identify me as one of the candidates for being the Chairman of the Board of the joint venture, the Common Securitization Solution, they are forming?

As reported by National Mortgage News,

The government-sponsored enterprises are making significant progress toward creating a common securitization platform for the issuance of Fannie Mae and Freddie Mac MBS, according to the GSE regulator. 

The Federal Housing Finance Agency said that Fannie and Freddie have leased office space in Bethesda, Md., for the joint securitization venture. And a certificate of formation has been filed with the Delaware secretary of state to create a limited liability company that will be called Common Securitization Solutions LLC. 

In addition, an executive recruitment firm has been retained to identify candidates for the positions of chief executive officer and chairman of the board of managers for CSS, the FHFA said Monday....

Once completed, the common platform will issue Fannie and Freddie MBS and possibly private-label MBS.

Writing book on FDR Framework & current crisis

For the next couple of weeks, I will be finishing writing a book on the FDR Framework and our current financial crisis.  As a result, I will not be blogging, but instead using twitter.  Please follow me on twitter under @tyillc.  Thanks.

Coming this fall will be a series of posts on how Fannie and Freddie building and/or being involved in the day to day operation of the securitization platform has already resulted in and will continue resulting in the US taxpayer being screwed.

London Whale trading scandal legacy is requirement banks disclose their exposure details

The JP Morgan London Whale trading scandal showed how important it is that all market participants, not just management and regulators, have access to each bank's current global exposure details.

For example, when everyone can see a bank's proprietary trades, banks don't make these bets.  JP Morgan demonstrated this fact by closing its position as quickly as possible after the position had been "leaked" to the marketplace.

In his Guardian column, Nils Pratley looks at how the trading scandal demonstrates that JP Morgan is too big to manage and too big for regulators to oversee.  If it is too big to manage or regulate, the logical conclusion is that it should be shrunk.

But how do you effectively shrink JP Morgan or other similar Too Big to Fail bank and exert restraint on it so it doesn't become a problem in the future?

By requiring the bank to provide transparency into its current global asset, liability and off-balance sheet exposure details and letting the market exert discipline.

With transparency, the first thing to go are its proprietary bets, as oppose to the market making positions, as the bank doesn't want the market to trade against its bets.  Hence, we get compliance with the Volcker Rule without 500+ pages of regulations.

With transparency, the second thing to go are the thousands of subsidiaries that exist for regulatory or tax arbitrage.

In short, with transparency, market discipline gives each bank the incentive to reduce its risk profile and organizational complexity as the failure to do so results in a lower stock price and higher cost of funds.

Too big to manage? Too big to regulate? Both criticisms of JP Morgan should ring loud and true for readers of the various regulatory postmortems on the bank's "London Whale" trade. 

From chief executive Jamie Dimon's initial dismissal of the affair as a "tempest in a teapot" to the various botched internal investigations, this was a corporate calamity. 

And the worst part was JP Morgan's high-handed attempt to deceive regulators. The UK's Financial Conduct Authority says it was "deliberately misled" by London-based executives on one occasion. 

Please note that requiring exposure detail transparency would have prevented this entire scandal.

First, the bank wouldn't have made the proprietary bet.

Second, even if it did make the proprietary bet and take on the risk of the market trading against it, management would have been able to get a clear picture as it too could have seen the trades.

Third, there would have been no reason for management to lie to the regulators as the regulators could easily verify, with the assistance of other market participants, what they were being told by the bank.

Total fines of $920m (£574m), to add to the $6bn loss from the trading activities themselves, will destroy any lingering notion that JP Morgan was the smartest manager of risk on Wall Street. 

The FCA's report reveals the bank's almost comical inability to get a handle on its credit derivative exposures even after senior management realised there was a crisis.... 

Incompetence is one thing, of course. Misleading regulators is the serious part of this scandal. 

JP Morgan's behaviour was brazen and extraordinary. In a discussion with the UK regulator in March 2012, JP Morgan staff in London didn't mention that traders on the synthetic credit portfolio – the source of all the problems – had been told to stop trading. 

That was a basic piece of information to reveal. 

The following month, on a conference call, London executives said there had been no material changes to the portfolio since the March meeting. In fact, the portfolio was expected to lose a significant amount of money that very day, pushing losses for the year beyond $1bn, as London management had been told by their traders prior to the call with the regulator. 

Thus the FCA's damning assessment that it had been deliberately misled.

We need a fair system for restructuring debt

Since the beginning of the financial crisis, your humble blogger has predicted that the global economy will not recover until creditors recognize their losses on the debt in the financial system that will never be repaid.

Embedded in this prediction is the notion that a fair system can be developed for rapidly restructuring this debt.

The closest we have come to a fair system for rapidly restructuring debt is Iceland.

Iceland adopted the Swedish Model for handling a bank solvency led financial crisis and required its banks to recognize upfront the losses on the excess debt.

Specifically, the banks had to write down the value of their loans to a level where the borrower could afford the repayment.  Affordability was based on standards like limiting debt payments to 35% of gross income.

However, there were limits placed on this write down.

Specifically, if an independent third party would pay more for the asset collateralizing the loan than the supportable loan amount, the banks only had to write down the loans to this level.  This meant the write down was limited so that it would not create any equity for the borrower.

On the surface, this system for restructuring appears fair.

The creditor takes responsibility for the portion of the loan that exceeds the borrower's capacity to repay.  This is as it should be as the creditor is suppose to evaluate the borrower's repayment capacity and not extend debt in excess of this level.

The borrower takes responsibility for paying what they can afford.  They cannot simply walk away from the debt.

Please note that this system for restructuring debt could be applied to sovereigns as well as to individuals and companies.

In an interesting column, Joseph Stiglitz argues that a fair system for restructuring sovereign debt is needed.

In debt crises, blame tends to fall on the debtors. They borrowed too much. 

But the creditors are equally to blame – they lent too much and imprudently. 

Indeed, lenders are supposed to be experts on risk management and assessment, and in that sense, the onus should be on them. 

The risk of default or debt restructuring induces creditors to be more careful in their lending decisions.

As JP Morgan pays over $1 billion in fines today, it is worth noting bad behavior occurs across banking industry

As JP Morgan pays over $1 billion in fines today (including for lying about London credit default swap trade and for lying about credit card add-on products it charged for but didn't provide), it is worth noting that the fines are a cost of doing business and that this type of behavior cuts across the entire banking sector.

Regular readers know that the only way to change bank behavior for the better is to require transparency.  Specifically, transparency under which the banks disclose the current global asset, liability and off-balance sheet exposure details.

Why transparency?

Because sunlight is the best disinfectant.  With exposure detail transparency, sunlight is shown on the banks and all of their activities.

Gone are the days of misleading or politically bullying their regulators as market participants can use this data to independently assess what banks are doing.  Based on this independent assessment, market participants can exert market discipline on the banks; something that has been absent for the last 40 years.

Zoe Williams nicely summarizes the bad behavior of the banking sector and why transparency is needed in her Guardian column.

Putting aside the people who just can't bear for this to be true, it is plain to everyone that the main high street banks are morally bankrupt. If only we could have bailed them out morally instead of financially – I feel sure our moral deficit would have been easier to pay down. 

Two scandals hit Barclays this week within 24 hours of each other – in one it is contesting a £50m fine for reckless Qatari fundraising that it hadn't told its shareholders about. In the other, it may have to repay £100m for mistakes (in its favour) made in personal loans. 

This doesn't tell us much we didn't already know. 

We knew from Liborand the mis-selling of personal protection insurance that cheating people has become peer-normalised among the main banks, and we know this has been going on since at least 2005. 

There has been a moral deficit since then, and the crash didn't make a dent in it. 

We also know, from those epic fines issued by the Financial Services Authority (now the FCA) over Libor, that much of the punishment is as good as meaningless. Money was just taken from one bank and distributed among the others. This only works if just one of them is crooked. When they all are, it's just a kitty....

We spend so much time talking about this titanic clash between the free market and the social state – yet ignore the fact that most of our major "markets" no longer operate as such. 

This is an oligarchy whose only governing authority is the administrator of wrist-slaps, and whose principles begin and end with the preservation of its jointly and severally managed profit. 

Which is to say that they're not competing against each other; they collaborate brilliantly – which would be sweet to watch were it not for the fact that they are working together the better to screw us. 

When you criticise a bank, you are often accused of the crime of "minding profit". I don't mind profit. But the system as it stands has come untethered from all the principles by which profit justifies itself. 

Buyers and sellers are only equal parties working towards mutually beneficial deals when both have all the relevant information. 

Generally we have no information and discover what the banks are up to roughly six years later, if at all....

[RBS] has all the garden variety failures that affect me personally as a customer – you can check them on a scorecard produced by Move Your Money – as well as occupying the hot epicentre of an FT diagram which details the causes of the 2008 financial crash. 

That was a complicated disaster, caused by bad lending, bad investments, risky funding structures, low capital, and mergers and acquisitions. RBS alone had a finger in every pie chart (it is actually a Venn diagram). 

So this institution is at the very heart of an event that has caused misery for millions of people, not to mention lobotomised our political culture...

Why we are not in recovery mode or having seen the end of QE

Deutsche Bank's Jim Reid, global head of fundamental credit strategy, explained why the global economy is not in recovery mode and why we have not seen the end of QE:  too much debt that will never be repaid still in the financial system.

“Nominal GDP growth is important because of the level of debt we still have in the system,” he told an audience on asset owners and their advisors. 

“At an aggregate level, we’re still on a huge pile of debt: if there’s little growth, there’s little chance of eroding that debt. And that makes us vulnerable to market shocks.”...

Please re-read Mr. Reid's observation that effectively we have not reduced the excess debt in the financial system since the financial crisis began.

This lack of debt reduction reflects the policy choices made and still being implemented to deal with a bank solvency led financial crisis.

Specifically the choice to adopt the Japanese Model and protect bank book capital levels and banker bonuses at all costs.

Just like Japan, the EU, UK and US has made little to no progress in restructuring the excess debt in their financial systems.  The burden of the excess debt has instead been placed on the real economy where it diverts capital needed for growth and reinvestment to debt service.

The result of adopting the Japanese Model has been the same economic malaise that has plagued Japan for the last 2+ decades.

Part of the situation has been caused by monetary policy interventions being directed at the wrong end of the market, Reid continued. 

Quantitative easing (QE) has resulted in an inflation in asset prices, but the money isn’t trickling down into the public’s pockets, making those wealthier people with assets better off, and the poorest people worse off, Reid said. 

This led to an effective propping up of the inefficient resources in our economies, instead of a radical redesign, he said. 

The financial system doesn't need a radical redesign.  It just needs to be used the way it was designed in the 1930s.

Specifically, policymakers need to adopt the Swedish Model which a modern banking system was designed to support and have the banks recognize upfront the losses on the excess debt.

This ends the excess debt burden on the real economy and allows capital to flow to where it is needed for growth, reinvestment and support of the social programs.  The Swedish Model also ends the need for all sorts of monetary policies like QE and ZIRP.

Banks are able to support the Swedish Model because of the combination of deposit guarantees and access to central bank funding.  With deposit guarantees, taxpayers are effectively the banks silent equity partners when the banks have low or negative book capital levels.

One partial consequence of QE and the greater access to refinancing methods is a decade of record-low default rates, making credit an attractive asset class for investors seeking greater returns in a low-yielding environment. 

Under normal circumstances, withdrawal of QE should lead to default rates increasing, as money is removed from the refinancing pool. 

But Reid argued central banks and governments won’t be able to accept a rising default rate as they want to keep markets calm. This will force central banks to put yet more unconventional monetary policies back on the table. 

Even worse, this will in turn hamper GDP growth by allowing bad companies to continue running, blocking more efficient, better performing new companies from breaking through. 

“The authorities are trapped,” he said. “I predict this low default rate environment will stay that way for a couple of years. But this isn’t a free market, it’s not capitalism. 

“A normal default cycle is good: if companies go bust it cleanses the system and allows entrepreneurial spirit to come through. I expect that default rates will be kept artificially low to keep the markets calm… it will get to the point where it chokes off economic activity.”

Please note, just like Japan, there is no endpoint for QE and a return to a "normal" capitalistic financial market where default rates are allowed to fluctuate freely.

Roger Lowenstein: Obama should name banker, not economist, to Fed

In a Bloomberg column that sent fear through macro economists everywhere, Roger Lowenstein laid out the case for why Obama should appoint someone other than a macro economist as the next chairman of the Fed.

Mr. Lowenstein looked at the task at hand and identified what he felt were the credentials the next Fed chairman should have.

Rather remarkably, your humble blogger possesses these credentials.

Mr. Lowenstein left out the two most important credentials for the next Fed chairman.

First, did they predict the financial crisis.  This is important because it strongly suggests that they had an insight into why the crisis occurred.

Second, do they have a plan for ending the financial crisis and restoring the economy and financial markets to normal functioning based on this insight.

I have written extensively on this blog about how I would end our bank solvency led financial crisis.  Virtually every aspect of my plan can be implemented by the Fed chairman.

As the head of bank regulation, the chairman has the power to bring transparency to the banking system and require banks to disclose their current global asset, liability and off-balance sheet exposure details.

As the head of monetary policy, the chairman has the ability to raise short-term interest rates above 2% and eliminate the economic headwinds caused by ultra-low rate monetary policy.

Mr. Lowenstein observed:

But the next chairman will have to decide when to trim the Fed’s portfolio, swollen with its extraordinary program of bond purchases. And it will have to raise short-term interest rates, which are currently near zero. It may be sooner, it may be later -- the moment will come. 

Money cannot be free forever. 

To make this decision, the Fed should be led by a fresh pair of eyes -- one not compromised by its current policies....

And what will these fresh pair of eyes see?

ultra-low interest rates are punishing savers and discouraging thrift, not a healthy condition. 

Investors are responding to razor-thin yields by “looking for yield” in suspect places. (Rwanda offered $400 million of debt this year, and the issue was wildly oversubscribed.) 

As we’ll recall from the mortgage crisis, chasing yield can lead to big trouble....

If ultra-low interest rates worked as a monetary policy for ending a bank solvency led financial crisis, then Japan's crisis should have been over years ago.  Instead, Japan has had ultra-low interest rates for 2+ decades.

In addition, there was no reason to believe ultra-low interest rates would work as Walter Bagehot, the founder of modern central banks, set the minimum interest rate at 2%.  He observed that there are changes in economic behavior that occur below 2%.

History suggests that moving away from zero rates will be unpopular and difficult -- especially for a Fed on cozy terms with the White House....

Actually, moving away from zero rates would be incredibly popular with individuals who save and invest.

Moving away from zero rates would be unpopular with the banks.

For those of us who are concerned with fixing the financial system and restarting the economy, winning popularity contests is not a consideration.

If the next chairman isn’t a Washington hand, who should it be? 

It is too soon after 2008 to tap an executive from Wall Street, which bundled the toxic mortgages at the heart of the crisis. That rules out William Dudley, president of the New York Fed and a former Goldman Sachs Group Inc. economist. 

There is no head-hunting recipe for a Fed chairman, but knowing a little institutional background helps....

I got this credential covered.

In recent times, the Fed has been dominated by policy makers. Bernanke was an academic and then a government official (Yellen has a similar background, though she also ran the San Francisco Fed). Greenspan was a consultant and adviser to President Gerald Ford. Geithner was a Treasury official before taking over the New York Fed. 

But Paul Volcker, the most independent Fed chairman in history, was a banker -- president of the New York Fed and an economist at Chase Manhattan Bank when Chase was a lender to corporations....

I got the banking credential covered.

Rather than look for a consultant, an academic or a regulator, Obama should nominate a chairman with an institutional grasp of the banking system.

I have the required institutional grasp of the banking system.

Regular readers have read literally hundreds of posts that I have written on how a modern banking system is designed and how it can be used to end our financial crisis.

Is Barclays raising capital simply to absorb existing losses on its balance sheet?

In its independent analysis of Barclays, PIRC, a UK institutional investor consultancy firm, raises the question of is the bank raising capital simply to cover losses that already exist on its balance sheet.

Regular readers know that this question would be easy to answer if banks like Barclays were required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants could independently assess the exposure details and determine if and where any losses might be.

Barclays AGM in April 2013 was against a backdrop of the company denying the PIRC analysis that it needed more capital due to overvalued assets, whilst at the same time seeking a general authority to issue new shares. 

The rights issue announced in July 2013 as a result is contrary to that denial and there will not be an EGM to give accountability for the rights issue and its reasons. 

Furthermore, inspection of the rights issue announcement reveals that the story in it does not quite stack up. Barclays is saying that its £5.8bn equity capital raising, is to reduce “leverage” (gearing). 

That might be the case in its IFRS accounts where it is not booking the £4.1bn losses that the PRA has identified and is the substantial reason for the rights issue. However, when adjusted for the loss, the proper accounts would show that the bulk of the equity capital raising is to deal with the overvalued assets. 

Therefore the substantial reason for the rights issue is not to reduce gearing it is funding the loss that the PRA has identified that Barclays is not putting through its IFRS books. The explanations not matching is inherently a problem with running two sets of books. 

UK banks received favorable accounting treatment from regulators

PIRC, a UK institutional investor consultancy firm, looked into how UK banks were required to report their financial statements since the beginning of the financial crisis.

What PIRC found is the regulators effectively broke the spirit if not the letter of the law by letting banks report financial statements that made the banks appear healthier than they were.

This is yet another example of why banks must be required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This disclosure minimizes the potential for banks to overstate their health as the statement can be independently verified by market participants.

Amidst the fallout of the banking crisis, where all of the failed banks appeared healthy by their accounts, is the question of quite why did the Financial Reporting Council quietly dissolve the legal entity the Accounting Standards Board (“ASB”), shortly afterwards, and subsume the functions within itself? 

PIRC has discovered tucked away at the back of the ASB’s yawningly long Statement of Principles, from 1999 (a very good year for very bad ideas) the very clear admission that the ASB had a systemic disregard for the law, because it thought it knew better. Or, quoting from the document, the ASB preferred to focus on “what is deemed to be right”. 

Given that “what is deemed to be right” included abolishing general provisions for bad debts, meaning that risky lending was overvalued in the balance sheet and underpriced for the risk, what was “deemed to be right” was in fact nothing less than reckless and wrong and illegal. 

The law that was being disregarded was the very simple rule that accounts must show whether any company is solvent or not. The full statement is below: 

“However, the development of the Statement has not been constrained by legal requirements because the Board believes that accounting practice evolves best if regard is had in documents such as the Statement of Principles to what is deemed to be right rather than what is required by law.”

Hard evidence that bankers frame the discussion of the financial crisis and financial reform

Mike Berry at Cardiff University provides hard evidence that the mainstream media effectively allowed the bankers to frame the discussion of the financial crisis.

Being able to frame the discussion of the financial crisis was critically important as it allowed the bankers to effectively block the discussion of solutions that would have been unfavorable to them.

For example, the bankers blocked discussion of both the Swedish Model and transparency.

Under the Swedish Model, the banks would have been required to recognize upfront their losses on the excess debt in the financial system.  Doing so would have protected the real economy from the burden and distortions caused by the excess debt and the policies to protect bank book capital levels and banker bonuses.

The Swedish Model was almost never discussed (it was and still is by your humble blogger).

Instead, the focus was on the need to adopt the Japanese Model and protect bank book capital levels and banker bonuses at all cost because without doing this banks couldn't lend more to support economic growth.

Of course, the argument for adopting the Japanese Model wasn't true.  Banks are designed to continue to support the real economy even when they have low or negative book capital levels.

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

Bankers kept transparency out of the discussion (despite opaque, toxic subprime RMBS deals being at the heart of the crisis) because they make their money from the use of opacity.  When investors and regulators cannot properly assess the risk of the banks or the financial products the bankers produce, bankers profit off of the underpricing of risk.

However, if you want to take risk out of the financial system, you have to bring valuation transparency to all the opaque corners of the financial system.

To date, any conversation about bringing transparency has focused on price transparency.  However, price transparency is meaningless without the ability to independently assess the risk of and value using valuation transparency.  Without valuation transparency, there is no point of comparison to make buy, hold or sell decisions based on price.

Instead, market participants are simply gambling on the content of black boxes and brown paper bags.

Mr. Berry and his colleagues did a content analysis on the BBC coverage of the financial crisis.  What they found was:

The robustness of these findings is reinforced in research on how the BBC’s Today programme reported the banking crisis in 2008. 

The table below shows the sources featured during the intense six weeks of coverage following the collapse of Lehman Brothers.

Today programme banking crisis interviewees 15/9/2008 to 20/10/2008.

The range of debate was even narrower if we examine who the programme featured as interviewees in the two week period around the UK bank bailouts. This can be seen in the next table.

Today programme banking crisis interviewees 6/10/2008 to 20/10/2008.

Here opinion was almost completely dominated by stockbrokers, investment bankers, hedge fund managers and other City voices. Civil society voices or commentators who questioned the benefits of having such a large finance sector were almost completely absent from coverage. 

The fact that the City financiers who had caused the crisis were given almost monopoly status to frame debate again demonstrates the prominence of pro-business perspectives.

Anne Pettifor: This is not the road to recovery, but to Wongaland

In her Guardian column, Anne Pettifor questions whether a UK economic recovery based on low interest rates and housing speculation is really the cure for an economy suffering from excess debt from a prior housing bubble.

Much of her argument applies equally well to the US.

The question posed is this: is the direction of the supposed recovery a sound one? Is it based on solid foundations? The reason I doubt that is ...

Before becoming chancellor, George Osborne provided a sound analysis of the British economy. In his Mais Lecture of February 2010, he said: "The overhang of private debt in our banking system and our households weighs heavy on future prosperity." A new model, he announced, rooted in more investment, more savings and higher exports, would require "new policies and new institutions". 

Then, as chancellor, he changed direction. He ignored the vast burden of private debt, which has not been deleveraged. ... 

For three years the government has revived and propped up a very old, Victorian model of the economy. 

Just as in the 19th century, bankers or creditors dominate policymaking, ensuring that the value of their assets (mainly debt) is not just stable but rises relative to profits, wages and incomes. Above all, as in pre-Keynesian times, creditors lobby to ensure limited public oversight or regulatory control over their huge power to determine the rate of interest on the full spectrum of lending.

So the nationalised Bank of England is stealthily recapitalising the private banking sector with low rates of interest while turning a blind eye to the much higher rates charged to productive economic actors. 

All the time, the illusion that the Bank's base rate is dominant, and that overall rates are very low, is maintained, encouraging consumers and homebuyers to go shopping – and the poor to turn to payday lenders for "help". 

But that illusion has already been shattered by the bond markets. Yields on government bonds – which will ultimately influence mortgages – have been rising, and the chancellor, governor Mark Carney and his colleagues at the Bank are determined to leave control over these rates to the money-lenders. 

As retail sales increase, a new threat looms: rising imports that satisfy consumer demand but worsen the trade deficit. ...

At this point, the next election began to loom on the political horizon. 

The government decided to deploy taxpayer resources into stimulating economic recovery. But the resources are aimed not at increasing investment in productive activity, but rather at subsidising, for instance, buy-to-let investors speculating on future house-price inflation. 

So, far from pursuing a "new economic model" based on investment, savings and exports, it's back to the old inflate-the-housing-market-and-boost-consumption meme – but this time with a high-debt, low-wage economy. That is the road to Wongaland.

CFTC's Chilton calls for better transparency of banks' commodity assets to stop market manipulation

Reuters reports that Bart Chilton, a member of the Commodity Futures Trading Commission, has called for better transparency of banks' commodity exposures to end market manipulation.

And why is better transparency needed?

"It is still nearly impossible to figure out exactly what banks own," Chilton said in notes prepared for speaking in Michigan at an event on Saturday. 

"Unless we can see that, we can't reasonably and responsibly protect against market manipulations," he said.

Please re-read Mr. Chilton's comment as it confirms what your humble blogger has been saying about the need to bring transparency to banks since the beginning of the financial crisis.

In order to know exactly what banks own, banks must disclose their current global asset, liability and off-balance sheet exposure details.

Nucleus of our current financial crisis

The Financial Times put together a terrific graphic in which it lists the five main causes of bank and broker failure (bad lending, bad investments/trading, low capital, risky funding structure and M&A) and which combination of these causes brought down each bank or broker during our current financial crisis.

Your humble blogger likes this graphic because it is both very informative and because each of these causes was made possible by opacity.

The latter point bears repeating.  What made each of the causes of bank and broker failure possible was opacity.

Because of opacity, banks and brokers were not subject to market discipline that would have restrained the banks and brokers exposures to each cause of failure.

Let's look at how opacity works to allow bad lending.

When a bank has to disclose its current global asset, liability and off-balance sheet exposure details, market participants can assess both how the bank underwrites its loans and equally importantly how it charges for these loans.

Is the bank compensated for the risk it is taking on?  If not, market participants can exert market discipline by reducing their exposure to the bank and charging the bank more for funds.

With opacity, banks were free to engage in bad lending in the run-up to the financial crisis.

Let's look at how opacity works to allow low capital.

When a bank has to disclose its current global exposure details, market participants can assess the risk of the bank.  Market participants can then adjust their exposure to the bank based on this risk assessment to what they can afford to lose.

The result is a link between the risk a bank is taking and its stock price.

For example, banks with less capital will have a lower stock price for the same level of earnings as banks with higher levels of capital.  There is a natural bias for banks to have higher capital levels. In the 1930s, when disclosing a bank's exposure details was the sign of a bank that could stand on its own two feet, bank capital levels exceeded 20% of their exposures.

With opacity, banks were free to lower their capital levels as there was no link between the risk they were taking and their stock valuations.

The takeaway from the Financial Times' graphic is that the causes of the financial crisis could have been prevented if the banks had been required to provide transparency and disclose their current exposure details.

Senator Warren: "How much longer should Congress wait for regulators to fix this problem"

In her speech on state of financial reform on the fifth anniversary of Lehman Brothers' collapse, Senator Elizabeth Warren asked: "how much longer should Congress wait for regulators to fix this problem?"

While she was referring to Too Big to Fail banks, this question applies equally well when "the financial system" replaces the more limited "this problem". [How much longer should Congress wait for regulators to fix the financial system?]

Senator Warren suggested and then rejected some potential time periods for waiting: 3 months, 3 years or until another big bank comes crashing down.

Instead, Senator Warren suggested that Congress should act.

Below, your humble blogger has laid out Senator Warren's case for why Congress should act.  I have inserted the words "the financial system" where appropriate as her case can be applied more generally.

In April 2011, after a two-year bipartisan enquiry, the Senate Permanent Subcommittee on
Investigations released a 635-page report that identified the primary factors that led to the crisis. 

The list included high-risk mortgage lending, inaccurate credit ratings, exotic financial products, and, to top it all off, the repeated failure of regulators to stop the madness.  

As Senator Tom Coburn, the Subcommittee’s ranking member, said: “Blame for this mess lies everywhere from federal regulators who cast a blind eye, Wall Street bankers who let greed run wild, and members of Congress who failed to provide oversight.”...

Not on Senator Warren's list is transparency, however, transparency is at the very heart of her argument for why Congress should act.

The crash happened quickly and dramatically, and it caught our nation and apparently even our regulators by surprise. 

But don’t let that fool you. The causes of the crisis were years in the making, and the warning signs were everywhere.... 

I’ve also studied the financial services industry and how it has developed over time. 

A generation ago, the price of financial services—credit cards, checking accounts, mortgages, and signature loans—was pretty easy to see. Both borrowers and lenders understood the basic terms of the deal. 

But by the time the financial crisis hit, a different form of pricing had emerged. Lenders began to use a low advertised price on the front end to entice customers, and then made their real money with fees and charges and penalties and re-pricing in the fine print. Buyers became less and less able to evaluate the risks of a financial product, comparison shopping became almost impossible, and the market became less efficient....

This movement from transparent products to opaque products was not limited to the consumers, but also occurred with investors (think structured finance).  As Yves Smith observed, no one on Wall Street was compensated for creating low margin, transparent products.

As a result, investors became less and less able to evaluate the risks of an investment and instead relied on the risk assessments conveyed by rating firms and regulators.  This lead to the market becoming more and more fragile, until....

There are many who say, “Sure, Too Big to Fail [fixing the financial system] isn’t over yet, but Congress should wait to act further because the agencies still have to issue a bunch of Dodd-Frank’s required rules.” 

True, there are rules left to be written, but that’s because the agencies have missed more than 60 percent of Dodd-Frank’s rulemaking deadlines. 

I don’t understand the logic. Since when does Congress set deadlines, watch regulators miss most of them, and then take that failure as a reason not to act? 

I thought that if the regulators failed, it was time for Congress to step in. That’s what oversight means. And that’s certainly a principle that would have served our country well prior to the crisis....

Ironically, Dodd-Frank puts such a huge burden on the regulators to write new rules that it appears to have limited their ability to rewrite existing rules based on what has been learned as a result of the financial crisis.

For example, the financial crisis showed that Regulation AB covering disclosure requirements for structured finance securities was fundamentally flawed.  It allowed Wall Street to create opaque securities that hid their toxicity (think opaque, toxic sub-prime mortgage-backed securities).

Five years later, Reg AB still hasn't been rewritten when all it would have taken is a simple one page addition.  This one page would have required all structured finance securities to a) disclose all the data fields tracked by originators and servicers (while protecting borrower privacy) and b) report on all observable events, like payments or delinquencies, involving the underlying collateral before the beginning of the next business day.

For example, the financial crisis show that banks are 'black boxes'.  Clearly, being a black box allows Wall Street to make proprietary bets where they keep the winners and taxpayers get the losers.

Five years later, the SEC still hasn't rewritten the disclosure rules for banks.  Again, all it would have taken is a simple one page addition that said banks must disclose at the end of each business day, their current global asset, liability and off-balance sheet exposure details.

But if the regulators won’t end Too Big to Fail [fix the financial system], then Congress must act to protect our economy and prevent future crises. 

We should not accept a financial system that allows the biggest banks to emerge from a crisis in record-setting shape while ordinary Americans continue to struggle. And we should not accept a regulatory system that is so besieged by lobbyists for the big banks that it takes years to deliver rules and then the rules that are delivered are often watered-down and ineffective. 

What we need is a system that puts an end to the boom and bust cycle. A system that recognizes we don’t grow this country from the financial sector; we grow this country from the middle class. 

This is the system that was designed and implemented as a result of the Great Depression.  This financial system is based on what your humble blogger refers to as the FDR Framework.

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

It is adherence to this framework which allows for market discipline to restrain risk taking by banks and puts an end to the boom or bust cycle.

This framework does this because each market participants knows they are responsible for all losses on their exposures.  As a result, they have an incentive to independently assess risk and limit their exposures to what they can afford to lose.

It is the act of limiting their exposures through which investors exert market discipline.

This framework also changes the behavior of bankers.  It ends practices like manipulating Libor.  It does this because sunlight is the best disinfectant.

Powerful interests will fight to hang on to every benefit and subsidy they now enjoy. 

Even after exploiting consumers, larding their books with excessive risk, and making bad bets that brought down the economy and forced taxpayer bailouts, the big Wall Street banks are not chastened. 

They have fought to delay and hamstring the implementation of financial reform, and they will continue to fight every inch of the way. 

That’s the battlefield. That’s what we’re up against.

Transparency is a make or break issue for the banks.  They know that if they are required to provide exposure detail transparency their days of taking excessive risk are over.

Banks have been lobbying very aggressively to protect their opacity.

For example, bank lobbyists helped to write the Office of Financial Research in Dodd-Frank Act in such a way that they could hope that OFR was the place where transparency would go to die.  OFR allows the banks to claim not only can the regulators see their exposure details, but so to can a regulatory entity that is suppose to worry about risk.

What they won't say is that this regulatory entity cannot share this data with other market participants who might be far more skilled at assessing the data (do you think OFR or JP Morgan would do a better job of assessing the risk of Citi?).

But David beat Goliath with the establishment of CFPB and, just a couple months ago, with the confirmation of Rich Cordray.... 

And I am confident David can beat Goliath on Too Big to Fail [fixing the financial system]. 

We just have to pick up the slingshot again.

How to stop the next financial crisis

In his column in the Atlantic, Glenn Hubbard examines what your humble blogger refers to as technocratic financial regulation and finds that it is insufficient to prevent the next financial crisis.  He then calls for bringing in the big gun.

In Mr. Hubbard's case, the big gun is the Fed.  In your humble blogger's case, the big gun is the market.

Which is more likely to prevent the next financial crisis?

The Fed which failed to prevent the current financial crisis and is pursuing a policy of re-inflating the real estate and stock market bubbles or the market which because of opacity was unable to exert discipline in the run-up to our current financial crisis?

I agree with Mr. Hubbard's assessment of why technocratic financial regulation will not prevent the next financial crisis.  I also agree with his calling for an end to small fixes and bringing in the big gun.

What is needed is transparency into all the opaque corners of the financial system, including banks and structured finance, so market participants can once again exert restraint on risk taking and bad behavior.

As regular readers know, our financial system is based on the FDR Framework.  It 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 accessible in an appropriate, timely manner.  Market participants are responsible for all losses on their exposures so they have an incentive to use the information disclosed.

Market participants use this information to independently assess the risk and value each of their exposures.  Based on the assessment of risk, market participants then limit their exposure to what they can afford to lose (the basis for market discipline).

Our current financial crisis showed that the FDR Framework works.  Markets, like the equity markets, where there was and still is transparency continued functioning.  It was the markets, like the interbank lending market, where there is opacity that froze and effectively still remain frozen.

Our current crisis is the direct result of the government's failure in its responsibility to ensure transparency.  As a result, we ended up with opaque, toxic sub-prime mortgaged-backed securities and banks that are 'black boxes'.

It time to rollout the big gun and let the market, using the information disclosed as a result of transparency, end our current financial crisis and prevent the next financial crisis.

This worked for 7+ decades before government forgot that it was suppose to error on the side of too much transparency and allowed Wall Street to create opacity in large areas of the financial system.

One key reason for skepticism that policy has put us on a course toward financial stability is that we have treated the loose ends of the financial crisis as technical problems to be solved …

• If proprietary trading by financial institutions is risky – though such risk-taking paled alongside old-fashioned bad lending before the crisis – ban it. 

• If taxpayers and investors lost money in the crisis, force institutions to hold much larger amounts of capital to mitigate future losses. 

• If securitization led to losses, force mortgage originators to hold more “skin in the game.” 

… and so on. 

Each technical problem has been solved using complex rules and regulatory oversight rather than transparency and market discipline.

Post financial crisis policies promise chronic stagnation

In his Financial Times column, Satyajit Das observes about the policies adopted to deal with the financial crisis:

These policies will engineer a chronic stagnation, requiring continuous intervention to prevent rapid deterioration.

Mr. Das uses arguments that should be very familiar to readers to support this conclusion.

The arguments should be familiar because your humble blogger has been using them under the description of the Japanese Model for handling a bank solvency led financial crisis since the beginning of the current crisis.

The collapse of Lehman Brothers and the ensuing financial seizure was symptomatic of high debt levels, global imbalances, excessive financialisation and unfinanced social entitlements, which underpinned an economic model reliant on credit-driven consumption.

What made all of these conditions possible was opacity in the financial markets.

As a result of opacity, market participants were not able to independently assess risk.  Specifically, market participants could not independently assess the risk of banks, both commercial and investment, and structured finance securities.

Without an ability to independently assess risk, market participants relied on organizations, regulators and rating firms, that represented they had transparency and the ability to independently assess risk.

Unfortunately, even if these organizations were capable of accurately assessing risk, there were institutional reasons why they would not accurately communicate their assessment to the market.

Regulators do not accurately communicate risk because of fear of damaging the safety and soundness of their financial system.  Rating firms do not accurately communicate risk because they compete to be paid by the issuers for their ratings.

Regardless, the reliance on faulty risk assessments led to too much debt in the global financial system.

Surprisingly, little has changed. Unsurprisingly, activity has not equated to achievement. Since 2007, total public and private debt in major economies has increased not decreased, with higher public borrowing offsetting debt reductions by businesses and households. 

Debt levels have also risen in emerging countries from before the crisis....

The financial sector exists to support the real economy. Financial instruments, such as shares, bonds and their derivatives, are claims on real businesses. But over time, trading in the claims themselves has become more rewarding, leading to a disproportionate increase in the level of financial rather than real business activity. 

Regular readers will recall that modern banks are designed to protect the real economy from excess debt in the financial system.

Banks can protect the real economy because they have an ability to absorb upfront the losses on this excess debt and continue to operate.

Banks can continue to operate with low or negative book capital levels because of the combination of deposit insurance and access to central bank funding.  When banks have low or negative book capital, deposit insurance effectively makes the taxpayers the banks' silent equity partner.  As a result, so long as a bank can generate earnings, it can continue operating while it rebuilds its book capital level.

The financial sector needs to be pared back to its utility function: making payments, matching savers and borrowers, and providing simple risk management tools.

Your humble blogger has repeatedly said that paring back the financial sector requires bringing transparency to all the opaque corners of the financial system.

JP Morgan has shown that I am right about this benefit of transparency.  JP Morgan showed this in its handling of the London "Whale" trade.  As soon as the market found out what JP Morgan's position was, it closed the position.

If banks were required to disclose their current global asset, liability and off-balance sheet exposure details, there are a significant number of "positions" that they would quickly exit.  This includes proprietary trades as well as regulatory and tax arbitrages.

Instead of fundamental reform, policy makers are introducing complex capital, liquidity and trading controls of dubious efficacy that invite regulatory arbitrage.

Fundamental reform would have been bringing transparency to all the opaque corners of the financial system.

Instead, we have what your humble blogger refers to as the substitution of technocratic financial regulation involving complex rules and regulatory oversight for transparency and market discipline.

As Christopher Whalen said of this substitution of technocratic financial regulation for transparency and market discipline,

The moral of the story of Lehman Brothers is that no amount of regulation can prevent acts of wanton stupidity, fraud, and greed in a free society. Expecting regulators to proactively prevent a financial crisis is at best wishful thinking.

Returning to Mr. Das.

Too-big-to-fail banks have become larger. Initiatives such as the central counterparty for derivatives have introduced complex interconnections and new systemic risks. ...

The real solution always required reducing debt, reversing imbalances, decreasing financialisation and modifying behaviours....

Transparency is the real solution.

By requiring banks to disclose their exposure details, markets would have been able to exert discipline on the banks so that they recognized their losses on the excess debt in the financial system.

With transparency, financialization would have been decreased as market participants would then be in a position where they could independently assess the risk of the various products Wall Street and the City sell.  Many fewer of these products would be sold as market participants would see that the potential rewards from ownership did not compensate for the risk being taken.

Finally, transparency brings about behavior modification.  Sunlight is the best disinfectant of bad behavior by bankers.

Bank of England to develop secret warning system to prevent bank collapse

The Telegraph reports that the Financial Stability Board has called on the Bank of England to develop a  "secret warning system" to communicate to banks without telling investors and depositors that the banks are in danger of failing and need to raise capital.

A secret warning system highlights everything that is wrong with technocratic financial regulation and the substitution of complex rules and regulatory oversight for transparency and market discipline.

The whole idea behind a secret warning system is to keep from market participants knowledge about what the true condition of the bank is.  

Effectively, the regulators are lying in the belief that this protects the safety and soundness of the financial system.  This lying violates and undermines the FDR Framework on which our financial system is based.

Under the FDR Framework, governments are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  Market participants are given an incentive to use this information as they are responsible for all losses on their exposures.

Isn't the fact that a bank is in danger of failing useful, relevant information?

By conspiring with the banks to hide useful, relevant information, the financial regulators create a moral obligation to bailout the investors in the bust bank.

How can you make an investor take a loss when the government is hiding the information needed to make a fully informed investment decision?

Answer is you cannot.  This is why bailing out banks has proven irresistible to financial regulators.

By not ensuring transparency, financial regulators create another problem:  banks are not subject to market discipline.  There is no market discipline when investors do not have the information they need to independently assess the risk of a bank and adjust their exposure to the bank to what they can afford to lose given this level of risk.

When banks are not subject to market discipline, there is no restraint placed on them as they increase their risk and increase their chances of going bust.  If there is transparency, market participants can restrain risk taking by increasing the cost of funds to a bank to reflect an increase in risk.

Since before the financial crisis began, your humble blogger has been saying that we need to bring transparency to all the opaque corners of the financial system.

If there were transparency, financial regulators would directly add their voice in support of market discipline to keep banks from failing.  There would be no need for subtle suggestions to banks to raise more capital or lying to market participants.

The Bank of England needs to develop a secret warning system to tell struggling banks they are about to go bust, the global financial regulator has said. 

The Financial Stability Board, which is chaired by Bank Governor Mark Carney, has urged Britain’s regulators to find a way round disclosure rules that would complicate an instruction to raise capital or take other remedial action. 

Under the Bank’s “proactive intervention framework” (PIF), the Prudential Regulation Authority (PRA) will rate each bank’s “proximity to failure”. 

However, “the PRA has decided not to disclose the PIF rating to the firm concerned in order to avoid a situation in which the firm would then have to publicly disclose the rating,” the FSB noted. 

A public disclosure that the regulator believed a bank was close to collapse would potentially cause a calamitous collapse in confidence that would itself result with the lender’s failure.

If there were transparency, market participants would know the current condition of each bank and therefore a public disclosure would not trigger a calamitous collapse in confidence.

Furthermore, the experience of Ireland, Greece, Cyprus, Spain and Portugal shows that with deposit insurance in place there are limited bank runs when everyone knows the banks to be insolvent.

However, the FSB said it was necessary for the regulator to ensure banks were “aware of any heightened concerns and accompanying intervention activities”. In order to do so, the PRA “should explore options to disclose the PIF rating to such firms without triggering public disclosure”.

FSB doesn't see a problem with the failure to disclose all useful, relevant information in an appropriate, timely manner.

A clear sign of financial regulators having lost track of their primary responsibility under the FDR Framework.

Unfinished business in battle to fix banks...transparency

The Financial Times ran an interesting article in which it identified what it felt were the five principle reasons for bank failures ("low capital, weak funding structures, poor lending, poor trading investments and misguided mergers and acquisitions").

It concluded that 5 years after Lehman Brothers' collapse significant progress has been made using complex rules and regulatory oversight to address four of the reasons for bank failures and the fifth reason, poor lending, could not be addressed.

Left unsaid was the simple fact that transparency would successfully address all five of these reasons for bank failures.

Also left unsaid is the simple fact that it would not have taken five years to implement transparency and have each bank disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

In an attempt to gauge the merit of the glut of global reforms, the Financial Times has looked back at the 34 main banks and brokers that failed in the crisis, judging the principal reasons for failure from a menu of five – low capital; weak funding structures; poor lending; poor trading investments; and misguided mergers and acquisitions.

Each of these reasons is really a symptom of opacity.

For example, when banks don't have to disclose their current exposure details, they aren't subjected to market discipline to restrain their risk taking.  As a result, they reduce their capital levels in lock-step to what they can convince their regulators is adequate to handle any losses they might incur.

History shows that when banks disclose their current exposure details they have a higher level of book capital.  This higher level of book capital reflects both market discipline and the recognition that transparency requires a bank show it can stand on its own two feet.

Many failed for multiple reasons, though Royal Bank of Scotland is the only institution to which all five triggers applied. 

Any analysis of the precise causes of the global financial crisis, even after five years of reflection, is necessarily subjective. 

Please note, your humble blogger assessed and told everyone about the cause of the global financial crisis, opacity, before the crisis hit.

But if there were five main causes of failure, regulators can claim at least partial victory on four of them. 

Please re-read how the regulators can claim at least partial victory on addressing for of the five main causes of failure.

This is entirely unacceptable and is a damning indictment of complex rules and regulatory oversight.

By simply using the securities laws that have existed since 1930s, all five main causes of failure could have been addressed through requiring banks to provide transparency and disclose their current exposure details.

Capital levels in the system are more than three times higher than they were before the crisis as banks pre-empt the requirements of new Basel III global standards. 

Financing is more stable, with far less reliance on risky short-term market funding and new incoming rules demanding banks hold minimum levels of cash and safe assets. 

Big acquisitions are a thing of the past, too, with regulators making it clear such dealmaking is unwelcome. 

And the kind of complex structured investments that spread the contagion of US subprime mortgage losses around the world are close to extinct, the victim of regulators’ higher capital charges and banks’ lower risk appetites....

The one category of the FT’s five triggers of failure that is immune to regulation is bad lending – a perennial curse of banking since the Middle Ages and one that in the heat of the crisis, when the focus was on complex collateralised debt obligations, was often neglected. 

“The crisis was overspun as a markets problem,” says Robert Law, a former banks analyst and adviser to the UK’s recent parliamentary commission on banking standards. “There were major problems in traditional lending, too.” 

According to the FT’s analysis, this was the single biggest factor in the crisis. Of the 34 big banks that failed, three-quarters succumbed in large part because of the poor quality of basic lending – in particular to residential and commercial mortgage customers. 

There is little that the authorities can do directly in a market economy to curb foolish lending practices by private sector banks.

Authorities cannot do much directly about lending as they don't want to be in the position of allocating capital throughout the economy.

As a result, bank examiners don't approve or disapprove of any exposure taken or loan made by a bank.  Rather, bank examiners ask if the bank has enough capital to absorb any losses that are likely to result from the exposure or loan.

Hence, we have the following:

But reformers argue that a laser focus on capital, which can absorb losses, is the essential way to protect the system from further harm.

Unless regulators are willing to let banks take losses, something they have not done since the beginning of the financial crisis, capital is not the way to protect the system from further harm from foolish lending.

Rather, transparency is the way to protect the system from harm by foolish lending by private sector banks.  Transparency protects the system in two ways.

First, transparency allows market discipline which restrains banks making foolish loans in the first place.  It does this because market participants can see what loans the banks are making and can assess whether or not these loans are properly priced.

Second, transparency allows market participants to reduce their exposure to banks that make foolish loans.  By reducing their exposure to what they can afford to lose should a bank that makes foolish loans go under, market participants eliminate any possibility of contagion from the bank's failure.

BoE's Carney calling for clampdown on bank risk model to restore trust

Bloomberg reports that Bank of England Governor Mark Carney is calling for a clampdown on bank risk models to restore trust.

This call highlights the need for banks banks to disclose their current global asset, liability and off-balance sheet exposure details.  Without this disclosure, market participants are never going to trust bank financial statements as they have no idea what the banks, with the permission of their regulators, are hiding on and off their balance sheets.

As for a clampdown on bank risk models, this is a classic case of why complex rules combined with regulatory supervision doesn't provide the same benefit as transparency and market discipline.

In the world envisioned by Mr. Carney, all banks would value securities the same way.

Fortunately, this isn't the way the real world works.  There are legitimate business reasons why different banks would assess the risk of and value the same security differently (hint: this difference of opinion is what makes markets).

To have all banks assess the risk of and value securities in the same way would be to make the financial system more prone to instability.

If the mandated risk assessment and valuation proves faulty, then every bank is has a problem.  This doesn't add to stability, but rather instability.

Regular readers know that trust in the financial markets is a function of transparency.  By making the banks disclose their current exposure details, each market participant can independently assess the risk of and value of each bank's exposures.  Market participants trust their own assessment.

Based on this assessment, market participants can adjust their exposures based on the risk of each bank.  This subjects the banks to market discipline and adds an additional layer of robustness and stability to the financial system.

The additional layer of robustness and stability takes the form of market participants limiting their exposure to each bank to what they can afford to lose and ending the risk of financial contagion.

“The risk models that banks use to calculate their capital needs show worryingly large differences,” Carney, governor of the Bank of England, said in a letter yesterday to leaders from the Group of 20 nations meeting in St. Petersburg, Russia. “This must be addressed for depositors, investors, clients and authorities to have full confidence in the strength of bank balance sheets and their resilience during a downturn.”...

The Basel Committee on Banking Supervision, an international regulators group, said in July that some lenders were backing investments with as much as 20 percent more capital than other banks. European banks generally apply lower risk weights to their holdings of bank-issued debt than lenders based elsewhere, the Basel group said. 

“Given large banks risk-weight based on internal models approved by supervisors and populated with their own historic data, it is not surprising that there is substantial inconsistency,” Bob Penn, financial regulation partner at law firm Allen & Overy LLP in London, said in an e-mail.

“Consistency is arguably a good thing here: but for so long as the Basel rules explicitly embed inconsistency it is hard to see how Mr. Carney’s call will be heard,” he said.

UK's Financial Conduct Authority discovering transparency

Under the FDR Framework, governments are given the responsibility for ensuring that for each financial product or security market participants have access to all the useful, relevant information in an appropriate, timely manner so they can make a fully informed decision.

The UK's Financial Conduct Authority is learning what this means in the aftermath of the PPI mis-selling scandal.  As Yves Smith observed, no one on Wall Street is compensated for creating transparent, low margin products.  PPI was not an exception.

Phillip Inman points out in his Guardian column,

No amount of consumer education could undermine the efforts of high street banks desperate to sell PPI. It was a dangerous and fraudulent product that made fantastic profits for the banks. 

Try as they might, no single campaigner could block the marketing juggernaut designed to drive sales until more than half the working population had been sold one and the compensation bill topped £10bn. 

In the end it dawned on the government that only the regulator could fix the problem.

But the question is how could a regulator fix the problem of PPI or similar financial products or securities?

the Financial Conduct Authority (FCA), has .... enshrined a policy of "temporary product intervention" that means regulators step in when it becomes obvious financial companies are bamboozling their customers. 

Such bamboozling is happening now on packaged current accounts, which banks sell typically for £10 a month with phone and travel insurance bolted on. The accounts are sold despite many customers not needing the extra products or not being able to make a claim. Complaints are pouring in. 

Speculation abounds that the FCA is about to announce a temporary product intervention, or in common parlance a clampdown, on their sale. 

Temporary product intervention is an after the fact solution.  The idea being to end the sale of a financial product before too much damage has been done to customers.

This is a flawed role for regulators for the simple reason that it doesn't prevent financial customers from being taken advantage of in the first place.  Rather it lets Wall Street/The City take advantage of their customers and hopes to end the most egregious practices.

There was a hint in the aftermath of the banking crash that regulators would go further and examine each and every new financial product for its potential to cause harm, but that was dropped.

In the US, the Consumer Financial Protection Bureau has been given the role of examining each and every new financial product for its potential to cause harm.

There are two problems with this solution.  First, Wall Street is very good at devising products that don't appear harmful but are actually toxic (see sub-prime loans).  Second, it takes away from consumers the responsibility for losses and therefore the incentive to assess if a financial product or security is right for them.

The solution that was adopted in the 1930s under the FDR Framework was to make the government responsible for ensuring the transparency of each product before it could be sold.

This means for every financial product or security all the useful and relevant information about the product or security must be disclose to the buyer before they make a purchase decision and they must have enough time to independently assess this information before making a purchase decision.

So the question becomes what is useful and relevant information.  An example of useful and relevant information when insurance is sold is what it takes to actually trigger the insurance.

Of course, if financial firms had to disclose this information, it is likely to end up in a newspaper with a financial expert explaining why nobody should buy the product because they are being ripped off.

Instead we have a system that hopes to stop bad dealing before too many customers become victims. 

As a compromise it is not the worst outcome. 

Actually, it is a compromise that doesn't need to be made.

The government just has to perform on its responsibility to ensure transparency.

However, it ignores the more fundamental point that the financial services industry is pathological in its pursuit of profit. As a result, most financial products are over-complicated and over-priced. 

As Yves Smith observed, financial products are designed to be opaque (over-complicated) and high margin (over-priced) because this is how bankers are compensated.

There are some competitive arenas like house insurance, but mostly our savings, investments and mortgage interest payments leach into the pockets of countless City folk. 

Five years after the crash, they have somehow clung to their bonuses and commissions, trail fees and termly payouts. 

Politicians, fearful that any move against the industry will depress profits, have rarely intervened. Ultimately they believe one of the UK's biggest taxpayers could wither away.

Bankers have clung to their lofty pay because politicians have adopted policies to let them retain their pay and regulators have failed in their responsibility to ensure transparency.

The OECD appears to be equally accepting of the finance industry's dominance. And just as the food industry blames individuals for getting fat, so the financial services industry is allowed to re-establish caveat emptor. 

After all, an "educated" consumer is one they can blame for their own misfortune.

Caveat emptor is part of the FDR Framework.  At the end of the day, bank customers have a responsibility for the results of the financial products they purchase.

With transparency, customers have the ability to do their homework and say no.

Yet when most people in the City fail to understand products sold in other parts of financial services industry, what chance do ordinary consumers have? 

The government hasn't just not upheld their responsibility with regards to ensuring transparency for consumer financial products, but also institutional products as well.  A classic example of this failure to ensure transparency are the opaque, toxic structured finance securities.

The OECD should attack the profiteering by financial services firms and demand simpler products, while dodgy products are regulated out of the system. 

Yes, there should be a demand for simpler products.

The way to assure these simpler products exists is by requiring transparency of all products.  Transparency reveals which products are dodgy and makes it easier for bank customers to avoid any exposure to these products. 

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.