Frantic rule-writing won't prevent next banking crisis

In his Bloomberg column, Clive Crook identifies why the current effort to create dozens of complex regulations to be overseen by regulators won't prevent the next banking crisis:

The emerging framework of regulation is no great departure from the one that failed in 2008 (USRINDEX). 

There’ll be no reinvention of finance -- it will be business mostly as before, within slightly tighter (and far more complicated) bounds. 

Rethinking from first principles? Maybe next time.

There’s been no political pressure to address this tough problem. 

Calls for bolder financial reform have come mostly from people who want to punish Wall Street and put bankers in jail -- an understandable sentiment, but also a distraction. 

Calls for more capital and a new Glass-Steagall fit the evil-banker template, so something, however inadequate, is happening. [Unfortunately, it too is a distraction.]

Please re-read the highlighted text as Mr. Crook has nicely summarized what your humble blogger has been saying since the beginning of the financial reform process.

Thanks to the Geithner Doctrine of do nothing that will hurt the profitability of a large or politically connected bank, there was no investigation into the causes of the crisis from a Pecora-type commission.  

Both the US' Financial Crisis Inquiry Commission and the UK's Commission on Banking Standards were given limited resources and time to investigate our current financial crisis.  More importantly, the decision on what financial reforms to pursue was made before these investigative bodies had submitted their conclusions and recommendations.

By definition, this precluded basing financial reform on addressing what actually caused the financial crisis, opacity, and returning to first principles, transparency.

Remember why Glass-Steagall was passed is a story about need for transparency

In his Bloomberg column, James Greiff succinctly summarizes why Glass-Steagall was passed in the 1930s.  The story he tells also applies to the adoption of transparency as the foundation of our financial system.

Regular readers know that our financial system is based on the FDR Framework.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under this framework, governments are given the responsibility for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Under this framework, market participants are responsible for all losses on their exposures.  As a result, they have an incentive to use the information disclosed to assess risk and limit their exposures to what they can afford to lose.

By design, this framework makes it possible to invest rather than just gamble when buying or selling a security.

The investment process has 3 steps:

1. Independently assess the information disclosed on an investment to determine its risk and value;
2. Solicit prices from Wall Street;
3. Compare the prices provided by Wall Street to the independent valuation and make a buy, hold or sell portfolio management decision.

If the government fails to require all the useful, relevant information be disclosed in an appropriate, timely manner, then market participants cannot go through the investment process.  If market participants cannot go through the investment process, making buy, hold or sell decisions is simply gambling on the value of the contents of a brown paper bag.

It seemed like a good idea at the time. After making loans to borrowers who were unable or unwilling to repay them, one of the nation's biggest banks came up with a solution: Take the loans, repackage them and sell them to customers and, in effect, bail out the bank from its money-losing positions. 

As for telling investors about the distressed state of the borrowers, well, why bother? 

The head of J.P. Morgan, perhaps the most respected banker of his era, had already sounded the tocsin about the consequences of deteriorating credit standards. ``A warning needs to be given against indiscriminate lending and indiscriminate borrowing,'' he said. 

Yes, this is a trick. The banker wasn't Jamie Dimon, chief executive officer of what now is JPMorgan Chase & Co.; it was Thomas W. Lamont, speaking in 1927. And the bank selling securities in the bum loans wasn't one of today's too-big-to-fail behemoths, but National City Co., the predecessor of Citigroup Inc.

These anecdotes come from a report issued in 1934 by the Pecora Commission, which was charged with digging into the financial industry's misdeeds in the run-up to the stock market crash of 1929. 

The commission's hearings and findings provided a rationale for many of the laws adopted in the 1930s to regulate banking and the securities markets, including the Glass-Steagall Act, which forced banks to split their lending and securities businesses.

Please note that Mr. Greiff chose a story that is really about securitization transactions (sound familiar? think subprime RMBS) and the need for disclosure so that investors could know what they were buying or know what they owned. 

Economist magazine discovers we still have zombie banks throughout global financial system

The Economist magazine captures the state of the global financial system when it observed

[it] is in a terrible state, and nothing much is being done about it.

But the problem doesn't end with the global financial system.  It extends to the global economy.

Regular readers know that policymakers and financial regulators chose to pursue 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.

The costs of this protection include transferring the burden of the excess debt in the financial system onto the real economy where it diverts capital needed for reinvestment, growth and supporting the social programs to debt service.

The result is economic malaise and re-writing the social contract.

Regular readers also know that there is a proven solution for handling and ending a bank solvency led financial crisis:  the Swedish Model.  Under the Swedish Model, banks are required to recognize upfront their losses on the excess debt in the financial system.  This protects the real economy and the social contract.

Our modern banking system is designed to support adoption of the Swedish Models.  Specifically, banks are capable of continuing to support the real economy even when they have low or negative book capital levels.

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

The zombie banks and economic destruction caused by these banks that the Economist finds are the result of pursuing the Japanese Model.

Banks are central to Europe’s prospects.

Since banks are central to Europe's prospects, it is important to understand how they are designed and to realize that the designers understood that there would be a time when excess debt once again existed in the financial system.

So the choice to have zombie banks is entirely the policymakers and financial regulators.

The fear, especially in peripheral economies, is a repeat of Japan’s experience in the 1990s, when “zombie” banks staggered along for years, neither healthy enough to lend to firms nor weak enough to collapse.

Given that global policymakers and financial regulators chose to pursue the Japanese Model, it is guaranteed that Japan's experience with zombie banks would occur in the EU, UK and US.

There are the same unvital signs in Europe. The average price-to-book ratio for European banks remains below one, suggesting that investors think lenders are worth more dead than alive.... 

Weren’t the Europeans supposed to be cleaning up their balance-sheets?...

Regulators worry that banks, rather than writing off or selling bad loans, have been fiddling with the models that dictate how much capital they need to hold. Danske Bank, a big Danish lender, was abruptly ordered by its supervisor to change its calculations last month, lowering its capital ratio. Denmark is outside the euro, but even German politicians joke about the nasty surprises in their banks’ balance-sheets.

None of this presages a full-scale collapse: European banks have more capital than they did before the start of the crisis. But lending is being throttled....

All of this applies in the UK. In the US, price to book is slightly higher, but these banks aren't lending either.

Please note that while lending is being throttled, banker pay has not been.

The second cure involves lifting the cloud of suspicion over European banks. 

The ECB will undertake an “asset-quality review” before it takes up the role of euro-zone banking supervisor next year. 

Previous stress tests by national supervisors were not tough enough—and convinced nobody. 

The asset-quality review is the ECB’s first and best chance to establish its credibility. 

Banks that fall short must be recapitalised—by raising fresh equity from private investors, by bailing in creditors and, in some cases, by bringing in public money. 

An asset-quality review suffers from the same problem as a stress-test.  Nobody believes the results.

Ireland did both with its banks and nobody believes the banks are solvent.  Greece and Spain have also done asset-quality reviews and stress-tests.

The reason that asset-quality reviews and stress-tests are not believable is that they are not accompanied by the requirement that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is needed so that market participants can independently confirm the results of the asset-quality review and stress-test.

Without the ability to independently review the results, a big red flag is waved in front of the market participants that says don't trust the results.

Regulators request recovery plans from TBTF banks that shows why regulators fail

Regulators have asked the Too Big to Fail banks to document how they would respond to a series of events that would trigger the need to raise capital without relying on a taxpayer funded bailout.

This request for useless documentation is the classic example of why tens of thousands of pages of complex regulations and regulatory oversight fail to protect the stability of the financial system as well as transparency and market discipline.

The world's top banks must spell out what would trigger capital raising and other steps to survive a crisis without needing taxpayer money, a global regulatory body said on Tuesday. 

The Financial Stability Board (FSB) published final guidance for lenders and supervisors listing "triggers" that would force a bank to consider action to shore up its capital, such as writing down its bonds.... 

Compared with a draft version put out to consultation, the FSB has given banks a bit more leeway, saying that hitting a trigger should not automatically require rescue action. 

The British Bankers' Association (BBA) had told the FSB that the word "trigger" implied the need for an automatic response. 

Instead, banks will have to say in advance what happens once a trigger is hit, such as how the issue will be escalated to a top executive or the bank's board....

Without requiring the banks to take immediate action and recapitalize themselves once a trigger is hit, how exactly does this documentation reduce the chances of a taxpayer funded bailout?

By backing off the need for an automatic response, the global financial regulators demonstrate just how captured they are by the TBTF banks.

"The aim of triggers in recovery planning is to enable firms to maintain or restore financial strength and viability before regulatory authorities see the need to intervene or enforce recovery measures," the FSB's new guidance said. 

Our current financial crisis established that global regulatory authorities won't "see" the need to intervene or enforce recovery measures before bailing out the TBTF banks is the only option.

A recent example of the global regulatory authorities' inability to "see" a problem within a bank was JP Morgan's London Whale trade.  None of the global regulators supervising JP Morgan identified the trade as a problem before it was written up by the press.

Knowing they will never "see" the problem before the global regulatory authorities consider a taxpayer funded bailout necessary, the global regulators have asked the banks to identify for the authorities triggers where the banks can take action that might make the bailout unnecessary.

Given how nicely the bankers have been treated in the current financial crisis (no interruption in bonus payments), what exactly is their incentive to find triggers and take actions after they are breached that would make a taxpayer funded bailout unnecessary?

"Firms should be required to provide supervisors and resolution authorities with an explanation of how the trigger calibrations were determined and an analysis that demonstrates that the triggers would be breached early enough to be effective." 

Triggers can include a credit rating downgrade, a fall in capital ratios, a run on deposits or being asked to post more collateral to back trades.

To summarize the intent of this complex regulation: its a good idea that a top executive or the bank's board should be notified if the bank has a credit rating downgrade, a fall in capital ratios, is asked to post more collateral to back its trades or has a run on its deposits.

Commerzbank loan sale highlights need for transparency

As Bloomberg's Jonathan Weil pointed out in his article, Commerzbank loan sale hides as much as it reveals.  Specifically, it raises the question of what the bank's loan portfolio looked like before the sale and what it now looks like?

Is the riskiness of the loan portfolio unchanged as a result of the sale?  Did it decline?  Did it increase?

Without the bank disclosing on an ongoing basis its current exposure details, market participants have no way to assess any change in the bank's risk profile.

This is why banks must be required to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

Commerzbank AG, Germany's second-largest bank, today said it is selling 5 billion euros ($6.5 billion) of loans to Wells Fargo & Co. and the private-equity firm Lone Star Funds at a 3.5 percent discount to book value.... 

Commerzbank's balance sheet still has little credibility with investors.... the market continues to believe that most of the bank's book value is illusory. The stock is down 33 percent since the end of last year. 

Sure, it's nice to see that a couple of outsiders were willing to pay something close to book value for a block of the bank's loans.....

Because the transparency of Commerzbank's financial statements is so poor, investors can't see if Commerzbank might have sold its best loans and kept the worst ones stashed on its books at inflated historical values. During the 1980s U.S. savings and loan crisis, this practice was known as "gains trading," although the term doesn't fit this situation, given that Commerzbank is recording a loss. 

To be fair, the lack of transparency at Commerzbank isn't unique. It's a problem at most large banks, especially in Europe.

Adair Turner: has financial capitalism failed the world?

Adair Turner, a former chairman of the UK financial services authority, tried to answer the question of "has financial capitalism failed the world?"  His conclusion was no, financial capitalism had not failed the world but rather that financial regulators and central bankers were responsible for letting too much leverage enter the financial system.

Mr. Turner is headed in the right direction when he places the blame for the failure of the financial capitalism at the feet of financial regulators and central bankers.

The problem however was not the amount of leverage they allowed into the financial system.  This leverage was simply a symptom of the underlying problem: opacity.

Opacity in the financial system made it impossible for market participants to understand exactly how much risk was building up and where it was building up.

For example, bank disclosure leaves them in the words of the Bank of England's Andrew Haldane resembling "black boxes".  Only the financial regulators know what is inside the box.

Because of opacity, other market participants have no way of assessing how much risk the banks are taking.  As a result, they cannot exert discipline by linking risk and a bank's cost of funds to restrain risk taking.

This leaves the financial system dependent on the financial regulators accurately assessing the risk of the banks and taking steps to restrain the overall level of risk in the system.

Clearly, as shown by our current financial crisis and the CFTC's admission they did not catch JP Morgan's London Whale trade, the financial regulators are not up to this task.

Mr. Turner proposes banks hold more capital as the solution.

Higher capital ratios don't solve an opacity problem.

What solves an opacity problem is transparency.

Why does anyone pay economists for their work?

Dean Baker looked at the state of economic debate and the accuracy of economists' predictions of economic performance and asked a very important question: "why does anyone pay economists for their work?"

This is a very important question because leading up to and since the global financial crisis began on August 9, 2007, both the accuracy of their predictions of economic performance and their policy recommendations have been terrible. (This has also been true of economists with respect to Japan in the run-up and subsequent to its credit bubble bursting.)

Why has the economic profession's performance been so abysmal?

Your humble blogger's theory is that this performance reflects the fact that leading up to the financial crisis economic models effectively excluded the financial sector and subsequent to the financial crisis the economic models don't know how to handle the distortions caused by the excess debt in the financial system.

Mr. Baker points out the natural conclusion when one looks at this terrible performance:

This says everything anyone needs to know about the quality of economic debate. It is complete nonsense....

why don't we just save a few bucks and fire all the damn economists. 

Let's shut down the econ departments in universities, the Fed's research department, the I.M.F., the OECD. Let's get real, no one cares about economics....

John Authers on best case for reviving Glass-Steagall

In his Financial Times column, John Authers looks at why Glass-Steagall should be revived and finds that the compelling reason for reviving the Act is it was accompanied by 7 decades of financial stability with few, if any, bank runs and economic growth.

Unfortunately, this falsely attributes to Glass-Steagall the stability that transparency brought to the financial system.

Our current financial crisis occurred and is still occurring in all the opaque corners of the financial system.  Opaque corners of the financial system include banks and structured finance securities.  For example, the unsecured interbank lending market froze and has remain frozen.  Or for example, despite 5 years of monetary policy designed to get investors to chase yield, the market for new private label RMBS deals is a rounding error compared to its peak size.

On the other hand, the transparent parts of the financial system continue to operate without the need for government intervention.  An example of this is the global stock markets.  For every seller, there has been a willing buyer.  The price might not have been what the seller wanted, but there was a buyer.

Am I saying the industry structure had no impact on the degree of transparency in the financial system?

No.  I am saying that the change in the industry structure as a result of repealing Glass-Steagall had a negligible impact, but the structure itself had a big impact.

At the time Glass-Steagall passed, the standard for banks was to disclose their current exposure details.  Ultra transparency was seen as a sure sign of a bank that could stand on its own two feet.

This all changed with the introduction of deposit insurance and bank regulators who had access to all the current exposure details on a 24/7/365 basis.

Since the regulators were already getting this information from the banks, the SEC asked the regulators whether the banks needed to continue to provide this information to all market participants.  The regulators answered no.

As a result, over time banks became "black boxes" and were no longer subject to market discipline (it takes a long time to go from providing a sure sign of the ability to stand on your own two feet to acceptance of the idea that hiding behind a veil of opacity is acceptable).

So from a historical perspective, banks become opaque black boxes while Glass-Steagall was still in place.

Next, we have the emergence of securitization.  Securitization, packaging loans into securities that were purchased by investors, also arrived while Glass-Steagall was still in place.

Initially, securitization was confined to assets backed by a government guarantee (think GSEs).  As a result, transparency into the performance of the underlying collateral was unnecessary.  The risk of credit loss was borne by the government.

Unfortunately, this lack of transparency carried over into non-government guaranteed asset classes (think sub-prime mortgages).  Here, the investors needed observable event based reporting under which any activity like a payment or delinquency involving the underlying assets was reported before the beginning of the next business day so that the investors could know what they owned or know what they were buying.

Ironically, securitization with its opaque securities helped to drive repeal of Glass-Steagall.  Quite simply, Wall Street used securitization with its cheaper funding to take away the lending business from the banks.  Wall Street financed firms to originate the assets that were packaged into the securities.

Repealing Glass-Steagall let the banks compete on a level playing field and steal business from Wall Street (or at least that was the theory).

Am I saying that transparency is the only cause of financial stability?

No.

What our current financial crisis has shown is in the absence of transparency complex regulations and regulatory oversight doesn't lead to stability.

There is nothing surprising about this finding.  Regular readers know that our financial system is built on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Transparency is the foundation that allows regulation and regulatory oversight to contribute positively to financial stability.

Finally, as I have said before, I can support a return of Glass-Steagall if the result is that it weakens the financial industry's lobbying power so that banks are required to once again provide ultra transparency into their exposure details.

Yet another bank hides behind opacity to mislead investors

A recurring theme since the beginning of the financial crisis has been how banks have hid their true financial condition behind a veil of opacity and used this to take advantage of other market participants.

These participants include, but are not limited to, taxpayers and central bankers through bailouts (see Anglo Irish), depositors who were mis-sold investments (see Bankia and the other Spanish cajas) and investors.

The Telegraph reports how the Co-op bank mis-led pensioners about its true financial condition.

In emails seen by The Sunday Telegraph, a manager at the Co-op Bank told a worried pensioner that “there is no need to be concerned” about a £50,000 investment. The email was sent on May 13, just three days after the ratings agency Moody’s downgraded the bank to “junk” . 

The following month, the Co-op suspended interest payments to pensioners and told savers they faced losses of at least 40pc on their investments. The bank also said it had a £1.5bn capital shortfall. 

The pensioner wrote: “I am a member of the Co-operative Group and my wife and I ... are extremely fearful that we are about to lose all of this very important retirement savings nest-egg, the income from which we rely upon. We are very, very worried.” 

The manager replied: “There is no need for you to be concerned. We do acknowledge the need to strengthen our capital position ... and we have a clear plan to drive this forward. I hope this provides some reassurance.” 

At that point, the bank was in discussions with the regulator about the size of its capital shortfall. A month later it revealed it needed £1.5bn, £500m of which was to come from enforcing losses on bondholders. 

Including large investors, the bondholders have £1.3bn of debt, £65m of which is with 15,000 pensioners and small savers. 

One of the primary reasons for requiring the banks to provide transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details is to end bankers mis-leading anyone about their current financial condition.

Robert Jenkins: "banks have bamboozled government" with false tradeoffs

Former Bank of England Financial Policy Committee member Robert Jenkins said that "banks have bamboozled government" with false tradeoffs.

As reported by Bloomberg,

banks have wrongly convinced government that measures to improve the safety of the financial system will curb growth. 

“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,” Jenkins said in an interview. “These are all false choices.”

Regular readers know that the best example of where the banks wrongly convinced government is the need to protect bank book capital levels including the use of taxpayer bailouts to recapitalize the banks.

Bankers argued that if they had to absorb losses on the excess debt in the financial system they would not be able to make new loans to support the economy.  As shown by the US during the Great Depression, Sweden during the 1990s and Iceland with the current financial crisis, this tradeoff does not exist.

The banks recognizing the losses upfront on the excess debt in the financial system protected the real economy and set the stage for growth in the real economy.  This growth was supported by loans originated by the very banks that had taken the losses.

How was this possible?

Regulators recognized that because of the combination of deposit insurance and access to central bank funding the banks could continue to operate even with low or negative book capital levels.  While operating, the banks generated earnings that could be used to recapitalize the banks over several years.

Asked what surprised him the most while at the Bank of England,

 Jenkins said what surprised him most during his time on the panel was the absence of a “banker-statesman” among the current crop of British bank chief executives. 

“Name one who has acknowledged the industry’s failings, embraced the need for reform and then got out and worked with wisdom, humility, selflessness and objectivity to structure a sound, stable and fair financial system,” he said. “Most have fought the regulatory agenda. None has got out in front of it -- much less set it. Society deserves better of the financial leaders who claim to be serving society.”

The absence of a banker-statesman is not surprising.  It is entirely consistent with an industry that has compensated its members for developing opaque, high margin products.

If you want a banker-statesman, you have to require the banks to provide transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this level of disclosure, sunshine can act as the best disinfectant.