BBC's Robert Preston searches for how to restrain bank risk taking

In a terrific column, the BBC's Robert Preston examines how both bank regulators and Basel capital requirements failed in the run-up to the financial crisis and asks what can be done to restrain bank risk taking.  Mr. Preston proposes a cap on bank leverage as a solution.

Regular readers know that the only way to restrain bank risk taking is to subject the banks to market discipline by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is not the size of the bank nor the leverage that it has, but the riskiness of all of its exposures that needs to be restrained.

Leverage is the ratio between what banks lend and invest on the one hand and the capital they hold to absorb potential losses on their loans and investments. 

So all else being equal, which they never are of course, a bank with a lower leverage ratio is a safer bank, because it has relatively more capital to protect depositors from losses.

But that doesn't necessarily mean that you should always place your precious savings in the bank with the lowest leverage ratio: the bank with the low ratio might be lending and investing in a particularly reckless and risky way; although it might have more capital than other banks, its losses might turn out to be massively bigger than those other banks. 

That's why a low leverage ratio is not a guarantee that a bank is safe..... 

Please re-read the highlighted text as Mr. Preston makes a very important point that a bank's leverage ratio is not necessarily a good indicator of how much or little risk it has.

Dexia confirms this.  Dexia had one of the lowest leverage ratios as measured by the Basel capital requirements in the EU shortly before it was nationalized.

Here are the important points: riskier loans and investments provide bigger rewards to banks, until the loans and investments go bad; and capital is expensive for banks. 

Which is why governments did not trust banks to behave prudently if they were subject to a simple gross leverage restriction. 

The assumption was that if every bank was told it could not lend - for example - more than 20 times its capital, large numbers of those banks would lend everything they could to reckless gamblers prepared to pay the highest interest rates, till gamblers and banks went bust. 

Instead governments hired regulators to check that banks were not taking insane risks. And the regulators invented the Basel system of risk-weighted capital ratios, which stipulates different leverage ratios for different categories of loan, in theory to take account of the riskiness of those loans. 

To put it another way, governments set up a system that in effect treated bankers as naughty children or ravenous puppies who could not be trusted not to eat too much of the dangerously fattening stuff - and regulators were to be the health conscious parents. 

The perhaps predictable result is that the bankers lived up to the low expectations of their common sense, and devised ever more clever ways to raid the biscuit tin without being seen. And the regulators turned out to be the worst kind of parents: ignorant of what was really happening in the world; prescriptive in all the wrong ways....

In the many hundreds of pages of Basel rules in their assorted iterations since the 1980s, each bank became an amalgam of hundreds of different leverage ratios, reflecting the perceived riskiness of the different categories of the loans it made and indeed of the age and size of the bank....

With good intentions on the road to ruin, regulators through the Basel rules were trying to provide a framework in which the risks and rewards of lending were properly captured. 

In practice they did precisely the opposite: the Basel system provided the following arguably insane incentives: 

1) banks had incentives to become bigger and bigger, to benefit from "advance" status that rewarded them with relatively lower capital requirements; 

2) banks had a disincentive to know their corporate and personal customers, but instead had an incentive to insist that each loan was a mortgage backed by property - thus encouraging a dangerous boom in property lending; 

3) banks had an incentive to become huge in trading loans and investments; 

4) banks had incentives to convert risky loans into opaque AAA bonds that appeared - spuriously - to be safe. 

In other words, regulation in the form of the Basel rules contributed directly to so much that is wrong with today's banks....

Please re-read the highlighted text as Mr. Preston has nicely summarized why when it comes to restraining bank risk taking the combination of complex rules and regulatory oversight doesn't work.

Besides, all of the Basel capital requirements have been designed to provide opacity so that banks can increase their leverage and their return on book equity.

And the big banks could stick to the letter of the Basel rules and appear to be sound, when in fact they were massive, fiendishly complex and impenetrable institutions taking insane risks....

Please re-read the highlighted text as Mr. Preston makes the case for why banks should be subjected to market discipline and required to provide ultra transparency.

With ultra transparency, banks cannot hide behind the facade of appearing sound under either the complex Basel capital requirements or leverage ratios.

With ultra transparency, banks are no longer impenetrable institutions and their complexity and risks are exposed.

Now the 2008 Crash made it impossible any longer to pretend that the system of keeping banks on the straight and narrow was working. 

But government's response has been a bit skewed and odd. 

On the one hand, the collapse of the financial system has been taken as proof that bankers are incorrigibly, irredeemably naughty children. 

By contrast, there is a presumption that the regulators who got it so wrong - the useless parents - can be redeemed.

Who can forget former Treasury Secretary Tim Geithner assuring us that the regulators had learned their lesson from the 2008 Crash?

Actually, the response of the regulators and policymakers was predictable because they are simply continuing with their existing policy of financial failure containment and its corollary, the Geithner Doctrine.

One consequence is that the Basel rules that were so hopelessly flawed have been redrafted, and in the process have become even more complicated and impenetrable. 

And regulators have been given more powers to interfere in banks, to supervise them, and deter them from misbehaving. 

Some might say that the banks have been punished, and the regulators - who arguably were just as much at fault - have been rewarded.....

Actually, neither the banks or the regulators have ever been punished.

Which brings us back to where we started, the bloomin' gross leverage ratio. And it is to ask the question whether the global financial system, and the economies of developed countries like Britain, would be in such dire straights if banks had been subject to a simple leverage ceiling, limiting how much banks could lend in total, irrespective of the nature of their loans, as a multiple of their capital....

It brings us back to the issue of how to restrain bank risk taking as Mr. Preston has already acknowledge that a bank with a low leverage ratio can be carrying substantially more risk and incur far greater losses than a bank with a higher leverage ration and lower risk profile.

All that said, some might argue that this important debate still misses the big point. Because any leverage ratio is being seen - in Basel and Westminster - as a backstop, or only a bit of background insurance in case the Basel rules prove inadequate yet again. 

There is no serious discussion of the idea that a low leverage ratio should be the first line of defence, and that the Basel risk-weighting rules should be less prescriptive and more in the form of guidance....

The entire discussion needs to be taken off of leverage ratios or Basel risk-weighting rules.

The discussion needs to be focused on requiring the banks to provide ultra transparency and disclose on an ongoing basis their exposure details.  It is the exposure details that reveal the risk a bank is taking.

Ultimately, it is the amount of risk that a bank takes that needs to be restrained.  And the best way to limit bank risk taking is to have the investors who are first in line for absorbing any losses exerting discipline to restrain bank risk taking.

All of which is perhaps to point out that the terms of the debate about how to sanitise the bloated financial system have been set by a regulatory community whose legitimacy should perhaps have been destroyed but which still seems (amazingly?) to be in loco parentis.

Please re-read the highlighted text as Mr. Preston confirms Jeff Connaughton's observation about why Wall Street always wins.  The Blob (aka, policymakers, regulators and Wall Street's lobbyists) set the terms of the debate.

Do you think it is by accident that transparency is not in the discussion by regulators and policymakers as a means for restraining bank risk taking?

Regulators begin to think that maybe market should be used to value securities

Bloomberg reports that away from the bank cheerleading at Davos, financial regulators might have suddenly realized that the best way to limit the variation in values banks put on their assets is to require disclosure and let the market value the assets instead.

Regular readers know that your humble blogger has been calling for regulators to take this step and require banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, the market can value each of the bank's exposures and exert discipline on the banks if the banks' valuation of the exposures for calculation of the riskiness of their assets strays from the market's.

Global regulators may impose restrictions on the way lenders model risk and assign capital after a review of banks’ trading practices found wide differences in their number crunching. 

A probe of banks’ calculation of the riskiness of their assets found “material variation” across the industry, Stefan Ingves, chairman of the Basel Committee on Banking Supervision, said in a speech in Cape Town. 

Regulators could respond with tougher disclosure rules or “limitations in the modelling choices for banks,” Ingves said in the prepared remarks today. 

“The committee’s work on how banks calculate risk weighted assets also feeds into a broader concern that, in pursuit of risk sensitivity, the Basel III framework has grown too complex.” 

BoE's Andrew Haldane: changes coming to "too complex" bank capital rules

Reuters reports that the Bank of England's Andrew Haldane has told British MPs that changes are coming to both "too complex" bank capital regulations and bank accounting rules.

In both cases, the changes are aimed at getting the regulation and rules to better reflect reality.

Regular readers know that even though these are steps in the right direction, at the end of the day we are still talking about the combination of complex rules and regulatory oversight being substituted for the combination of transparency and market discipline.

The number one lesson from the financial crisis is that the combination of complex rules and regulatory oversight doesn't work and the continued pursuit of this combination will result in another financial crisis.

Requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details would be far more effective in preventing future financial crises than the modest improvements Mr. Haldane is suggesting might occur in bank capital regulations and accounting rules.

Bank capital rules coming into force this month are too complex and efforts to simplify them are already underway, a senior Bank of England official said on Monday. 

Andrew Haldane, the bank's director of financial stability, was among the first senior regulator to question Basel III, the world's core regulatory response to the 2007-09 crisis, that led to banks being bailed out by taxpayers. 

Basel III, agreed by world leaders, forces lenders to hold more capital, but Haldane says it is too complex and relies on banks using their own models to determine capital buffers. 

He told British MPs there was an increasing awareness among international regulators they may have taken a "false turn in the road" by backing Basel III which was written by the Basel Committee. 

"Regulators cannot really police this complex beast," Haldane said. "There are moves afoot with the Basel Committee to seek ways to simplify and streamline the move to a proper regulatory rather than self-regulatory edifice. That may take some time."....

Regulators can't police even the simplest bank capital rules.  It frankly isn't in their job description.

The question that financial regulators ask is 'does the bank have enough capital to absorb the potential losses from the exposures on and off its balance sheet?'  The answer is either the bank has enough capital to absorb the potential losses or it does not regardless of what its capital ratio might be.

That global financial regulators have a tough time answering the capital adequacy question has been shown many times over the last few years when banks that passed the regulators' stressed tests subsequently needed another bailout or to be nationalized.

The Basel Committee said earlier this month work on reviewing in-house models would be accelerated this year. 

"There is a big straw in the wind ... The big trend here is the retreat is from in-house models," said Simon Gleeson, a financial lawyer at Clifford Chance....

But Haldane said Britain won't wait for Basel's work to finish and the Financial Services Authority watchdog was already forcing banks to use simpler models for totting up risks from commercial property on their books. 

"There is no reason why they could not do that across a wider set of portfolios," Haldane said. 

There was also nothing to prevent UK regulators from imposing "floors" below which capital levels could not fall irrespective of what internal models show, Haldane added.

All of this is simply rearranging the deck chairs on the RMS Titanic.

He is member of the bank's Financial Policy Committee (FPC), which sets the tone and direction for regulation in Britain. From April, the bank becomes the regulator for lenders.

There was also support on the FPC for a higher leverage ratio or balance-sheet cap on banks than the 3 percent set under Basel III, he said....

Accounting rules used in the EU, drawn up by the International Accounting Standards Board, were also "not as prudent as they could and should be for financial firms," he said, arguing the rules failed to ensure banks make early provisions on souring loans and also lead to under-recognition of losses. 

Reforms to accounting rules put forward by the IASB and its U.S. counterpart were still "unfinished business" and therefore Britain was asking banks directly to make bigger provisions than they need to under accounting rules. 

"We are working privately with FSA and auditing firms to see if we can't at least provide better disclosure about fair value gains and losses than is the case right now," Haldane said. 

The UK authorities are thrashing out a "prudent valuation framework" to put a price tag on illiquid or toxic assets, and force banks to make deductions from their capital buffers.

Excuse me, but it is the role of the markets and not the financial regulators to value financial securities.

Since the beginning of the financial crisis it has been abundantly clear that the market cannot value opaque securities like the 'black box' banks or the 'brown paper bag' structured finance securities.

Common sense suggests that the regulators' time would be better spent bringing transparency to all the opaque corners of the financial system rather than creating unenforceable regulations.

"We might in time be able to inject a notion of prudent valuation into accounting," he added.

Actually, if banks were required to provide ultra transparency it would be unnecessary to inject the notion of prudent valuation into accounting.

Market participants would simply adjust each banks' accounting numbers for the difference between the actual value of the bank's assets and the reported value.

Time to rethink regulatory reform and replace it with ultra transparency

The American Banker ran an interesting article on all the complex rules that are being implemented as a result of the Dodd-Frank Act and Basel III and asking if there is a better solution.

Regular readers know that all these complex rules and increases in regulatory oversight are a substitute for the simple solution of transparency and market discipline.

As I have said numerous times, with the exception of the Consumer Financial Protection Bureau and the Volcker Rule, Dodd-Frank should be repealed.

It should be replaced with an Act that brings transparency to all the opaque corners of the financial system.  At a minimum, this Act should

• Require that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This is the data market participants need to independently assess the risk of the banks and exert discipline to restrain risk taking.

• Require that structured finance securities provide observable event based reporting on all activities like a payment or default involving the underlying collateral before the beginning of the next business day.  This is the data that investors need to know what they own.

Utilizing 21st century information technology, all of this disclosure can be centralized in the 'Mother of All Financial Databases' and made available to all market participants.

Market participants have an incentive to use this data because there is money to be made from using it.

• For example, banks with deposits to lend can use this data to assess the risk of banks looking to borrow.  With this assessment, the interbank lending market can reopen.

• For example, market participants can calculate Libor because they have access to all of the interbank transactions.

Regular readers know that unlike complex rules and regulatory oversight, transparency and market discipline have pass the test of time.

How ripe is the moment? Even lawmakers who voted for the 2010 reform law are open to improving it. 

"Congress never gets it right, when you're looking at massive reform legislation, the first time through," Sen. Mark Warner, D-Va., told The Hill newspaper last week. "You directionally head in an area and then you come back, two years, three years hence to do a corrections legislation."...

Ammunition for anyone seeking change arrived Monday from Karen Shaw Petrou of Federal Financial Analytics.... 

Her stark conclusion: even if regulators did everything called for in Dodd-Frank, and did it perfectly, financial services supervision would still be a mess. Throw Basel III in the mix and it just gets worse. 

The end-result of numerous agencies pumping out massive rules to meet statutory deadlines will be a tangle of contradictory mandates that will be tough to enforce and impossible to comply with....

Please re-read the highlighted text as Ms. Petrou makes the case for restarting financial reform with a simple focus on bringing transparency to all the opaque corners of the financial system.

As I have documented on this blog, simply bringing transparency back to the opaque corners of the financial system will go a long way towards fixing all of the problems that financial reform is suppose to address.

Transparency has one more advantage over loophole ridden complicated regulations that the industry will render irrelevant.  Transparency has been shown to prevent a financial crisis in the first place.  

Echoing Andrew Haldane, FDIC's Thomas Hoenig calls for rejecting complicated regulations

Former president of the Federal Reserve Bank of Kansas City and acting vice chairman of the FDIC board Thomas Hoenig is the latest to come out in support of the idea of rejecting complicated regulations and substituting regulators for the market.  In his case, he specifically recommended that the US not approve the Basel III capital requirements.

Regular readers know that the Basel III capital requirements represent the pinnacle of regulators replacing transparency in the financial system with complicated rules and themselves.

According to a Wall Street Journal article,

The U.S. should reject new international bank-capital rules, a federal banking regulator said, making the case that they are too complicated and vulnerable to being gamed by "the most brazen and connected banks."

Please re-read the highlighted text as it describes the real problem with most bank regulations.

The problem is that the complicated regulations introduce opacity into the financial system that the most brazen and connected banks then proceed to game.

Thomas Hoenig, a board member of the Federal Deposit Insurance Corp., said in a speech Friday that the U.S. should replace the rules, known as Basel III, with a simpler and, in his view, tougher alternative, if international regulators refuse to do so.... 

In June, U.S. regulators in published draft capital requirements to comply with the Basel III standards. While bankers have been up in arms about the proposal, arguing that it will harm the economy, Mr. Hoenig argues that the rules should be rejected because they are too complex and rely on models that are subjective. 

Bankers "will delegate the task of compliance to technical experts, and the most brazen and connected banks with the smartest experts will game the system," he said. The rules use "highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved." 

In general, this is why formalized capital requirements are a bad idea.  No matter how simplistic the requirement, without knowledge of the bank's exposures capital requirements suggest more insight and accuracy than can possibly be achieved.

Mr. Hoenig said the Basel rules should be replaced with a more simple formula of the ratio of "tangible equity" to "tangible assets." This would measure a bank's equity without goodwill, tax assets or other accounting entries. Tangible assets include a bank's assets minus intangibles. 

Mr. Hoenig's measurement, unlike the Basel rules, wouldn't rely on banks to measure the riskiness of their assets. 

"This simpler but fundamentally stronger measure reflects in clear terms the losses that a bank can absorb before it fails and regardless of how risks shift," Mr. Hoenig said.

At a theoretical level this is true.

In practice, this is not true.

As explained by the OECD, bank capital ratios are currently meaningless.  They are meaningless for a number of reasons.

For example, regulators are currently engaged in regulatory forbearance and as a result banks are using 'extend and pretend' practices to keep a number of zombie loans alive.  This distorts both the numerator (over states equity) and the denominator (over states assets).

The only way to restore meaning to capital ratios and reconnect theory and practice is by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert discipline on banks to record a proper valuation for all of their assets.  Since equity is an accounting construct, it will adjust to reflect these values.

Also, in an apparent dig at J.P. Morgan Chase & Co. Chief Executive James Dimon's repeated references to a "fortress balance sheet," Mr. Hoenig said, "there can be no fortress balance sheet without fortress capital."...

There can be no fortress capital without transparency to show that the capital levels reflect the current valuation of the bank's exposures.

Mr. Hoenig's critique of the rules' complexity and opacity is "reasonable" and reflects widespread concerns about how the Basel rules will be implemented, said John Dearie, executive vice president for policy at the Financial Services Forum, a group representing 20 financial chief executives. 

However, the simple approach preferred by Mr. Hoenig also has the potential for problems as it could encourage banks to hold riskier assets. 

"The trick is to identify the appropriate balance and the most effective middle ground," Mr. Dearie said.

Actually, trying to find an appropriate balance and most effective middle ground is an example of the regulators substituting themselves for the market.

It there is ultra transparency, market participants can independently assess the risk of each bank and adjust the amount and price of their exposures based on this independent assessment.

As a result, the market will reward banks that are appropriately capitalized (less risky) with a higher share price and lower cost of funds.  The market will discipline banks with inadequate capital (more risky) with a lower share price and higher cost of funds.

Ignoring Basel III key to EU ending financial crisis

UK Chancellor George Osborne confirmed why the EU's ignoring Basel III is key to ending the financial crisis.

According to a Telegraph article,

George Osborne ... told European finance ministers that the EU needed to show the world it had sorted out its banks. 

"If we duck the challenge of implementing Basel we could face very important challenges to confidence in Europe this year," the Chancellor said. 

"We certainly won't fool the financial markets, who will continue to be wary of investing in Europe and investing in European banks....

The financial markets are not fooled by the current condition of European banks.  They understand that the banks are insolvent (the market value of their assets is less than the book value of their liabilities).

These banks have been insolvent since the beginning of the financial crisis.

Furthermore, the market is not fooled by the focus on capital.  As the OECD said, bank book capital and capital ratios are 'meaningless'.  

There are several factors that contribute to why bank book capital and capital ratios are meaningless including suspension of mark-to-market accounting and adoption of regulatory forbearance.

Finally, the market has already shown that it is wary of investing in Europe or in European banks so long as policymakers continue to pursue higher capital levels prior to the recognition of bad debt hidden on and off the bank balance sheets.

Confirmation of this fact comes by simply looking at how the market is staying away from European banks despite the current financial regulators' mandate that banks achieve a 9% Tier I capital ratio.

As well as being an issue of prudential rules, the question is seen by Britain as a national sovereignty issue, a protection for taxpayers who would be forced to bail out a bank that failed due to capital requirements being set too low.

"National taxpayers have to underwrite banks so it should be a national decision," said a British official....

Actually, national taxpayers do not have to underwrite banks in a modern banking system.  Banks are perfectly capable of absorbing today all the losses on the excesses in the financial system without being bailed out.

By absorbing these losses, the banks would take the burden of bad debt off of the real economy and let the EU recover.

Given deposit insurance and access to funds from the central bank, banks have the ability to continue operating and supporting the real economy while they repair their balance sheets by retaining future earnings.

The so-called "Basel III" agreement was agreed by the world's leading economies after the 2008 financial crisis showed many banks did not have enough of a capital cushion to absorb sudden losses on loans.

The simple fact is that banks have virtually unlimited capital and therefore can absorb all the losses in the financial system.  They have what is on their balance sheets today and what they can earn in the future. 

Basel outlines capital disclosure rules for banks

Reuter's reports that regulators are working on improving transparency in the reporting of bank capital.  While this is a step forward, to be truly valuable it needs to be matched with ultra transparency under which banks report on an on-going basis their current asset, liability and off-balance sheet exposure details.

Market participants need this data to really assess how well capitalized a bank is.

Banks across the world will have to use a common format for disclosing the size and quality of their capital safety buffers from 2013 to help reassure investors they are stable.... 

Without ultra transparency, capital disclosure does not reassure investors that banks are stable.  Capital is only one part of the equation.

In the run-up to the financial crisis, it was hard for regulators and investors to compare capital buffers of banks. 

"It is often suggested that lack of clarity on the quality of capital contributed to uncertainty during the financial crisis," the Swiss-based Basel Committee said in a statement. 

"Furthermore, the interventions carried out by the authorities may have been more effective if capital positions of the banks were more transparent," the committee said....

All of which ignores that regulators encouraged extend and pretend with loans by engaging in regulatory forbearance as well as regulators dropped the mark-to-market requirement on opaque, toxic structured finance securities.

In short, the problems lurking both on and off the balance sheet were hidden.  It was these problem that called into doubt capital adequacy.

Banks are already disclosing their capital levels in a bid to reassure jittery investors. 

Given the current level of bank stock prices and the inability of banks to access the capital markets for more equity, clearly this disclosure is not working.

Banks 'lose' battle over Basel in order to win war to retain opacity

The Wall Street Journal ran an article on how US banks are losing the battle over the adoption of the Basel III capital requirements including the requirement for larger banks to hold additional capital.

However, this 'loss' allows them to continue to win the war to retain opacity.

Regular readers know that Basel III capital requirements are completely meaningless as they are easily manipulated by the banks and the capital requirements were always intended to allow the banks to increase their leverage and therefore the return on equity that banks might generate.

In short, the Basel capital requirements are regulators doing everything in their power to promote the interests of the banks including defending opacity.

As an example of defending opacity, let's compare Basel I to Basel III.  According to the Bank of England's Andy Haldane, Basel I takes 6 simple calculations to determine the capital ratio while Basel III takes upwards of 6 million calculations.

To an outsider, it appears that Basel III is dramatically more opaque and far less informative.  This is not surprising given that Basel III is the result of a negotiation between the banks and their regulators.

Both parties perceive they benefit from opacity.

The banks perceive they benefit because with Basel III, they can continue to take excessive amounts of risk that market participants cannot see.  Even better, they get to represent themselves as being less risky so that they can access funds for rates far below what a fully informed market would charge for their risk.

Regulators perceive they benefit because the market is still dependent on them to assess and communicate the risk of the banks.  The regulators get to keep their ability to gamble with financial stability as well as to leave through the revolving door to a high paying job with the banking industry.

Naturally, the preservation of opacity creates losers.  Those losers are every other market participant.

Compare and contrast our current system of banks and regulators who create meaningless Basel capital requirements versus a financial system for the 21st century that is based on ultra transparency (banks are required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure detail).

Which system has already shown itself to be prone to crashes and exploitation by the bankers?

Finally, is there anyone besides your humble blogger who keeps wondering why if capital is there to absorb losses, banks haven't used it in the current crisis?  Why are regulators following a policy of regulatory forbearance that allows banks to engage in 'extend and pretend' on their loans rather than requiring losses be realized?

The Federal Reserve is expected to embrace a new global framework that requires giant financial institutions to hold extra capital, said people familiar with the situation. 

The central bank's decision to accept the rules laid out by regulators in Basel, Switzerland, as part of a draft proposal that could come before Christmas is a defeat for giant U.S. banks that argued the guidelines needn't be so strict. They contended the Basel approach could prompt them to reduce lending and hurt the economy. 

At the same time, it isn't clear the bigger capital buffers will accomplish what regulators set out to do in the Dodd-Frank financial overhaul and other recent moves: end the "too big to fail" syndrome that paved the way for the government bailouts of the 2008-09 financial crisis. 

While big U.S. banks that are asked to maintain higher cushions could be forced to raise prices on certain transactions to compete with rivals, they also could benefit from lower funding costs if they are perceived to be likely recipients of government aid in a market shock or steep downturn. 

Even after the release, banks won't know exactly how much extra capital they will be required to hold as a protection against losses. Basel regulators last month designated 29 so-called systemically important firms—including eight in the U.S.—but didn't say just how much capital each bank would be required to carry.... 

Banks initially were united in their opposition to the extra surcharge, but now some appear happy enough to just not be in the highest bucket. "Nice to be us," said a top executive at one major U.S. bank that isn't expected to share the top category with J.P. Morgan Chase. "I would prefer to be at the kids' table." 

The Fed's embrace of the Basel surcharge is expected to come as part of a draft of new rules for U.S. firms that are considered by regulators to be big enough to pose a risk to the financial system. 

The proposed rules, required by the Dodd-Frank financial law, are expected to detail how much extra capital these firms must hold as a buffer against losses, the cash they must keep around to reduce their need to tap volatile funding markets, and how much money they can pour into any sort of investment.

WSJ: Regulators create systemic risk

In an editorial on the Basel capital requirements, the Wall Street Journal observed that through these requirements regulators are creating systemic risk.

Regular readers know that the global financial regulators are a source of systemic risk because of their monopoly on all the useful, relevant information for assess the risk of a bank.

The WSJ identifies yet another way that the global financial regulators create instability.

In this case, the regulators do it by the risk weightings they put on different asset types that banks hold.  These risk weightings encourage banks to have similar portfolios.  As a result, a problem with one asset type is likely to permeate the entire banking system.

The Basel capital requirements themselves are the product of banking regulators in the 1980s attempting to help banks generate a higher Return on Equity so that the banks could attract capital. [I know as I worked on Basel I.]

The idea of risk weights was developed to allow banks to take on more leverage.

The idea of a risk-free asset that would have a zero risk weight has always been fundamentally flawed.  The only asset that a bank holds that fits this criteria is cash in its vaults.  All the other assets have a component of risk:  including credit, interest rate and liquidity.

It is well known that zero risk weight sovereign debt is definitely not risk free.  For example, a large bank in the US managed to lose over half of its book value from a position in long term US Treasuries.

Standard & Poor's Monday night put nearly every country in the euro zone on notice for a possible credit downgrade ... European officials denounced the announcement as counterproductive and somehow politically motivated, but the rating agencies are merely catching up to the reality that sovereign debt isn't a risk-free asset.  

This same realization may even be dawning at last on the international banking regulators in Basel, Switzerland. Business Week reports that the authors of the Basel standards, which set capital and liquidity requirements for large international banks, are reconsidering rules that all but require banks to hold large amounts of sovereign debt. 

Unfortunately, the rules under review concern only the new liquidity buffers that banks will need to hold under the forthcoming Basel III standards. Under this new requirement, banks are supposed to have a 30-day supply of funds available in case lending markets seize up as they did in the fall of 2008, and 60% of that supply is supposed to be in high-quality, highly liquid assets, such as, believe it or not, government bonds....

Under Basel's risk-weightings, government debt of your home country is assigned a zero risk under both the old rules and the new. 

The rationale is that a government can always tax more or print more money to pay off its debts, at least nominally. So a country that issues debt in its own currency should in theory never be forced into actual default, even if it has to resort to inflationary money printing to avoid it. 

On this, the Basel gnomes have a point, even if it's taken everyone too long to realize that this option wasn't open to the likes of Greece and Italy. 

But even when correctly applied, those rules create systemic risk by nudging large banks toward holding similar assets. This reduces diversity in the system, increasing the odds that if one bank is in trouble, all or most of them will also be in trouble. 

A normal market has a balance of buyers and sellers, longs and shorts, bulls and bears. But risk-weightings put a thumb on the scale. 

Recall that the Basel rules also assigned a very low risk-weighting to triple-A-rated mortgage-backed securities, which helps explain why sleepy banks in Dusseldorf loaded up on the stuff during the housing bubble and lost billions during the panic. 

And now here we are doing it again with sovereign debt. 

In a paper commissioned by the European Parliament in 2010, former Commerzbank Chairman Achim Kassow notes dryly that "The regulatory incentive which results from the 0% risk weight is apparent: banks in Member States are effectively encouraged to place their most liquid assets into the worst possible government debt, maximizing the yield with a regulatory capital requirement of zero." 

It's encouraging that the Basel rule makers are considering even a limited climb-down from pushing banks into government bonds, but the whole policy needs revision.

BoE Financial Policy Committee member Robert Jenkins claims banks are 'lying' about cost of reform

A Philip Aldrick Telegraph article reports on Bank of England Financial Policy Committee member Robert Jenkins' observation about the banking lobby's deliberate dishonesty about the cost of reforms.

In some of the strongest words on self-interest in the financial industry to come out of the Bank, Robert Jenkins, an independent member of the Financial Policy Committee (FPC), said the banking lobby has been deliberately dishonest to suit its argument that tough new regulations will damage the economy. 

"The latest lobby tactic is to convince pundits, public and politicians that encouraging prudence too soon will hit the economy too hard," he said. "This is no longer amusing. This strategy is intellectually dishonest and potentially damaging. It is dishonest because it is untrue." 

Banks across the world have been pushing against reforms that will force them to have bigger capital buffers, to protect them against future losses, and hold more liquidity, to stop a run on the bank from causing its collapse. 

Banks would prefer these reforms to ultra transparency as these reforms preserve opacity into the banks' exposures and let the casino bank continue to operate.

This blog has already shown how requiring banks to disclose their current asset, liability and off-balance sheet exposure details on an on-going basis will subject them to market discipline.

The result of market discipline will be banks that hold much less risk and much higher levels of liquid assets and capital.

The Institute for International Finance, the leading global banking lobby group, has claimed that the harsher rules could result in millions fewer jobs being created across the world in the coming years as global growth progressed at a more sedate pace. 

Stressing that "my remarks are my own", Mr Jenkins characterised the banks as attempting to hold regulators hostage by claiming that only by starving the economy of credit can they be made safer. "If we do, it will be all your fault," is how Mr Jenkins summed up the industry's approach. 

"The truth is that banks can strengthen their balance sheet without harming the economy. They can do so by cutting bonuses, by curtailing intra-financial risk-taking and by raising term debt and equity," he said. "Thus a profession which should stand for integrity and prudence now supports a lobbying strategy that exploits misunderstanding and fear."...

As Mr. Jenkins knows, bank lobbyists will present the facts in the best light for their clients' interests.  Recent events would seem to play into the lobbyists' story line.

First, we have the fact that banks have very limited access to capital as investors are not going to invest in banks where they cannot assess the risk of the banks.

Without ultra transparency, banks are what Bank of England's Andy Haldane calls 'black boxes'.  With ultra transparency, investors have access to the current asset, liability and off-balance sheet exposure detail they need to assess risk and make a decision on the amount and pricing of their exposure.


Second, we have the fact that market participants, including regulators, are justifiably nervous about bank exposure to sovereign debt.  As a result, Eurozone banks are reducing their holdings of none host country sovereign debt.  As banks cut back their exposure, it reduces demand and drives up the cost of sovereign debt in both the primary and secondary markets.


Third, we have the fact that Eurozone regulators are calling for banks to meet a 9% Tier 1 capital ratio by next summer.  One way for banks to achieve this ratio is to reduce the size of their loan book.  The decline in loans potentially hurts the economy.

Mr Jenkins, who as an FPC member will help decide when to restrain the banks, added that "not all bankers agree with" the lobbyists' tactics. 

"They should distance themselves quickly," he said. "For in pursuing its short-sighted approach the banking lobby is unwittingly making the case for more intervention in an industry which refuses to reform."

As this blog has frequently observed, the only reform the industry really needs is to require ultra transparency.  Market discipline will force the banks to carry a much higher capital ratio and much less risk.

Andrew Ross Sorkin and the IMF's Chief change of tune on bank capital

Andrew Ross Sorkin wrote a column in the NY Time's Dealbook on how Christine Lagarde's change in roles from French bank regulator to Chief of the IMF appears to have influenced her position on the adequacy of European bank capital.

He roundly praises her for coming clean about the need for more capital and asks if she can bring the rest of the European financial regulatory community with her.

Regular readers would like to know why he thinks she should stop there.  If Bank of America has shown anything over the last few weeks, it is that the US financial regulators are every bit as guilty when it comes to hiding what is going on.  Is it credible that the 2009 stress tests missed what many analysts today believe is a $200 billion hole in BofA's balance sheet?

If he truly believed in what he wrote, he would become an advocate of the FDR Framework.

Under this framework, 21st century information technology is harnessed to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner.  For banks, this is their current asset and liability-level dat which the financial regulators currently have a monopoly on.

Over the weekend, Christine Lagarde, the managing director of the International Monetary Fund, was desperately trying to back-pedal. A report had surfaced citing an internal I.M.F. document estimating that Europe’s banks were woefully short of capital — by a whopping $273.2 billion....

While Ms. Lagarde acted as if she was surprised by the number — and tried to play it down — she shouldn’t be. And in truth, she wasn’t. 

Changing her tune seems to be a theme for Ms. Lagarde, which may explain her feigned sense of shock. 

Ms. Lagarde sounded alarm bells last month about what she called the need for an “urgent recapitalization” of European banks, and was roundly criticized for it. 

“Developments this summer have indicated we are in a dangerous new phase,” she said then. Her refreshingly honest remarks had been so honest — apparently, too honest — that some bankers blamed her for further undermining confidence in European banks. 

Yes, Ms. Lagarde had broken the secret code of silence among Europe’s top bankers — a silence she herself had kept for far too long when she was a politician. 

It is this code of silence about what is actually going on with the banks that is a major source of financial instability.

As BNP Paribas Chairman Michel Pebereau observed, 'utter transparency' is needed.

Just this summer,... Ms. Lagarde was trying to will the world into believing that the French banks, the ones she oversaw as France’s Minister of Economic Affairs, Finances and Industry, and the ones which are now in the headlines every day — BNP Paribas and Société Générale, among them — were sound....

In an interview even before the results of this summer’s stress tests of European banks, she told The Economist: “As far as my banks are concerned, the French banks, I am very confident about the results; and No. 2 and probably more importantly, from what I have seen of the criteria, and the kind of tests that are applied to the 91 banks in Europe, it’s a very tough standard that is applied. And I’m saying that because I have seen here and there some, you know, allegations, little hints, and, and, various comments, analysts saying ‘Oooh, not so sure about the tests.’ Well, let’s go down to the details, the tests are really, really hard.” 

... Europe’s central bankers continue to defend the fictional stress test. 

Even as late as last week, they somehow argued that “individual disclosures of sovereign exposures were an essential component of the exercise and a great enhancement in terms of transparency” despite disbelief in the markets.

The markets disbelief was in the stress tests themselves which have been subsequently shown as not very credible.

It is an undisputed fact that the individual disclosures of sovereign exposures were a significant enhancement in terms of transparency.

We often blame United States politicians and regulators for not owning up to our economic problems until it is too late. But the Europeans have tried to keep up the fiction of their economic strength for much longer....

While the United States was injecting capital in banks, guaranteeing debt and trying to increase capital requirements, European regulators were fighting behind the scenes to keep capital requirements low.

Perhaps my memory is hazy, but I think that France injected capital into its banks and, following the example set by the US, let the banks repay this capital.

The US policy of guaranteeing financial institution debt was and is a major contributor to moral hazard.

On the other hand, this blog has argued that the US should guarantee the debt if the regulators are going to have a monopoly on the information that market participants need to assess the risk of investing in the debt.

Furthermore, when regulators say that the banks are solvent (see stress tests above), they are explicitly offering investment advice.  Given that the information monopoly makes market participants dependent on the regulators for analysis of the information, if the regulators fail to properly assess the risk, the government should pick up the loss.

Instead, European regulators, including Ms. Lagarde, jumped on the banker compensation bandwagon, which might have won her political points, but appears now to have also kept the public eye off the bigger issue: Europe’s banks were woefully undercapitalized and every regulator knew it. 

Why does anyone not think the same about US banks and what their regulators knew?

Recently, a considerable amount of attention has been focused on Bank of America and analysts' estimates that it is undercapitalized by $200 billion.  Is it believable that US regulators did not know about this capital shortfall when they conducted their 2009 stress tests?  What are we to make of the representation by the regulators that accompanied the 2009 stress tests that BoA would be adequately capitalized if it raised less than a fifth of this estimated shortfall?

... Europe’s economic problems won’t be solved until the banks — and their regulators — accept that they need more capital and a solution is reached about the structure of the European Union. (It probably has to happen in that order.) 

Actually, what has to happen first is that the banks need to disclose their current asset and liability-level data.  Market participants can use this data to determine which banks are solvent and which banks are insolvent and the amount of capital needed to restore each insolvent bank to solvency.

Some of the insolvent banks will be able retain earnings and restore their solvency.  Other banks will need to be recapitalized.  Private investors are likely to participate in this recapitalization because they will know what they are buying.  Other banks will have to be closed.

The question, of course, is now that Ms. Lagarde has broken her code of silence, can she persuade the rest of her European counterparts to come clean too?

Can she persuade the rest of the global financial regulator to come clean too?

Now that the code of silence has been broken, there is no excuse for not implementing 'utter transparency' across all financial institutions.

Basel III capital requirements, Dodd-Frank ban on using credit ratings in regulations and disclosure by banks

A Reuter's article highlighted how the Dodd-Frank Act impacts the adoption of Basel III capital requirements in the US.

The Act bans the use of credit ratings in US bank regulations.  However, these same banned credit ratings are used to in determining the risk-weighting of an asset for compliance with the Basel III capital requirements.

The question is what can be used as a substitute for relying on the credit ratings for three or four firms?

Under the FDR Framework, the substitute is to replace the opinion of three or four firms with the opinion of the market.  This is easily achieved by requiring disclosure of each bank's current asset and liability-level data.  Market participants including competitors, credit and equity market analysts, and valuation experts will use this data to perform their own risk assessments of the assets on the individual bank's balance sheet.

Rather than having to rely on three or four firms, regulators can now rely on the assessment of risk by the market participants.

The United States' ability to implement global capital rules is being made more difficult by a provision in the Dodd-Frank financial reform law, JPMorgan Securities said in a research note released on Friday. 

The 2010 law bans the use of credit agency ratings, such as those provided by Moody's Corp and McGraw-Hill Cos' Standard & Poor's, in U.S. banking regulations. 

That is a problem for bank regulators, who currently have no good alternative to the credit ratings they use to help judge the risk on banks' books when determining capital requirements. 

... The ban on credit ratings in U.S. regulations will also likely make it more difficult to implement the latest sweeping global capital accord reached as part of the Basel III agreement, the note said. 

That agreement does not have to be fully in place until 2019, but U.S. regulators hope to begin issuing draft rules by the end of this year. 

... Last summer U.S. regulators sought comment on what could be done to replace credit ratings in their rules. They say good alternatives have yet to materialize. 

The Dodd-Frank change has been a burr in their saddle. 

"The Dodd-Frank Act's prohibition against the use of credit ratings also will impede our efforts to achieve international consistency in the implementation of Basel III," acting Comptroller of the Currency John Walsh told the House Financial Services Committee on June 16. 

The Basel III agreement is a response to the financial crisis and aims to force banks to meet tougher capital standards so they can better withstand a financial shock. 

Regulators have asked the U.S. Congress to amend the law to deal with the credit rating problem, but that seems unlikely for the foreseeable future. 

One possible outcome is that regulators will require banks to perform their own risk assessments to replace the work of credit rating agencies, and the banks' assessments would be reviewed by a third party, said Karen Petrou, managing partner at Federal Financial Analytics, a regulatory policy consulting firm. 

That third party could wind up being the credit raters, she said. 

"This is a sort of halfway house," she said.