Matrix for judging banks: competent/incompetent versus good/evil

In an interesting editorial in the London Evening Standard, Jim Armitage discusses a 2x2 matrix for judging banks.  On the x-axis is incompetent/competent.  On the y-axis is evil/good.

Naturally, the goal is to have all banks in the quadrant of the matrix that is defined by competent and good.

The question is where are we now?

Based on everything that has happened to date, there are very few, if any, banks in the competent and good quadrant.

Looking at banks in the UK, Mr. Armitage suggests

HSBC was generally competent and good, RBS was incompetent and evil, Lloyds was incompetent and good and Barclays was competent and evil.

Of course, HSBC's rating does not include its recidivist tendencies when it comes to money laundering.  So, a rating of competent and evil appears more appropriate.

What about Standard Chartered?  Again, due to its money laundering, a rating of competent and evil appears appropriate.

Given that the goal is to get all banks into the competent and good quadrant, what does it take to move along the y-axis from evil to good?

Regular readers know that it takes transparency.  Sunlight is the best disinfectant.

When a bank provides ultra transparency and discloses on an ongoing basis its current global asset, liability and off-balance sheet exposure details, it is forced to adopt a culture of good behavior.  A bank is forced to adopt a culture of good behavior because of market discipline.

So long as bankers can hide behind a veil of opacity, the Bank of England's Andrew Haldane refers to banks as "black boxes", they will engage in bad behavior as they are not subject to market discipline.

"As long as bankers live in a world free of consequence, our finance system is doomed to fail"

In a must read Guardian column, Joris Luyendijk looks at the implications for our financial system of bankers being free of both market discipline and legal liability.  When greed is not checked by the consequences of failure, you get a dysfunctional system where bankers privatize the gains and socialize the losses.

The first step in subjecting the bankers to market discipline is 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 this disclosure that bankers fear most.

JPMorgan and Jamie Dimon showed this when they tried to hide the London Whale's CDS trades and even cut off the regulators from the information about the positions.  The stated reason for limiting access to the information was fear that the market would find out and trade against them and make the losses on the positions worse.

For anyone not working for JPMorgan, this is known as market discipline and linking consequences to actions.

This is how a former top banker in treasury described his time in a bank that failed: "Risk produces profits, profits lead to a higher share price, and executive pay was linked to that. It was so fucking easy to manipulate the share price; simply take some more risk. 

"I was having a great time – travelled around the world, feted by people. I used to be invited to every major sporting event in the world … Everyone is nice to you because you represent a chance for them to make money. It becomes very tempting to think that actually all these people like you for who you are. I stressed internally the risk we were taking. But you have to understand, nobody likes a prophet of doom." 

This is not a job but a lifestyle, people working in the City say. And why would they risk that lifestyle by taking a harshly critical look at themselves and their colleagues? Why would they go against the grain, isolate themselves and become the messenger of scepticism or even bad news? 

Look at the HBOS brass. The worst punishment that may be in store for them is a ban on ever working in a bank again. No jail time, no financial penalties, not even a clawback of bonuses – even though these were based on profits that have proven illusory. 

What kind of an incentive structure is this? What kind of deterrent? 

Which brings us back to self-delusion. The fundamental problem in finance is not greed – which is really a different word for ambition, measured in monetary terms. The problem is that greed is not checked by fear of its consequences. 

As this HBOS affair makes clear, working in the top layer of finance means life-changing rewards when things go right, and minimal punishment, if any, when they don't.

JP Morgan shows it is too big to police by regulators

In his Huffington Post column on JP Morgan's "Whale" trade, Leo Leopold discusses how the bank is too big for the regulators to police and therefore it needs to be broken up.

Your humble blogger agrees with Mr. Leopold that JP Morgan has shown it is too big for the regulators to police, but I disagree with his solution (which has also been championed by regulators like Dallas Fed president Richard Fisher and FDIC vice chairman Thomas Hoenig and Economists like Simon Johnson).

I disagree because the solution assumes that we know what size bank the regulators can effectively police.  The history of the financial crisis doesn't suggest a specific size.

In addition, this solution focuses on size, which is a red herring argument, when the important issue is the amount of risk the bank is taking.

Your humble blogger much prefers that banks be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This provides two immediate benefits.

First, ultra transparency greatly expands the resources available to the financial regulators to police each bank and the financial system.  Specifically, it allows the financial regulators to tap the market's analytical ability.

For example, it allows the financial regulators to go to each bank's competitors and ask what exposures worry them the most that each of their competitor banks has.

Second, ultra transparency subjects the banks to market discipline.  Specifically, this information allows market participants to link the risk that a bank is taking with the return they require for investing in the bank.  It is this linkage between risk and return that allows market participants to exert discipline and restrain risk taking by the banks.

Since banks are currently not subject to market discipline due to the lack of transparency, introducing market discipline is likely to put pressure on bank management to reduce the risk of the bank.

Risk reduction can take some combination of reducing the asset size of the bank and the complexity of the organization.

For example, the large banks have literally thousands of subsidiaries that are engaged in arbitraging regulations and tax laws. Market discipline will give management an incentive to close these subsidiaries.

What is nice about market discipline is that there is no argument that the banks and their lobbyists can attack over what is the right size or degree of complexity for a bank.

Market participants vote by assessing the risk of the bank using the information disclosed under ultra transparency and only investing in the bank if it offers an adequate return for this risk.

JP Morgan Chase is much too big to police. Even though there are dozens of regulators who work each day inside the big bank, the relationship depends entirely on the cooperation of the banks. 

The regulators can easily be run around in circles, if the bank is intent on misleading them and hiding crucial information. 

By now it should be obvious to all of us, if a big bank sees a way to make big bucks they will do so even if it breaks every law in the books. 

Dodd-Frank has no chance of working. 

Prosecution won't work either asAttorney General Holder made clear because the banks are viewed as too big to jail without threatening the entire global financial system.

The only rational and just option is to put JP Morgan Chase out of business. It should be broken into much smaller entities as soon as possible....

Patrick Honohan makes the case for new model of bank supervision combining ultra transparency and market discipline

In his speech at the second UCC Garrett FitzGerald Spring School, Irish central bank Governor Patrick Honohan talks about an EU banking union, but in doing so makes a very strong case for a new model of bank supervision based on requiring banks to provide ultra transparency and subjecting the banks to market discipline.

The combination of requiring the banks to provide ultra transparency and subjecting them to market discipline achieves all of the benefits and none of the pitfalls Professor Honohan mentions from a banking union.

First, I hope that it will go some distance to removing politics from the enforcement of bank supervision.

Markets are decidedly non-political and unlike the regulators are not susceptible to lobbying by the banks.  The markets are non-political because the investor is concerned with whether they make or lose money on their investments.

Second, I hope that it brings emotional detachment to the process of supervision. 

While markets are driven by fear and greed, monitoring the banks for changes in their risk profile is done in an unemotional manner.

Third, I hope that it manages to lever the diversity of supervisory experience and aptitude across Europe to provide multiple cross-checks on bank soundness, while not limiting into straitjacket bank behaviour. 

Requiring the banks to provide ultra transparency not only levers the diversity of supervisory experience and aptitude of the regulators, but it also levers the diversity of the market.

For example, brought into the supervisory mix is each bank's competitors.  Each competitor understands how to assess the risk a bank takes and will adjust the amount and price of its exposure based on its assessment of the bank's risk profile.

Fourth, I hope it is effective in breaking the link between sovereign and banks, not only to protect the sovereign but to allow banks to operate effectively and have access to European funding markets on a basis that is not subject to a sovereign risk-add on, but depends only on the bank’s own creditworthiness and standing.

Requiring the banks to provide ultra transparency breaks the link between sovereign and bank as it relates to unsecured debt and equity investments.

When every bank is required to disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details, market participants have the information they need to independently assess the risk of each bank.

With access to the information necessary to assess each bank's risk, market participants become responsible for any losses incurred on their investments in the unsecured debt and equity of the banks.  This responsibility for loss gives the market participants an incentive to use the disclosed information.

The combination of requiring the banks to provide ultra transparency and subjecting them to market discipline has none of the pitfalls that Professor Honohan thinks can occur with the EU banking union.

First, I hope that it doesn’t get bogged-down in overly complex layering of decision-making structures. 

Second, I hope that the huge task of transferring knowledge to the centre and building new communications channels between national supervisors and the central team does not result in process overwhelming product in an interim period with the result that some problems remain undetected, hidden by the dust kicked-up by the creation of the new structure. 

Third, I hope that the decision-making bodies are truly communautaire and not simply an amalgamation of national interests.  

Fourth, I hope that moving decisions to the centre and away from national authorities in what can be a very sensitive area will not result in divisive clashes between broad European and national interests.   

Bankers timing bonuses to minimize taxes highlights need for transparency

As reported by the Guardian, the Bank of England's Mervyn King has expressed his moral outrage at the bankers timing their bonuses to minimize the taxes they pay to the detriment of society.

In response, the BBC reports that Goldman has announced that it will not delay it bonus payments (probably increase them at the expense of shareholders to achieve the same after tax bonus for their bankers).

There are two critically important lessons to learn from the row over banker bonuses.

First, the culture of banking has not changed since the financial crisis began on August 9, 2007.  Bankers continue to try to maximize their individual pay regardless of the cost to society.

Second and equally importantly, bankers adjust their behavior when market discipline is exerted on them.  This point is critically important because it highlights the simple fact that for banks sunshine is the best disinfectant of bad banker behavior.

As your humble blogger has pointed out on numerous occasions, to fundamentally change the culture at banks requires that they disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this degree of sunshine into what the bankers are doing, market participants can easily enforce discipline on bad behavior.

By stripping away the veil of opacity, bankers know that there will be a backlash against their activities that are detrimental to society.

From the Guardian,

Sir Mervyn King, governor of the Bank of England, has waded in to the row over bonuses at Goldman Sachs warning it would be "rather clumsy" and "lacking in care" of big banks to attempt to defer bonuses to allow highly paid bankers to pay a lower rate of tax. 

Goldman is considering deferring parts of bonuses from 2009, 2010 and 2011 which were due to be handed to bankers in the coming weeks beyond 6 April when the top rate of income tax will fall from 50% to 45%. 

Appearing before the Treasury select committee, King told MPs: "I find it a bit depressing that people who earn so much find seem to think that it's even more exciting to adjust the timing of it to get the benefit of the lower tax rate ... knowing this must have an impact on the rest of society, when even now it is the rest of society that is suffering most from the consequences of the financial crisis". 

He went on to say that it would be "rather clumsy" and "lacking in care". "In the long run, financial institutions do depend on goodwill from society," said King.

Capital: a very strange way to assess bank safety

Anyway your look at it, bank capital levels or ratios are a very strange way to assess bank safety.

Regular readers know that bank capital, in particular shareholder equity, is an accounting construct with two main components:  capital paid in to buy stock and retained earnings.

Capital paid in cannot be manipulated.  It is simply a reflection of the number of shares sold and the price at which they were sold.

Unlike capital paid in which is based on historic facts, retained earnings are a derived number based on a series of assumptions. Assumptions that can be easily manipulated.

Earnings can be manipulated by the banks.

For example, earnings can be manipulated by simply moving an investment (think opaque, toxic structured finance securities) from the trading account where it is subject to mark to market accounting to the bank's investment portfolio where it is held at acquisition cost to avoid taking a loss.  The result of this manipulation is to a) overstate earnings, b) overstate book capital and c) overstate the value of the assets.

Earnings can be manipulated by the regulators.

For example, by practicing regulatory forbearance, regulators allow the banks to engage in 'extend and pretend' and turn their bad loans into 'zombie' loans rather than recognize the losses on the loans.  The result of this manipulation is to a) overstate earnings, b) overstate book capital and c) overstate the value of the assets.

Because of the ease with which regulators can manipulate capital, the regulators use capital, both the balance sheet level and the ratio, to mislead the public and the financial markets.

For example, Tim Geithner said that the stress tests were rigged in an effort to restore market confidence.  What the stress tests were suppose to show was that the banks had sufficient capital.

Because of the ease with which earnings can be manipulated, even a simple ratio like shareholder equity to assets is meaningless as a measure of the bank's risk.  Piling on complexity by risk-adjusting the assets simply gives banks and regulators more ways to game the capital ratio and render it even more meaningless as a measure of the bank's risk.

Based on these facts, the OECD concluded that bank book capital and capital ratios are meaningless.

Regular readers know that your humble blogger thinks that the only way to assess the risk of a bank is by looking at its current global asset, liability and off-balance sheet exposure details.

I am not alone in this.

For example, Goldman's Lloyd Blankfein said that the only way Goldman knows to manage its own risk is to monitor every position every day.

For example, banks with deposits to lend stopped lending in 2008 when they realized they could not assess the risk of the banks looking to borrow.  The interbank lending market remains frozen.

Despite being meaningless and useless as a measure of risk, bank capital does have its supporters.

In his Bloomberg column, Professor Simon Johnson tries to save bank capital as a measure of bank risk.

Global regulators have a peculiar way of assessing the soundness of big banks: Ask bankers how risky their investments are, then figure out if they have enough capital to absorb the potential losses....

The strategy of trying to make sure that expected losses are less than a bank's book capital level is not unreasonable given that the goal of the financial regulators is to protect the deposit insurance funds.

This method ... has failed repeatedly -- most spectacularly during the 2008 financial crisis....

Is the problem with this method the question of do banks have enough capital to absorb their potential losses or the regulators' ability to answer the question?

The Bank of England's Andrew Haldane observed that the problem lays with the regulators' ability to answer the question.

I don't think that the stability of the financial system should depend on whether the regulators can or cannot answer the question.  By requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, we can use all the market participants to assess the soundness of the banks.

Like most firms, banks finance themselves with a combination of debt, which they get by taking deposits and issuing bonds, and equity, which they get from their shareholders. The latter, also known as capital, is crucial to the bank’s survival. 

If bad investments cause the value of a bank’s assets to fall, its equity decreases by an equivalent amount.

Not necessarily as shown by the examples above.

If equity is depleted, the bank is insolvent.

By definition a bank is insolvent if the market value of its assets is less than the book value of its liabilities.  Capital does not directly factor into this definition.

What is critically important to note is that a bank can be insolvent and still continue operating.

There will be either bankruptcy or some form of government bailout.

Actually, there is a frequent third choice made by regulators.

A modern banking system is designed so that banks can operate with low or even negative book capital levels.  The reason banks can do so is the combination of deposit guarantees and access to central bank funding.

With deposit guarantees, taxpayers effectively become the bank's silent equity partner when the bank has low or negative book capital levels.

While the taxpayer is the silent equity partner, if a bank can generate earnings, it can rebuild its book capital levels.

This choice has been made repeatedly.  Sometimes successfully.  Sometimes not.

An example of when the choice was unsuccessful was the US Savings and Loans.  To rebuild their book capital levels, they gambled on redemption.

One of the reasons for requiring the banks to provide ultra transparency is that it allows market discipline to restrain bank risk taking and prevents gambling on redemption.

Hence the need for capital requirements....

The facts simply do not support this conclusion.

One big problem is incentives. Bankers like to use as much borrowed money as possible, relative to their equity. This boosts the return to shareholders in good times, but also presents a threat to the financial system and the broader economy. 

If bankers are in charge of calculating their own risk weights, they will try to understate the risks. This happened with mortgage-backed securities and associated derivatives in the U.S., with real-estate-related loans and assets in countries such as Ireland and Spain, and with sovereign debt in much of the euro area.

This problem goes away if banks are required to provide ultra transparency.  Market participants can independently assess the risk of each bank and adjust both the amount and price of their exposure to reflect this risk.

As a result, simply increasing leverage or risk will result in a higher cost of funds and not necessarily a better ROE.

Second, regulators are no better than bankers at figuring out the right risk weights. For one, they are often heavily influenced by the bankers -- a reality I have experienced personally in my conversations with central bankers and other officials, who meet with banking staff continually and even now are convinced that top executives really know how to measure and handle risk. Beyond that, they are out of their depth. The system of risk weights has become too complex, unwieldy and far too easy to game.

This is what happens when complex rules and regulatory supervision are substituted for transparency.

Actually, no one can calculate proper risk weights. They are unknowable. Analysts at credit-rating companies, even if one sets aside all the conflicts of interest they face, are just as prone to group think, fads and misconceptions as the rest of us. Academics would do no better. And the “wisdom of crowds” -- as reflected in the market for credit-default swaps -- suggested that Citigroup Inc. was a low-risk investment until 2007.

The reason that Citigroup credit-defaul swaps were mis-priced was the combination of lack of transparency into Citigroup's actual exposure details and the Federal Reserve claiming that risk had been taken out of the banking system.

Professor Johnson actually makes the case for requiring ultra transparency.  The "wisdom of crowds" can only be realized if they have the exposure details necessary to assess risk.

The right approach, as articulated by Hoenig, is to choose capital rules that are “simple, understandable, and enforceable.”...

Of course, for any capital rule or risk reduction rule like the Volcker Rule, the enforcement mechanism is market discipline made possible by ultra transparency.

The bottom line:  talk about bank capital is simply a distraction so that we don't talk about what is really necessary for assessing bank safety ... ultra transparency.

Unless forced to recognize losses, banks will gamble on redemption

Bloomberg ran an interesting article that shows that unless banks are forced to recognize the losses hidden on or off their balance sheets, they will continue to gamble on redemption.

Regular readers know that gambling on redemption is one of the many bad consequences of policymakers adopting the Japanese model for handling a bank solvency led financial crisis.

European banks pledged last year to cut more than $1.2 trillion of assets to help them weather the sovereign-debt crisis. Since then they’ve grown only fatter.... 

They have Mario Draghi to thank. 

The ECB president’s decision nine months ago to provide more than 1 trillion euros of three-year loans to banks eased the pressure to sell assets at depressed prices. The infusion, designed to encourage firms to lend, succeeded in averting a short-term credit crunch by reducing their reliance on markets for funding. It also may be making European lenders dependent on more central-bank aid. 

“Deleveraging isn’t taking place, especially in Spain and Italy,” said Simon Maughan, a bank analyst at Olivetree Securities Ltd. in London. “The fact that we haven’t got on with it, or very slowly, suggests that when the time comes we’ll need another ECB injection to roll over the first one, just to keep the balance sheets of Italian banks in business.”...

In the absence of transparency, banks would rather not absorb the losses hiding on and off their balance sheets.  Rather, they would prefer to postpone recognition of the losses in the hope that the borrowers will recover.

The ECB money has removed the incentive for banks to clean their balance sheets, according to Olivetree’s Maughan. 

“Some banks, especially in Spain and Italy, are just taking in the money that they can get from the ECB, which should be a short-term measure in order to enable them to manage while they implement structural reforms,” Maughan said. “It successfully staved off a funding crisis, but its real aim of facilitating restructuring hasn’t even started.” ....

Nor will a restructuring start until banks are required 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 identify all the bad exposures and put pressure on banks to address these bad exposures.

Banks trying to sell assets are finding that buyers are demanding steep discounts for their worst assets, according to executives at private-equity and hedge funds acquiring the loans. 

They’re seeking discounts of as much as 50 percent to face value for underperforming loans, said Andrew Jenke, a director at KPMG LLP in London who advises on such transactions. 

Selling a loan at a discount to the value marked on the books requires the bank to crystallize a loss that erodes capital.

Crystallizing their losses is exactly what the bankers are trying to avoid.

British and Irish lenders are selling the most because European Union regulators have forced them to divest divisions and loans in return for state aid....

And even with regulators putting pressure on them to divest divisions and loans, the banks are dragging their feet in complying.

Banks in other European countries have sought to sell performing loans, which carry higher prices, or some of their best assets to avoid taking too big a loss that would deplete capital.

How exactly is the banking system better off if banks sell of their performing loans?

Some also have changed their mix of assets to reduce the amount of capital they need to hold.... 

“What should we believe, the RWAs, that are often based on internal models, or assets defined by international accounting standards?” Nijdam said. “A reduction of risk-weighted assets doesn’t reduce funding needs. Only a reduction in gross assets does. French banks are still way too big to fail.”...

As the FDIC's Thomas Hoenig would say, this is just the big banks gaming the system.

Spanish banks, which will receive as much as 100 billion euros from the EU to boost capital, also may accelerate deleveraging after the government opens a so-called bad bank to take on souring real-estate loans from rescued lenders..... 

If Ireland and its bad bank is used as an example, Spanish banks will only shrink to the extent of the loans removed by the bad bank.

Analysts estimate the pace of asset sales will increase as banks face the next round of Basel rules, which go into full effect by 2019. 

To comply, lenders will need to raise about 400 billion euros of core Tier 1 capital, the highest quality of capital mostly made up of common stock, the EBA said. Firms may still try to meet that requirement largely by retaining earnings, which would be possible if profits remain stable, according to Panigirtzoglou. 

By providing money and removing the pressure on banks, Draghi has delayed necessary steps to shrink, Maughan said. 

“The banks are the weak link in the economy,” he said. “They have to be compelled to sell assets. If you let them do it in their own timeframe, they will wait.” 

That could lead to what RBS’s Gallo called the “Japanification” of the banking system, a prolonged period during which lenders are slow to clean up their balance sheets. 

Please reread the highlighted text as it nicely summarizes the problem with the Japanese model.  Without the market exerting pressure to clean up their balance sheets, lenders will wait.  This waiting drags down the real economy.

'London Whale' lawsuit highlights need for banks to provide ultra transparency

As reported by Bloomberg, public pensions are suing JP Morgan for providing false information about its credit default swap trades.

Regular readers know that if JP Morgan had been required to provide ultra transparency and disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details the public pensions would have had access to the information they needed to independently and accurately assess the situation.

As a result, with ultra transparency there would be no basis for the lawsuit (as an aside, the trade probably wouldn't have occurred if there was ultra transparency because the market would have exerted discipline on JP Morgan to restrain its risk taking).

Public pension funds from Arkansas, Ohio, Oregon and Sweden will be lead plaintiffs in a group lawsuit against JPMorgan Chase & Co. (JPM)over trades made by Bruno Iksil, known as the “London Whale.” 

U.S. District Judge George Daniels in Manhattan ruled today that lawsuits against the New York-based bank should be consolidated into a class action. The pension funds allege they lost as much as $52 million because of fraudulent activities by JPMorgan’s London chief investment office.... 

“The public pension funds, a group which includes some of the largest public pension funds in the world, have far and away the ‘largest financial interest’ in the relief sought by the class in these cases,” Gerald Silk, a lawyer with Bernstein Litowitz Berger & Grossmann LLP, said Aug. 9 in court papers. 

JPMorgan Chief Executive Officer Jamie Dimon said in July the firm’s chief investment office had $5.8 billion in losses on the trades so far, and the figure may climb by $1.7 billion in a worst-case scenario. Iksil amassed positions in credit derivatives so big and market-moving he became known as the London Whale.

The pension funds allege they sustained losses after being given false information that hid the nature of the bank’s trades. 

Parliament Libor Report: Both Banks and Regulators need to change

Parliament's Treasury Select Committee led by Andrew Tyrie issued a report on the Libor rigging scandal in which it concluded:

Among its wide-ranging conclusions were that Barclays operated for years with woefully inadequate controls, that senior staff at the bank should have taken action earlier, that the Financial Services Authority (FSA) failed in its duty as regulator to respond to rumours of rate-fixing, and that the Bank of England had been “naive” and “inactive”. 

“Public trust in banks is at an all-time low,” Andrew Tyrie, chairman of the TSC, said. “Urgent improvements, both to the way banks are run and the way they are regulated, is needed if public and market confidence is to be restored.”

This conclusion applies not just to UK regulators, but to EU and US regulators too.

In his Telegraph column, Damian Reece discusses the implications of Parliament's conclusion:

But what we’re also left with, yet again, is a story of regulatory failure. Since 1997 the UK has been plagued by porous rules that have allowed unalloyed avarice to seep into every nook and cranny of City life. 

It is Tyrie’s conclusions and recommendations in this area which are the most important elements of the report. 

The committee has quite rightly used its findings into the Libor scandal as ammunition in its attempts to get urgent changes made to the legislation passing through Parliament that will merge two failing institutions (the Financial Services Authority and the Bank of England) into one, even larger, failing institution. If we don’t get the future of regulation right, we’ll never get the future of banking right.

Please re-read the highlighted text as Mr. Reece has elegantly made the case for why we need to bring transparency back of every opaque corner of the financial system and create the 'Mother of All Financial Databases".  Everyone knows that sunlight is best disinfectant.

By requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, bank behavior can be changed and avarice held in check.

The regulators failed in the lead up to the financial crisis.  Libor is simply another example of their failure.

The only way to get the future of regulation right is not to let the regulators operate behind a veil of opacity. There is no reason to put the financial system at risk of failing again because the financial regulators fail once again to accurately assess the risk in the banks and the rest of the financial system.

Transparency reduces, if not eliminates, the financial markets dependence on the regulators as market participants can assess the data for themselves and adjust the amount and price of their exposures accordingly.

Tyrie’s report does highlight how the FSA, led by chairman Lord Turner, has shown glimpses of the so called “judgment-led” regulation that will be the founding principle of the new regime. 

Judgment-led regulation is the notion of regulators standing toe to toe with bank chiefs and telling them when they don’t like what they see on their balance sheets and informing them what needs to change. It’s about telling a board that changes need making to key personnel. The banks will hate it but that’s exactly the point. The quid pro quo is that at least some of the petty box ticking will be abolished that drives bankers wild and probably encourages, rather than discourages, the culture of pushing regulatory boundaries to the limit. 

Here is a classic example of the Financial-Academic-Regulatory Complex (FARC) trying to protect itself and expand its power.

A problem the financial crisis exposed is that regulators are not a reliable substitute for the market in enforcing discipline on banks.  Yet, judgment-led regulation is based on the notion of the regulators going toe-to-toe with the banks.

How dumb is that?

To enforce discipline, the regulators first have to be able to assess what is going on at the banks.  Without ultra transparency, the regulators are substituting their analytical ability for the markets' analytical ability.

It is well known that the market does a better job of analysis as it has much more in the way of resources (financial and expertise) as well as an incentive to do a better job than the banks.

To enforce discipline, the regulators then have to go toe-to-toe with bank executives. This is regulators substituting their machismo for the market.

Given the recent Standard Chartered money laundering scandal, we can see that the regulators are going to back down.  If engaging in $250 billion of money laundering with Iran after entering an agreement to prevent this practice is not enough to lose a banking license, bankers have nothing to fear from regulators other than a fine which is an insignificant cost of doing business.

Markets are much bigger than the banks and much more capable of meting out discipline than regulators.  This discipline takes the form of reducing bank stock prices and access to funds to reflect the performance of the bank.

But Tyrie’s report also reveals how Lord Turner and his counterpart at the Bank of England, Sir Mervyn King, were unable to exercise that judgment-based regulation properly when it came to the removal of Bob Diamond. They wielded the axe in an arbitrary way which was inappropriate and which cannot be tolerated. 

The fact that Lord Turner tried and failed to secure Diamond’s resignation and subsequently had to get Sir Mervyn involved also exposes him as a weak operator. Put this together with the fact that the FSA, along with the Bank, failed to spot Libor manipulation in the first place and that “doesn’t look good” to quote Tyrie once again. It doesn’t look good for the FSA but neither does it look good for Lord Turner’s candidacy to be the next Governor of the Bank of England, with supreme power over all financial regulation. 

So what have we learnt? We’ve learnt that the old guard has had its day. It’s changing at the banks but now it must change at the regulators too.

Regulations adopted since financial crisis inhibit recovery

In his Telegraph column, Jeremy Warner provides a terrific description of the financial regulations adopted since the beginning of the financial crisis.

In this description, he confirms your humble blogger's observation that the regulations are a response to the financial crisis that treat symptoms without looking at the root cause.  Since the regulations only treat symptoms, they often contradict each other and/or inhibit recovery of the real economy.

As if the [corporate debt] refinancing problem wasn't already challenging enough, into it all stumbles the European commissioner for internal markets, Michel Barnier, to prove the old saw that there is no mess quite so bad that official intervention won't make even worse.... 

After a crisis of the magnitude we've just seen, it's perfectly right and proper, and certainly very human, to want to take immediate steps to fix the system, so as to ensure that this kind of nonsense can never happen again. 

However, you cannot count on luck if you want to fix the system and make sure this doesn't happen again.  You actually have to look not at the symptoms, but the root causes.

If policymakers had looked at the root causes of the financial crisis, they would have seen that the bankers  reintroduced opacity into the financial system.

They did this in many ways.

For example, rather than offer ultra transparency that was the sign of a bank that could stand on its own two feet, banks complied with minimalists disclosure requirements and turn themselves into 'black boxes'.

For example, they created structured finance securities that gave Wall Street an informational advantage over the investors as Wall Street had access to reports on the underlying collateral performance well before investors.

There is also something to be said for striking while the iron is hot. Leave things too long, and the political will to act melts away.

Actually, by investigating the cause(s) of the financial crisis, the political will to regulate remains.  This was shown in the aftermath of the Great Depression when the Pecora Commission paved the way for the regulations implemented by the FDR Administration 3+ years after the start of the financial crisis.

Even so, it's not clear that right now, with the crisis self evidently approaching some kind of fresh denouement, is the time to be buttressing the system against the once in a hundred year event of the present maelstrom. Nor in any case can the sort of extreme regulatory overkill we are seeing at the moment ever be seen as appropriate.

As I have been saying since the start of the financial crisis, the right regulation can both resolve the current problems with the financial system and buttress the financial system against the once in a hundred year event.

The right regulation was to adopt ultra transparency and shine a light into every opaque corner of the financial system.

Adopting ultra transparency leads directly to adoption of the Swedish model.  This leads to banks recognizing the losses on all the excess debt in the financial system.  In turn, this removes the burden of servicing this debt from the real economy and the restoration of growth.

Adopting ultra transparency also leads directly to market discipline being applied to the financial system.  With this disclosure, investors can actually assess the risk of banks and structured finance securities.  This leads directly to an ability to value these securities and make investment decisions (buy, hold, sell) based on the prices being shown by Wall Street.

As far as I know, Mr Barnier is well intentioned enough. He wants to protect us all from the calamities of the past. But in attempting to regulate away all future risk, he also threatens to undermine growth and further reduce already wanting European competitiveness. 

To be fair, it's not all Mr Barnier's fault. He's only part of a posse of international regulators riding furiously off in the wrong direction long after the horse has bolted.

A direct result of not investigating the causes of the financial crisis.

If even a fraction of the time spent on trying to protect us against a crisis that's already happened was devoted to finding a way out of it, then we might actually be getting somewhere. As it is, almost every part of the reform agenda is making matters worse, not better.

Please re-read the highlight text as it summarizes both why ultra transparency needs to be adopted and why most of Dodd-Frank (the Consumer Financial Protection Bureau and Volcker Rule being exceptions) should be repealed.

In its analysis of the refinancing challenge, S&P concedes that it might just about be possible for the banking system to cope with the wave of corporate debt maturities, assuming no further deepening of the eurozone crisis. But providing the $13 trillon to $16 trillion of new money to spur growth is going to be a much bigger ask, especially in Europe. 

"Much will depend on the continued ability of banking system regulators to pilot a path through the minefield that lies ahead", S&P observes. 

Well that appears to be that, then. Abandon all hope, for at the moment these very same regulators seem to be blundering their way forward as if entirely unaware of what lies beneath their feet. Ever more onerous capital and liquidity requirements have steepened the refinancing challenge, even with highly supportive central bank funding on hand. 

European banks, still grappling with high leverage and a worsening sovereign debt crisis, are particularly badly affected. Because of the escalating European banking crisis, they face intense pressure to meet new capital and liquidity requirements more quickly. With new equity virtually impossible to raise, this has only further exaggerated the de-leveraging problem. Enforced recapitalisation from governments which are themselves insolvent scarcely helps matters.

The financial regulator driven credit crunch I previously discussed.

In the US, there is at least a highly developed corporate bond market to act as an alternative to bank funding.

The reason is that non-financial corporations have to provide disclosure that provides all market participants with acces to all the useful, relevant information in an appropriate, timely manner.

That's not the case in Europe, where to the contrary, the regulatory agenda seems determined to put as many obstacles in the way of a viable bond market as possible. 

Standard & Poor's calculates that if corporate issuers in Europe were to tap the bond market for 50pc of their new funding requirements (up from 15pc historically), it would imply net new yearly issuance of $210bn to $260bn. In only two years in the last decade has net new European issuance exceeded $100bn. 

You might think this a significant growth opportunity, but Mr Barnier's new solvency directive threatens to snuff that one out too, by requiring that only the most credit worthy and liquid bonds count for capital purposes. 

The new solvency requirements virtually outlaw bundling together corporate loans and issuing them as asset backed securities, or rather, they prevent financial institutions from providing a viable source of demand for such bonds. Instead, finance is pushed by regulation ever more aggressively into sovereign bonds, even though many of them are now less than credit worthy.

As I previously said, most of the regulations that have occurred since the beginning of the financial crisis should be dropped.

Today, bank capital is completely meaningless (by extension, so are bank capital requirements).  Regulators are practicing forbearance and as Spain has shown banks have a virtually unlimited number of ways to practice 'extend and pretend' on zombie borrowers.

 Mr. Warner identifies one of several problems with the new solvency requirements.

A much better approach would be to adopt ultra transparency.  This will end the financial regulators' information monopoly and bring market discipline to the banking system for the first time in almost 80 years.

My bet is that market participants will reward firms that have a strong, liquid balance sheet.

Europe desperately needs growth, but it seems determined to stifle the credit needed to provide it. How stupid can you get?

JP Morgan's loss highlights need to address transatlantic risks

A Telegraph article focused on how risk taken in the London subsidiary of JP Morgan hurt the parent company in the US.

The London subsidiary is overseen by the Financial Services Authority while the parent is overseen by the Federal Reserve.  As a result, regulators think in terms of improving cross-border regulation to assure this doesn't happen again.

Regular readers know that the best cross-border regulation is the requirement that banks provide ultra transparency and disclose on an on-going basis all of their current asset, liability and off-balance sheet exposure details.

It is only when all the exposure details are disclosed that market participants can independently assess the risk of each bank and adjust their exposure to reflect this assessment.

The JP Morgan trade shows why all exposures, regardless of where in the world a financial institution holds them, must be disclosed.  If ultra transparency only applied to the US holdings, then market participants would have been blind to the risk being taken in the London subsidiary.

Gary Gensler, the head of the Commodities Futures Trading Commission (CFTC), told Congress on Tuesday that the losses are a reminder that authorities on both sides of the Atlantic need to improve cross-border regulation. 

The trades behind the losses were linked to the London division of the chief investment office (CIO), a part of JP Morgan that is tasked with investing the more than $300bn (£190bn) of deposits the bank has yet to lend out.... 

"It's a good reminder that risks in London can come back here and we can't have the US taxpayer standing behind them," Mr Gensler told the Senate Banking Committee.

However, we do want investors in JP Morgan and other financial institutions to be exerting market discipline so that the risks taken by financial institutions are restrained on a global basis.

Ultra transparency on a global basis is needed if the markets are going to provide this type of discipline.

The losses that JP Morgan disclosed almost two weeks ago shocked Wall Street and have reignited the debate about how best to regulate the world's largest banks. 

The London division of JP Morgan's CIO is regulated from the US by the Office of the Comptroller of the Currency, while JP Morgan's investment banking business in London is regulated by the Financial Services Authority.

The best form of regulation is market discipline.  This is something that can only occur when market participants have access to all the useful, relevant information in an appropriate, timely manner.

Only ultra transparency on a global basis provides all market participants with the useful, relevant information they need in an appropriate, timely manner.

JP Morgan trade shows ultra transparency replaces need for Volcker Rule

The Wall Street Journal ran an article that confirms that when market participants have visibility into a trade they will exert market discipline.

Market discipline based on disclosure is important because it cuts through the need to determine under the Volcker Rule what is a proprietary trade versus what is a legitimate hedge.

If a bank is required to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details, market participants can assess the riskiness of the bank and the trade and exert discipline accordingly.

A J.P. Morgan Chase & Co. trader whose massive derivatives sales in recent months earned him the nickname the "London whale" has stopped making those trades, for now. But investors that were squeezed in his earlier action remain engaged in high-stakes strategies against the trader. 

Dozens of hedge funds are believed to have placed bets in the derivatives markets that pit them against positions taken by Bruno Iksil, the French-born trader who works for the bank's Chief Investment Office in London, according to people familiar with the matter. 

Funds that traded against Mr. Iksil earlier this year recorded big paper losses as his trades helped push down one credit index. The losses made Mr. Iksil a target for some hedge funds, who felt they could capitalize on his outsize position, these people say. 

The funds' wagers against Mr. Iksil's positions have become increasingly profitable in recent weeks as prices in the credit-derivatives index that was at the center of one of Mr. Iksil's trades rose after his trades ceased. 

"I view the entire market as a chess match playing against this guy," said a person who is familiar with Mr. Iksil's positions and is trading against him.

The idea that the entire market is playing a chess match against a trader confirms that market discipline will be exerted if banks are required to provide ultra transparency.

Financial crisis amnesia

Once again, US Treasury Secretary Tim Geithner has taken to the op-ed pages of the Wall Street Journal.  This time he wants to remind everyone why in the aftermath of the financial crisis we needed to reform the financial system.

Regular readers know that financial reform as represented by the Dodd-Frank Act was pushed through before the Financial Crisis Inquiry Commission had submitted its work explaining what were the causes of the financial crisis.

Whether you agree with the Commission's conclusions or not, the simple fact is that Dodd-Frank does not address them.

For example, the Commission concluded that opacity in the financial system played a significant role in the financial crisis.  The Commission went further and defined by example that it was valuation opacity and not price opacity they were talking about.

The example the Commission gave was the opacity of banks that made it impossible to tell which banks were solvent (the market value of their assets exceeded the book value of their liabilities) and which were insolvent.

Dodd-Frank does nothing to address the absence of valuation transparency for banks or, much more remarkably, the opaque, toxic structured finance securities. [valuation transparency refers to the disclosure to market participants of all the useful, relevant information in an appropriate, timely manner so they can independently assess risk before making a buy, hold, or sell decision at the prices shown to them by Wall Street.]

Four years ago, on an evening in March 2008, I received a call from the CEO of Bear Stearns informing me that they planned to file for bankruptcy in the morning. 

Bear Stearns was the smallest of the major Wall Street institutions, but it was deeply entwined in financial markets and had the perfect mix of vulnerabilities. It took on too much risk. It relied on billions of dollars of risky short-term financing. And it held thousands of derivative contracts with thousands of companies. 

And no one in the market had access to its current asset, liability and off-balance sheet exposure details so that they could properly assess its risk and adjust both the amount and price of their exposure based on this risk assessment.

Instead, market participants had to rely on the financial regulators to assess this data and to convey just how much risk they found.

Based on how much risk Bear Stearns had at the time of its failure, it is doubtful that the amount of risk was successfully conveyed to market participants.

These weaknesses made Bear Stearns the most important initial casualty in what would become the worst financial crisis since the Great Depression.

Not exactly a high hurdle given that we had not had a major financial crisis since the Great Depression!

But as we saw in the summer and fall of 2008, these weaknesses were not unique to that firm. 

In the spring of 2008, more Americans were starting to face higher mortgage payments as teaser interest rates reset and they could no longer refinance out of them because the value of their homes stopped rising—the leading edge of a wave of foreclosures and a terrible fall in house prices. By the time Bear Stearns failed, the recession was then already several months old, but it would of course get much worse in coming months. 

These problems were partly the result of amnesia. There was no memory of extreme crisis, no memory of what can happen when a nation allows huge amounts of risk to build up outside of the safeguards all economies require.

Actually, all of this risk build up was the result of the regulators having amnesia and failing to require banks and structured finance securities to disclose all their useful, relevant information in an appropriate, timely manner.  Without this information, market participants were not able to properly assess risk of either the banks or the structured finance securities nor were they able to exert market discipline.

This crisis represented a huge failure of the regulatory system.  It was the regulators who failed to remember the lessons of the Great Depression.  The leading lesson of the Great Depression being the need for transparency (see creation of SEC as Exhibit I).

When the CEO of Bear Stearns called that night, it was not because I was his firm's supervisor or regulator, but because I was then the head of the Federal Reserve Bank of New York, which serves as the fire department for the financial system. 

The financial safeguards in the law at that moment were tragically antiquated and weak. 

Neither the Fed, nor any other federal agency, had the necessary comprehensive authority over investment firms like Bear Stearns, insurance companies like AIG, or the government-sponsored mortgage giants Fannie Mae and Freddie Mac. 

Regulators did not have the authority they needed to oversee and impose prudent limits on overall risk and leverage on large nonbank financial institutions. And they had no authority to put these firms, or bank holding companies, through a managed bankruptcy that wound them down in an orderly way or to otherwise adequately contain the damage caused by their failure.... 

What regulators did have was the authority to make sure that there was no opacity in the financial system.  They had all the authority they need to require all of these financial institutions to disclose all their useful, relevant information in an appropriate, timely manner.

Had regulators done this leading up to the financial crisis, the market would have exerted discipline and reigned in the risk taking behavior of these financial institutions.

However, by letting opacity run wild in the financial system, the regulators effectively neutered market discipline.  Precisely at the time that they had made the internal decision to rely on market discipline as being more effective than regulation.

A large shadow banking system had developed without meaningful regulation, using trillions of dollars in short-term debt to fund inherently risky financial activity.

The derivatives markets grew to more than $600 trillion, with little transparency ...

The reason it is referred to as a 'shadow' banking system is because it is opaque and provides no valuation transparency.

The failure to modernize the financial oversight system sooner is the most important reason why this crisis was more severe than any since the Great Depression, and why it was so hard to put out the fires of the crisis. 

The failure to reform sooner is why the crisis caused gross domestic product to fall at an annual rate of 9% in the last quarter of 2008; why millions of Americans lost their jobs, homes, businesses and savings; why the housing market is still so far from recovery; and why our national debt has grown so significantly....

Outside of Washington, nobody believes it was the failure to modernize oversight of the financial system that was responsible for the fact that the fires of the crisis have still not been put out.

Market participants have the common sense to know that valuing opaque structured finance securities is the same as blindly guessing the value of the contents of a brown paper bag.  As a result, market participants know it was the failure of the regulators to require ultra transparency and not antiquated oversight that is responsible.

Market participants also know that it was the choice by the Obama administration to pursue the Japanese model for handling a bank solvency led financial crisis.  As a result, the administration championed preserving meaningless bank book capital and banker bonuses over protecting Main Street from damage from the excesses in the financial system.

Had the administration not listened to the regulators who were responsible for the crisis in the first place and instead adopted the Swedish model for handling a bank solvency led financial crisis, Wall Street and the banks would have rescued Main Street and we would have significantly less national debt and a better economy.

Remember the crisis when you hear complaints about financial reform—complaints about limits on risk-taking or requirements for transparency and disclosure....

Given that Wall Street's Opacity Protection Team helped to write Dodd-Frank, there aren't many complaints about transparency and disclosure as it only relates to price and not valuation.

Are the costs of reform too high? Certainly not relative to the costs of another financial crisis.... 

Hence the reason that the mother of all financial databases should be built so that all market participants have access to the current asset, liability and off-balance sheet exposure details for every bank and structured finance security.

Are these reforms complex? No more complex than the problems they are designed to solve....

Ultra transparency is the simplest reform and could be written in less than three pages.  There is no ambiguity about updating disclosure daily for all observable events that occurred with the bank's or structured finance security's exposures.

These reforms are not perfect, and they will not prevent all future financial crises. But if these reforms had been in place a decade ago, then the rise in debt and leverage would have been less dangerous, consumers would not have been nearly as vulnerable to predation and abuse, and the government would have been able to limit the damage that a financial crisis could have on the broader economy....

It is absolutely true that the reforms included in Dodd-Frank are not perfect and that they rely on regulators to be perfect.  Since one of the major lesson of the financial crisis is that regulators are not perfect, it seems that relying on them to be perfect is simply gambling with financial stability.

Instead, regulators could focus all of their attention on making sure that they eliminate opacity where ever it may be in the financial system.

This does not require that the regulators are perfect in their analysis.  This simply requires that regulators ask themselves is their information that market participants might find useful.

We cannot afford to forget the lessons of the crisis and the damage it caused to millions of Americans. Amnesia is what causes financial crises. 

Which is why we need the mother of all financial databases.  So that the next time the regulators forget and let Wall Street try to introduce opacity through financial innovation, there will be an entity in the financial system who sees it as its responsibility to insure that market participants have access to all the useful, relevant information in an appropriate, timely manner.

The Chancellor and RBS: Osborne's failure to get a grip

The Telegraph carried an interesting article discussing how the Too Big to Fail banks have driven policy since the beginning of the credit crisis.

In particular, the article highlights the number of false assumptions that have dominated the discussion.

[It] points to a first-class crisis in government, created by the state purchase of two banks at the height of the 2008 financial crisis – RBS and Lloyds, the former now 84 per cent state-owned, the latter to the tune of around 40 per cent. 

Between them these banks account for an astonishing and quite terrifying £1.6 trillion in assets, roughly the same as GDP. 

If things go wrong, the British economy could capsize. Mr Redwood told me yesterday that you could easily lose a sum equal to the defence budget for a year if RBS investments caught so much as a cold.

The first assumption is that the state is at risk for losses incurred by RBS.  This assumption is false.

As Spain has just demonstrated, banks can recognize all the losses on their balance sheets today and restore their book capital through retention of future earnings.

Said another way.  Until the UK financial regulators close down a bank, it can continue to operate.  If the bank actually has a franchise of value, it will be able to earn the money to restore its book capital without government intervention.

Allies of the Chancellor insist that he made the decision to keep RBS under state control and as a single unit after the advice of two very persuasive men – Mr Hester and Sir Nicholas Macpherson, permanent secretary at the Treasury. 

Mr Osborne was reassured that RBS could be “floated off the reef”, kept intact and sold back to the public sector relatively quickly, thus delivering a return to taxpayers.

The second assumption is that there is a market for the common stock of a bank whose disclosures leave it as the Bank of England's Andrew Haldane says resembling a 'black box'.  Even Stephen Hester has said publicly that investors would be dumb to invest in banks.  He knows they do not have the necessary information to assess the risk of the bank.

Meanwhile, Sir Nicholas warned that it would be politically dangerous to intervene directly in the management of RBS and Lloyds.

It would be far better, the Chancellor was told by his top Treasury adviser, to allow RBS to be run by the clique of investment bankers who had been appointed by former chancellor Alistair Darling 18 months earlier....

The third assumption is that the choice for intervention is either no intervention or allow RBS to be run by the clique of investment bankers.  There is a middle ground.

From day one the UK Financial Investments should have been requiring the data that any investor would want if the investor was going to independently assess and monitor the risk of the two banks.

The data that an investor would want is the current asset, liability and off-balance sheet exposure details.

With this data, investors could independently assess and monitor the risk of each bank.  Without this data, investors are guessing at the contents of a black box.

With this data, investors could exert market discipline so that management does not increase the risk of these banks and try to gamble on redemption.  Without this data, investors are reliant on financial regulators  to properly assess and monitor the risk.

With this data, investors are not troubled by bonus payments as they can see that the bankers earned these bonuses for superior risk adjusted performance.  Without this data, investors assume the bonuses were earned as a result of all the financial market life support programs.

Others feel that [Mr. Osborne] is too much in awe of City bankers and, like his predecessor, Mr Darling, has been intimidated by their bullying and occasional hints at resignation.

The fourth assumption is that politicians and financial regulators will be able to control City bankers.

Its failure forever ends the discussion in favor of banks being required to provide ultra transparency.


Why?


Because the only player in the financial markets big enough to stare down City bankers is the financial market itself.  Frankly, it doesn't give a damn about the bankers tactics of bullying or hints at resignation. 

Deloitte confirms Europe's banks insolvent, estimates they have 1.5 trillion pounds of toxic assets

According to a Telegraph article,

Europe's banks must dispose of a pool of toxic assets larger than the entire British economy if they are to return to profitability and meet new capital rules.

The article goes on to say,

Estimates from accountants Deloitte found that European banks currently hold more than £1.5 trillion of non-core and non-performing assets on their balance sheets. 

From the article's headline, it appears that there are 1.5 trillion pounds of non-performing assets.  If so, it is highly likely that all the European banks are insolvent.

Deloitte said that while banks will have to dramatically shrink the size of their asset books they are likely to face major challenge in doing so given the scale of the bad loan problems they face. 

British banks, despite beginning their disposal programmes much earlier than their Continental European peers, still have by far the biggest pile of toxic assets. 

Deloitte estimates the size of the non-core and non-performing assets held on the balance sheets of UK banks at £460bn, more than the combined total for Ireland, Spain and Italy. German banks come a close second with a toxic asset pool of about £447bn. 

It is one thing for bank's to be a 'black box' when they have few non-performing or toxic assets.  It is entirely another issue when banks clearly have so many non-performing or toxic assets that their solvency is highly questionable.

The time has come to require ultra transparency.  Each bank must be required to disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.

It is only with this information that the market can determine which banks are solvent and which are not.

It is only with this information that the market can properly assess the risk of the banks and adjust both the amount and price of their exposure to the banks.

It is only with this information that the market can exert discipline on the insolvent banks to keep their risk levels in check while they are retaining earnings to restore their solvency. 

Former Fed Governor Kevin Warsh adds his support to requiring ultra transparency

In a Wall Street Journal column, Former Fed Governor Kevin Warsh discusses how global policy makers are preventing informed judgments.

His solution is providing market participants with transparency.

Financial markets are in a precarious place, with European banks and sovereign balance sheets in the cross-hairs. Bank regulators are becoming increasingly aggressive, and euro-zone borrowing costs are rising as the debts of years past are coming due. 

In this environment, policy makers are finding their authority, credibility and firepower being tested. In turn, they are finding it tempting to pursue "financial repression"—suppressing market prices that they don't like. But this is bad policy, not least because it signals diminished faith in the market economy itself. 

Markets are not always efficient, but the market-clearing prices for stocks, bonds, currencies and other assets (like housing) are critical to informing judgments, in good times and bad. 

Market-determined asset prices often reveal inconvenient truths. But the sooner the truth is revealed, the sooner judgments can be rendered and action taken. 

By contrast, government-induced prices send false signals to users and providers of capital. This upsets economic activity and harms market functioning. 

Markets that rely on governmental participation will turn out to be less enduring indicators of value. 

In environments of financial repression, businesses are keener to retrench than recommit their time, energy and capital to new projects. Trillions of dollars of private capital remains on the sidelines. And the private-sector engine that drives prosperity sputters. 

Consider a few recent examples of this policy in practice: 

In Europe, share prices are falling among the largest banks, but these prices are little more than a symptom. European banks suffer from a lack of capital to offset future losses, and a lack of transparency that makes it futile to try to judge their financial wherewithal. 

This also applies to banks globally.

Until banks are required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants will not be able to judge their solvency.

The bank problem is not some unfounded attack by greedy speculators, so a leading proffered solution—extending the ban on short-selling shares in big banks—obfuscates rather than informs. It also delays the necessary private-sector recapitalization....

Financial repression is sometimes the effect of policy even if it is not the intent. It manifests itself, for example, when policy makers react more forcefully to declines in asset prices than to increases. Price increases tend to be treated with benign indifference. But declines often lead policy makers to respond with force, deploying fiscal stimulus and monetary accommodation.... 

Efforts to manage and manipulate asset prices are not new. But history provides little comfort that these practices work. Interfering with market prices occasionally buys time, but rarely do policy makers seize the window of opportunity to enact structural reform. 

Financial repression embeds the wrong incentives—obfuscation begets delay, and a robust recovery becomes unattainable. 

The path to prosperity requires taking the long road. It requires policy reforms that make the economy less reliant on the preferences of government and more responsive to the market. 

That means prioritizing long-term growth over fleeting market stability, and giving precedence to structural reforms over temporary stimulus and market manipulation.

Nothing would be a bigger structural reform than requiring ultra transparency.

Corzine's rebuff of internal warnings on risk shows why ultra transparency is needed

A Wall Street Journal article documented how Jon Corzine rebuffed MF Global's chief risk officer and his concerns over the Eurozone debt trade.

Mr. Corzine's ability to rebuff the chief risk officer and the board of directors shows why ultra transparency should be required of all financial institutions.

If market participants had access on an on-going basis to MF Global's asset, liability and off-balance sheet exposure details, they could have assessed the risk of the Eurozone trade.  As the risk of the trade to the firm increased, they could have exerted market discipline by requiring higher returns on their investments.

Seeing his cost of funds increase would have acted as a break on increasing the Eurozone debt trade.

MF Global Holdings Ltd.'s executive in charge of controlling risks raised serious concerns several times last year to directors at the securities firm about the growing bet on European bonds by his boss, Jon S. Corzine, people familiar with the matter said. 

The board allowed the company's exposure to troubled European sovereign debt to swell from about $1.5 billion in late 2010 to $6.3 billion shortly before MF Global tumbled into bankruptcy Oct. 31, these people said. The executive who challenged Mr. Corzine resigned in March. 

The disagreement shows that concerns about the big bet grew inside the company months before the trade rattled regulators, investors and customers. 

Inside the company, they had access to the information on the trade.  Outside of the company, the information on the trade was limited.

The executive, Michael Roseman, whose title was chief risk officer, also expressed concerns directly to Mr. Corzine in meetings of just the two men and with other people present, people familiar with the situation said. 

Mr. Roseman contended MF Global didn't have enough spare cash to withstand the risks of its position in bonds of Italy, Spain, Portugal, Ireland and Belgium. He also presented gloomy hypothetical scenarios of what could happen if MF Global's credit rating was downgraded because of the exposure. 

Mr. Corzine, who started betting on the bonds shortly after arriving as chief executive in March 2010, responded to Mr. Roseman's concerns that some of the scenarios were too extreme and likely impossible, people familiar with the matter said. The former New Jersey governor and Goldman Sachs Group Inc. chairman said MF Global's exposure was limited, adding that the likely profit was worth the risks, these people said. 

Boardroom disagreements in which the CEO's decisions are questioned by a lieutenant are rare. The situation at MF Global is even more unusual because it came just six months after directors hired Mr. Corzine to turn around the struggling brokerage firm.

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.