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.

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.

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. 

Unlike transparency, debate rages over benefit of derivative reforms

The International Financing Review ran a terrific article on the question of does the benefit of the proposed reforms of the derivative market exceed their costs.

Unlike transparency, where the benefit is measured in trillions of dollars and the cost measured in single billions of dollars, the case for the proposed reforms of the derivative markets is not so clear cut.

This is not surprising.

The complex rules and regulatory oversight being brought to the derivatives market is a belt and suspender imperfect substitute for transparency and market discipline.

As an imperfect substitute, complex rules and regulatory oversight is much, much longer on costs with far more ambiguous benefits.

This is a very important point as Wall Street has turned to the court system to have complex rules and regulatory oversight thrown out when it cannot be shown that its benefits outweigh its costs.

The Macroeconomic Assessment Group on Derivatives – a body of prudential and securities regulators chaired by the Bank for International Settlements – calculated OTC derivatives reforms would boost annual GDP growth by as much as 0.13% by avoiding future derivatives-fuelled crises. 

Some derivatives experts have questioned the findings, though, which could even be cynically interpreted as an exercise in self-validation... 

Craig Pirrong, professor of finance at the University of Houston, argues the group’s analysis is fundamentally flawed, as it evaluates derivatives regulations in isolation of the rest of the financial system and fails to account for spillover effects to other market participants.... 

The MAGD report reckons the regulations stemming from the G20 mandate of increased capital requirements, central clearing and initial margin for uncleared trades should be enough to prevent derivatives exposures from sparking future crises “absent the remote possibility of a CCP failure”. 

Using CDS default data, the group calculates the annual probability of derivatives fuelling a financial crisis at 0.26%. The Basel Committee has previously estimated the median cost of financial crises is 60% of annual GDP, meaning the implementation of the reforms should boost annual GDP by 0.16%. 

Meanwhile, the costs to the economy of higher collateralisation and forcing banks to hold more capital will reduce annual GDP by 0.03% to 0.07% depending on the amount of netting that can be achieved through central clearing, the group calculates. 

But Pirrong argues this is an overly-simplified analysis of the impact of derivatives market regulations, which only examines part of the picture. Overall, the concern is derivatives reforms merely redistribute losses elsewhere in the financial system in a way that may still undermine market stability. 

“The reforms do dramatically reduce systemic risk in derivatives markets. But they also have the effect of promoting derivatives counterparties to the head of the bankruptcy queue, which inevitably means somebody else will get less money,” said Pirrong.

Don't outsource bank risk management to global financial regulators

In an interesting ABA Banking Journal article, Dan Borge explains why he feels we should not outsource bank risk management to the global financial regulators.

Your humble blogger would offer a different reason for not outsourcing risk management to the bank regulators based on my experience working at the Federal Reserve and at a Too Big to Fail bank.

As demonstrated by our current global financial crisis, the global financial regulators are not very good at risk management and when they fail they have an irresistible urge to have the taxpayers pay for their failure.

By outsourcing bank risk management to the regulators, we interfere with how the financial markets are suppose to work.

For financial markets to work properly and risk to be restrained, banks must provide transparency into their current global exposure details.

With this information, market participants can independently assess the risk of and value each bank and adjust their exposures based on this assessment.  Then, bank management responds to market discipline as revealed through higher cost debt or lower equity share price that results from the adjustment in market participants' exposures and lower its risks.

Instead, we have a situation where financial markets don't work because risk management has been outsourced to regulators.

Leading up to the financial crisis and still to this day, banks have been allowed to remain opaque "black boxes".  As a result, they are not subject to market discipline.

Instead, banks are subject to regulatory discipline which they respond to by applying political pressure to get the regulators to back off or by gaming the financial regulations.

Regulators have besieged bankers with new and complex risk regulations in the aftermath of the financial crisis: Basel III; stress tests; risk-based compensation ... the list goes on. 

Whether all this regulation is making the financial system safer and healthier is debatable. 

But what is not debatable is that the regulators are taking a much more active role in asserting and enforcing their own notions of what constitutes excessive risk in banking.

Why have banks been exempt from recognizing losses since beginning of financial crisis?

On the sixth anniversary of the beginning of the global financial crisis, it is time to end the myth surrounding why banks have been exempt from recognizing losses from the crisis that they created.

I have chosen to write on this topic because recently I have been involved in a series of twitter exchanges where the justification given for a whole range of monetary and fiscal policies is based entirely on the assumption forcing the banks to recognize their losses would lead to a "disaster".

But is this disaster just a convenient myth spread by bankers or is it true?  And if it is true, who is it a disaster for?  Let's look at the question of who it is a disaster for first.

Is it a disaster for public and private borrowers?  No. They have their debt written down to a level that they can afford.

Is it a disaster for homeowners when neighbors have their debt written down and house prices decline? No.  Just like stocks, it is nice to sell at the top, but this is not guaranteed.  In the meantime, the neighborhood is better off as each of the owners can afford to maintain their property.

Is it a disaster for loan origination?  No.  Banks are senior secured lenders and having the debt written down means that the value of the assets pledged as security are not artificially inflated.  Lenders have to take into account this artificial inflation in price because it is likely to not be there when the collateral for the new loan is needed as a source of repayment.

Is it a disaster for the capacity to hold loans in the financial system?  No.  Selling loans out right to private investors (insurance companies, pension funds, hedge funds) or through syndication to other banks or securitization is commonplace in the US.  In Europe, the equivalent is the covered bond.

Is it a disaster for bank book capital levels?  Yes.  Bank book capital is the accounting construct through which losses on loans flow.  When losses are realized, bank book capital declines.

Is it a disaster for bank regulators?  Yes.  Bank regulators, through the bank examiners, attempt to determine if a bank is holding enough capital to absorb any losses that arise.  When their estimation of the probability of default (PD) and the loss given default (LGF) are too low, this is exposed when banks have to recognize their losses and bank book capital becomes a negative value.

Is it a disaster for bankers?  To answer this question, we also answer the question of is the notion of disaster just a convenient myth spread by bankers.

As Economist William White pointed out, if you ask a banker, there is never a good time to recognize their losses.  This is not surprising.  Bankers have an incentive to sell the disaster myth as recognizing losses would eliminate their bonuses.

But is it true that banks recognizing their losses would lead to a disaster?

The starting point for determining if  this is true is to look at the FDR Framework and see if banks are specifically exempted from recognizing losses.

The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Under the principle of caveat emptor (buyer beware), all market participants are responsible for all losses incurred on their investments.

The FDR Framework and its related legislation in the 1930s does not exempt banks from taking losses.

But what about any bank specific legislation like Glass-Steagall that was passed in the aftermath of the Great Depression or subsequently?

Again, legislation does not exempt banks from the consequences of their actions.  Legislation does however through deposit insurance exempt depositors from the consequences of the bank's actions.

But what happens if the losses at the banks are so big that disaster occurs?  Disaster for banks having large losses can only be that the taxpayers through the deposit guarantee would lose money should the losses be recognized.

Interestingly, this very scenario was planned for by the legislation that came out of the Great Depression.  By design, the legislation made banks special.  Unlike every other company, banks cannot go out of business unless the government steps in and puts them out of business.

Why can banks operate even when they have negative book capital levels or are insolvent (where the market value of the bank's assets is less than the book value of its liabilities)?

Because the combination of deposit insurance and access to central bank funding allows a bank to continue to operate.  Deposit insurance effectively makes the taxpayers the bank's silent equity partner when it has negative book capital or is insolvent.

Over the last 40 years there have been plenty of examples of banks that were insolvent but continued to operate for years.

Over the last 40 years there have been plenty of examples of banks that market participants knew would have had negative book capital levels if regulators had not intervened and prevented the banks from recognizing their losses.

Examples of banks like this include, but are not limited to, the money center banks with their exposure to loans to Less Developed Countries in the mid-1980s, US Savings and Loans with their concentration in low interest mortgages during a high interest rate period throughout the 1980s, and most recently all of the major global banks with their exposures to structured finance securities.

Please note that in each of these examples market participants were aware that the banks were or are hiding significant losses on and off their balance sheets.  Despite the existence of these losses, depositors continued to do business with these banks.

Why do business with an insolvent bank?

Because depositors don't care about solvency because of the deposit guarantee.

Why do bank regulators allow insolvent banks to continue to operate?

Because as long as the bank has the capacity to generate income in excess of its expenses it can use future earnings to rebuild its book capital level and return to solvency.  Plus the burden of paying for the disaster stays with the banks and not the taxpayers as retention of future earnings means the banks pay for their losses.

So if depositors aren't going to run and the banks are capable of generating income in excess of their expenses to pay for the losses incurred by the banks, what is the disaster lurking if banks are required to recognize their losses?

The disaster is it crushes banker bonuses.

Paul Krugman on what everyone got wrong about our current financial crisis

In his NY Times blog, Professor Paul Krugman discusses the three major issues that everyone has gotten wrong about our current financial crisis.

All modesty aside, it is publicly documented that I got each of these issues right.

Professor Krugman see these three issues as

a good way to get at the broader question of why recovery has been so sluggish. 

The starting point is that we had a monstrous housing bubble, and Janet Yellen recognized it in real time....

So did I.  So if recognizing a monstrous housing bubble in real time qualifies one to be Fed Chairman, then I am qualified.

It’s important to notice that just being willing to see the obvious here puts Janet Yellen way ahead of a lot of people who still presume to give us advice on the economy. 

But Yellen initially thought the damage from a bursting bubble could be contained, although she was starting to worry by 2007. 

Why was she wrong? Matt emphasizes the financial crisis — the way the bursting bubble created a run on the shadow banking system. And that’s clearly key to understanding the severity of the 2007-9 slump. 

Yes, it is critically important to understand the shadow banking system.

If one understands the shadow banking system you would recognize that we did not have a run.

When investors cannot value a security they are unwilling to lend against it.  To characterize an unwillingness to blindly bet as a run simply shows a lack of understanding of the shadow banking system.

Unfortunately, the economy didn’t come roaring back. Why? 

The best explanation, I think, lies in the debt overhang. For the most part, even those who correctly diagnosed a housing bubble failed to notice or at least to acknowledge the importance of the sharp rise in household debt that accompanied the bubble...

And I would argue that this debt overhang has held back spending...

Your humble blogger recognized the debt overhang and has been saying since the beginning of the financial crisis that banks need to recognize upfront their losses on this excess debt if the real economy is going to emerge from its economic malaise.

It is nice that a Nobel prize winning economist agrees with my analysis.

Finally, nobody really anticipated the disastrous response of policy, above all the squeeze on public spending at a time when we needed more government spending to sustain the economy until private balance sheets were repaired. 

Actually, I anticipated the disastrous policy response.  I even said what was needed as a policy response back in December 2007 before the financial crisis reached an acute stage.

Since then, I have used this blog to explain before a policy is adopted why it will not work to end the current financial crisis.

Given that Professor Krugman has established what it takes to be an expert on our current financial crisis who's opinion should be listened to, I look forward to talking with Professor Krugman and others on what it really will take to end this crisis.

Key problem with technocratic financial regulation: it doesn't work

Since the beginning of the financial crisis, global policymakers have indulged in an unprecedented ramp-up of technocratic financial regulation.

Technocratic financial regulation substitutes complex rules and regulatory oversight for transparency and market discipline.

There is just one key problem with this approach:  our current global financial crisis was the result of the failure of technocratic financial regulation and there is no reason to believe that technocratic financial regulation could be successful in preventing a future financial crisis.

The failure of technocratic financial regulation can be seen in the bailout of the banks.

Banks are "black boxes" into which only the banking regulators can look.  When they looked in the run-up to the financial crisis, the regulators told everyone that they had very little risk.

Whether this statement was the result of not being able to assess bank risk or they were concerned with the safety and soundness of the financial system is irrelevant.  What was relevant was the bank regulators failed to restrain bank risk taking.

When the financial crisis began, it was apparent to everyone that nobody, including the bank regulators, could tell which banks were solvent and which were insolvent and the most likely choice was all of the major banks were insolvent.

Policymakers acting upon the recommendation of the bank regulators choose to cover up the failure of complex rules and regulatory oversight to prevent the financial crisis.  The result was adoption of the Japanese Model for handling a bank solvency led financial crisis and protection of bank book capital levels and banker bonuses at all costs.

Given the global failure of technocratic financial regulation, there was and still is absolutely no reason to bet the financial system's stability on the bizarre notion that the outcome will be better next time.

This is particularly true because under the FDR Framework, the global financial system is designed to be anti-fragile.  Where there was transparency and market discipline, the global financial system functioned without need for government intervention even during the most acute phase of the crisis.

As Adam Levitin nicely summarizes technocratic financial regulation, it is:

Add two parts capital and one part co-cos, mix with risk retention requirements and garnish with macroprudential regulation...

In fact, as more and more complex regulations are enacted it becomes less and less clear that banks are becoming less as oppose to more risky.

The Financial Times reports on the conflict between simple bank capital leverage ratios and bank liquidity coverage ratios,

Can regulation make banks less safe? What has happened in the past week certainly seems to suggest so. 

Three large European banks – Barclays, Deutsche Bank and Société Générale – moved to partly dismantle one of their main bulwarks against another liquidity crisis: their massive cash reserves....

The bosses of all three banks sung the same refrain to explain the wind-down of cash and safe assets: It will help them boost their leverage ratio, a gauge of financial soundness that measures a bank’s equity against its overall assets....

Banks’ drive to reduce their liquid holdings reverses a trend that started after the collapse of Lehman Brothers in 2008. Since then, banks have tended to hoard large reserves of easy-to-sell assets. .... 

Regulators have pushed banks to do this as part of the lessons learnt from the global liquidity crunch of 2007-09. The first-ever global liquidity standards – an early element of the Basel III rule book called the liquidity coverage ratio – require banks to stockpile enough liquid assets to sustain their operations for 30 days if faced with another crisis....  

European bank executives might thus simply be using a reduction in their cash pools as a neat lobbying tool, trying to shock regulators into moderating leverage requirements. 

But even if that is the case, their key argument is worth listening to: Leverage ratios do not make a distinction between liquid, non-risky assets such cash on one side and high-risk, illiquid instruments such as complex securitisation products on the other. For leverage purposes, an asset is an asset. ... 

There is certainly a rationale for a leverage ratio threshold that will make banks safer by forcing them to hold more equity in relation to their assets. But it makes no sense to persist with definitions of leverage that clash with the objectives of liquidity rules.

Trader explains why dishonesty rewarded on Wall Street and only transparency can end bad behavior

In his must read Guardian column, Joris Luyendijk interviews a Trader from London's City who explains why dishonesty is rewarded on Wall Street and how only transparency can end misbehavior.

Regular readers know that sunlight is the best disinfectant.  The trader describes what happens when Wall Street and the City are left to operate behind a veil of opacity.

The trader presents petty theft as an every day occurrence.

"Where I worked people seemed obsessed with power structures and keeping on top. For instance when someone was made redundant a remaining trader would do a deal between his book and that person's, creating a profit in his book and a loss in that of the person leaving...."

Left unsaid is that the trader creating a profit in his own book has his compensation based on the profitability of his book.  From the bank's perspective, the position hasn't changed, just the payout.  So effectively, the trader has stolen money from the bank.

The trader explains how they use opacity to take risks knowing that if the bet pays off they are well compensated and if the bet loses they will just move on to the next bank.

"In the end the bank is like a shell. You need a place to trade from, this is how we saw our bank. Sometimes an entire team can be poached and go from one bank to another. There's no loyalty either way. And the top at your bank has no idea what's going on, how could they? Why would anyone tell them what's going on?

The trader explains Wall Street and the City's ethics.

"Of course traders are constantly inquiring across the bank: what's happening? What are our big clients like institutional investors doing? Then they 'front run' those investors; buying ahead of them so when the price rises due the subsequent buying, they pocket the difference. 

"Chinese walls [between deal making, asset managing and trading bankers]? Bullshit. We could simply log on to our system and see what was happening and what they were doing all the time. 

"If there is a lot of money at stake then people will not adhere outside rules and they will evade Chinese walls....

Next, the trader explains who Wall Street and the City use the complexity and resulting opacity of the financial products they sell to benefit at the expense of their customers.

"My advice to people dealing with the financial sector is: never buy anything that's complex. Because the more complexity the more opportunities there are to screw you over. 

Finally, the trader highlights how important the role of caveat emptor (buyer beware) is when dealing with Wall Street and the City.

Traders see the capital markets as a zero-sum game.  If they win, you must lose.

Individuals and small companies see their relationship with the bank as a partnership with the goal of both parties winning.  This makes individuals and small companies susceptible to being mistreated and sold products like interest rate swaps.

I just can't get my mind around how banks can still call clients in the corporate world and say, look we've got this great idea that's going to make you a lot of money. I mean, what are they thinking? 

Nobody in the City can be trusted because they don't work for you, they work for themselves. 

"I do wonder why there seem to be so many somewhat dishonest people in the bank, and why the most dishonest are often the ones to walk away with the most money."

Nuns and analysts alike recognize need for transparency into bank commodity earnings

Reuters ran an article highlighting the need for transparency as "for nuns and analysts alike, bank commodity earnings are a mystery".

The simple fact is that banks are not required to provide transparency.

Remember that under the 1930s Securities Acts, the government is given the responsibility for ensuring that all market participants have access to all useful, relevant information in an appropriate, timely manner so the market participants can independently assess this information and make a fully informed decision.

Commodities is one, but not the only area where the government is not fulfilling its responsibility of ensuring transparency to all market participants.

When the government does not fulfill its responsibility and ensure transparency, the market does not work properly as market participants are not able to assess and properly value risk.

Our current financial crisis is the result of market participants not having access to all the useful, relevant information in an appropriate, timely manner so that they could independently assess and properly value risk.

When the Reverend Seamus Finn got an email from Goldman Sachs last week, the giant Wall Street bank was addressing an issue that was already on his mind. 

"We were getting ready to go back to them and talk to them about commodities anyway," said Finn, who heads up faith-consistent investing for the Missionary Oblates, a Washington DC-based Catholic group that owns Goldman shares.... 

But it left unanswered many of Finn's questions about what the bank is doing in the sector.... 

The statement sent to Finn and later released widely did not address one of his broader concerns: that no one outside the banks themselves knows for sure how big their commodity trading arms are, how much they trade, or how much money they make. 

"We would like more disclosure on that," Finn said.

He is unlikely to get his wish. 

While the country's largest banks are required to disclose their activities in some consumer-facing businesses such as mortgages, there is no similar requirement for them to do so on the commodities side....

Please re-read the highlighted text as this experience not only applies to commodities, but also to all the other opaque areas of the financial system ranging from the banks themselves to Libor to structured finance.

"I don't think you have any banks that are properly disclosing commodities revenue," said George Kuznetsov, head of research and analytics at Coalition, a British consulting firm that employs more than 100 researchers to scrutinize public disclosures and conduct interviews to estimate trading revenues for investment banks. 

The issue is becoming increasingly important as politicians press the banks for more insight into the risks they are taking by owning metals warehouses or chartering oil tankers, and as some seek buyers for their physical commodities holdings. ...

The lack of clarity over trading operations has long been a vexing issue across other desks as well, such as foreign exchange and equities....

In sum, it's big money: the top ten global banks collectively made about $6 billion trading commodities last year, down 24 percent from in 2011, according to Coalition. 

The banks say that they are providing regulators and investors with all the information they are required to give. 

"Our disclosures are in line with all relevant reporting requirements and provide investors with all material information," said a spokesman for Morgan Stanley. He said the bank provides data on the main drivers of results across its three core business lines but does not break down earnings to a "product" level like commodities. 

Critics say the disclosures still leave much to be desired. 

"They really don't tell us much," said Robert McCullough, an energy economist who spent six years litigating an electricity market manipulation case against Morgan Stanley. 

"If you wanted an estimate of what their position was in electricity in 2001, six years of litigation was not sufficient to get it," he said.

To accurately assess the risk of a bank's commodity business, market participants need the bank's current exposure details.

Clearly, there is a significant gap between what market participants need to accurately assess risk and what the government has decided represents all the material information.

In terms of financial system risks, the Federal Reserve, which regulates banks, has the power to make on-staff visits and request data sets from the banks on their commodities activities. 

The agency also keeps on-site staff at the banks who are dedicated to monitoring commodities. 

So the government's solution is to give the Federal Reserve an information monopoly on all the useful, relevant information.

But that is not enough, according to some former examiners. 

"There's a sophistication gap between the regulator and the bank that they regulate," said Mark Williams, a former Federal Reserve bank examiner and energy executive who now teaches finance at Boston University. 

"The commodities are where the more sophisticated transactions take place," he said....

As Mr. Williams observes, the Federal Reserve is not up to the task of accurately assessing this information.  Even if it were, there is another problem: communicating this assessment to the other market participants.

If the Federal Reserve isn't capable of accurately assessing the information and the market participants who are capable of assessing the information don't have access to the information, then the result is that there is no one overseeing and exerting restraint on the banks risk taking.

This is a prescription for banks to take on excessive risk and engage in bad behavior.

As has been shown numerous times since the start of the financial crisis, bankers were and still are only too willing to fill this prescription by taking on excessive risk and engaging in bad behavior.

Goldman Sachs, for instance, reported only $100 million in "commodity and other" trading revenues to the Fed in 2012. In a separate filing with the SEC, the bank said it made $575 million trading commodities. Industry sources actually pegged Goldman's commodity revenues closer to $1.25 billion for the year. 

Asked about the different figures, a spokesman for Goldman Sachs said: "We disclose figures in the way we are required. That may not correspond to the way we actually measure the performance of certain trading businesses." He declined to provide a figure for the bank's commodity trading revenues....

With so much uncertainty around the headline numbers, attempting to separate banks' paper bets on commodities from physical trading - the segment most at risk from regulators - is all but impossible....

That hasn't stopped some influential groups from calling on banks to step up their reporting. 

Last year, the CFA Institute - which confers the Chartered Financial Analyst credential to investment professionals worldwide - endorsed a report calling for banks to improve their risk disclosures to investors. 

Banks' trading books, in particular, remain "very opaque" to investors, said Vincent Papa, the institute's director of financial reporting policy. 

"In many cases, they give you a figure which they deem to be meaningless from an internal management standpoint," Papa said. "They just give it for compliance reasons. That's not beneficial to investors. It's about giving relevant information, rather than just ticking the boxes."...

Paul Volcker explains how to fix big banks and financial system

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

Mr. Volcker observed:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Who should bear the pain?

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

The activity by regulators was unnecessary.

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

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

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

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

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

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

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

Did capitalism fail?

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

Their response was no.

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

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

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

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

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

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

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

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

However, this was not his conclusion.

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

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

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

But is the government up to this task?

Political scientists Nolan McCarty and Keith Poole would say no.

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

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

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

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

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

What happened after the 2008 crisis? 

Widespread illegality was left unpunished. 

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

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

Truth of transparency and liquidity

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

As I mentioned above, it is not that complicated. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Swallowing the bankers' line

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

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

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

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

There are three possible explanations for what has gone wrong. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Old-fashion regulators miss the foundation of finance

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

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

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

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

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

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

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

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

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

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

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

So what’s the problem? 

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

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

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

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

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

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

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

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

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