Basel Committee seeks to limit bank-to-bank exposure

In another classic example of the substitution of complex rules and regulatory oversight for the combination of transparency and market discipline, the Basel Committee is looking at how to limit bank-to-bank exposures so as to eliminate the risk of financial contagion.

The Basel Committee is effectively trying to do through regulation what market discipline would do more efficiently if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Regular readers know that our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  It is the principle of caveat emptor that makes each bank responsible for all losses on their exposures, including to other banks.

With the responsibility for losses comes the incentive to limit exposures to what the bank can afford to lose.

With transparency, banks look at their exposures to other banks not just as an exposure to another bank, but as an exposure to that bank's exposures.  It is these exposures that drive losses at both banks and therefore banks set their exposures to each other based on the risk of the other bank.

When the level of inter-bank exposure is based on transparency of each bank's risks, the global financial system both minimizes financial contagion and maximizes inter-bank exposures needed for supporting the real economy.

As reported by Reuters,

Global regulators have proposed tougher rules from 2019 to stop big banks from building a level of risk on their books that would make them vulnerable if a major customer goes bust. 

In an attempt to gain transparency on bank assets and facilitate speedy action from regulators in the event of a crisis, the global Basel Committee on Banking Supervision is proposing much tougher rules on banks' exposure to other banks. 

The aim is also to reassure markets that when a bank is in trouble, other banks' exposure to it would be relatively limited to avoid the type of contagion seen during the 2008/09 financial crisis.

Why attempt to gain transparency on bank assets and reassure markets through complex regulation when simply requiring banks to provide ultra transparency permanently solves the problem?

Big losses at some banks on asset-backed securities in 2008 prompted investors to withdraw funds from a wide range of lenders, exacerbating the market turmoil....

Investors withdrew funds because banks are 'black boxes' and there was and still is no way to assess each individual bank's solvency or risk.

Again, a problem solved by having the banks provide ultra transparency.

Basel is now proposing to impose a stricter exposure limit on big banks and a requirement for more detailed reporting on exposures. 

"This is to ensure that the large-exposures standard is effective and consistent for internationally active banks," a committee statement said. 

"On this basis, breaches of the limit should be exceptional events, should be communicated immediately to the supervisor and should, normally, be rapidly rectified."

Basel said that the very biggest banks would only be allowed to conduct business with another bank of similar size up to the equivalent of 10-15 percent of its core capital, well below the 25 percent limit recommended at present....

The Basel Committee is proposing substituting regulations and regulatory oversight for transparency and market discipline.

Exposure limits by their very nature are fundamentally flawed.  For example, is the 10-15% of core capital exposure limit based on gross or net exposures?  I ask because it is often the case that a net exposure becomes a gross exposure when the bank on the other side of the transaction fails.

"The knock-on effect is another dampener on the flow of capital around the system. It's a bit more grit in the machine," said Richard Barfield, of accountant and consultancy PwC. 

"What is coming into focus is the whole balance between the supervisory appetite for risk and the need to have a financial system that can support international business activity and commerce efficiently."

It is not a supervisory appetite for risk, but for additional regulation.  When the system fails next (and it already has in Greece, Cyprus,...), the regulators want to be in a position to say it was not their fault, just look at all the regulations.

The financial crisis highlighted the simple fact that a financial system that is dependent on the combination of complex regulations and regulatory supervision is prone to failure.  This is not surprising as the system has a single point of failure: the regulators.

Fortunately, our financial system is designed not to have a single point of failure and to be much more robust and resistant to failure.  Our financial system achieves this through transparency and caveat emptor.  When everyone is responsible for their losses, our financial system is much more robust and resistant to failure.

Where our financial system failed was in the areas it was dependent on the regulators.

WSJ: misguided faith that rules and regulators can prevent next financial crisis

The Wall Street Journal added its support to your humble blogger's argument that the combination of complex rules and regulations will not prevent the next financial crisis.

The misguided faith that rules and regulators can prevent the next financial crisis is hard to shake, but this week brought a glimmer of hope.

Regular readers know that the combination that will prevent the next financial crisis is transparency and market discipline.

The parts of the financial system that failed in our current financial crisis are those that feature complex rules and regulatory oversight (think banks) and/or opacity (think structured finance securities).

The parts of the financial system that continued to function throughout the financial crisis without government intervention feature transparency and market discipline (think stock or non-financial corporate bond markets).

The chairman of the Basel Committee on Banking Supervision signalled that regulators might be starting to understand how their rules contributed to the 2008 financial crisis—and the damage these rules could do in the future.

It is not the rules that do the damage.

It is the regulators' information monopoly that does the damage.

The regulators' information monopoly prevents market participants from accessing all the useful, relevant information in an appropriate, timely manner when it comes to financial institutions.

As a result, market participants cannot see how the rules are distorting the risk of the banks or, more importantly, how the banks are gaming the rules and adding risk.  Both lead to a financial crisis.

The Basel rules are the global standards that encouraged banks to hold mortgage-backed securities before the crisis and have since been re-written to favor investment in sovereign debt (such as Italian or U.S. bonds). 

Perhaps realizing how terrifying that sounds to taxpayers, Chairman Stefan Ingves said on Tuesday that the committee, whose members include U.S. financial regulators, has created a "high-level task force" to study the issues raised by Basel critics. 

Reformers like Andrew Haldane at the Bank of England and Thomas Hoenig at the U.S. Federal Deposit Insurance Corporation have pointed out that the complex Basel rules have been enormously costly yet were of little use before the crisis in determining which banks would run into trouble....

The failure of the Basel capital requirements in the run up to our current financial crisis should have forever ended the faith that the combination of complex rules and regulatory oversight can prevent a financial crisis.

The failure of the combination of complex rules and regulatory oversight in the run up to our current financial crisis should have caused us to look for an alternative.

The alternative that would have been found is the combination of transparency and market discipline.

Why would the combination of transparency and market discipline have been found?

Because our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  Which is simply the combination of transparency and market discipline.

Instead of relying on a straightforward calculation of how much capital banks hold, Basel has embraced complicated methods for assigning "risk-weights" to the various assets held by banks. 

The opportunity for banks is either to lobby regulators to favor particular assets, or to simply wait until regulators bless certain types of investments for political reasons, and then figure out how to construct the most Basel-friendly balance sheet. 

Either way, guess which firms are best at navigating this byzantine regulatory architecture?...

The combination of transparency and market discipline puts an end to banks gaming the rules.

It ends this gaming as the market is only concerned with the risk that banks are taking and not how the banks manipulate some meaningless rules.  If the banks are required to provide ultra transparency, the market will exert discipline based on the actual exposure details of the bank regardless of how the banks game the complex capital rules.

Mr. Ingves and his colleagues have a long way to go. 

Actually, Mr. Ingves and his colleagues will never get to the point where they acknowledge that the combination of complex rules and regulatory oversight will not prevent the next financial crisis.

They are regulators and this would be acknowledging a significant limitation to their capabilities.

Ex-compliance officer makes case for banks providing transparency

In a must read interview on the Guardian, an ex-compliance officer talks about regulators, high-frequency trading and transparency.

His view of the impact of transparency on banks is

What's more, you cannot have a banking environment that is risk free, gives high returns while being highly transparent. That's logically impossible. If you're transparent in what you're doing then others will see it and get in on the action driving down returns.

And why is it necessary that banks generate high returns?  Isn't a low risk banking environment that is highly transparent preferable from the perspective of society?

His view on the fundamental reason that regulators are ineffective

My impression was that regulators were not always alive to how things work in practice. 

The ones I dealt with were often economists, essentially philosophers who had learned to build models. 

Why understand how things actually work in practice when you can just make assumptions to plug into models?  A classic example of this is the bank stress tests.  Is there any surprise that the banks can pass stress tests for capital adequacy and then need to be nationalized shortly thereafter.

Finally, he offers his perspective on high frequency trading

The effect of HFT on the trading floor is fascinating. You can't see the HFT programme, as it is embedded in the computers. So you notice it negatively, when traders complain because something isn't working. And you notice it when you're watching the order book on a screen, and you see movement when the programme buys or sells.

It's when there's a panic that you really realise just how strange and evanescent these programmes are. How do we access them? In the last resort people can actually rip out the cable from the computer. I've seen that happen, but it seems ridiculously primitive in such technological environments. 

No human being could ever do what computers now do with high frequency trading. No human being can see what HFT does. We can only see it afterwards, when it already has made its impact. 

This raises important questions for regulators. HFT is very difficult to corset, to manage. Regulators will probably never have the manpower to monitor all the data, to follow all transactions. So a significant portion is delegated to innovative technology. Many people I have interviewed are genuinely concerned over this.

Perhaps rather than trying to monitor high frequency trading, the regulators should ban it until such time as they are actually capable of monitoring it and making sure that its impact on the financial markets is positive.

By letting high frequency trading continue right now, the financial regulators are effectively gambling with the stability of the capital markets and the financial system.  A gamble that doesn't appear prudent to your humble blogger.

Davos: Paul Singer versus the global financial regulators

One of the central themes of this blog is the always harmful substitution of the combination of complex rules and regulatory oversight for transparency and market discipline.

This theme played out in a Davos panel discussion involving Paul Singer from Elliott Management.

As reported on twitter by @Anthony_Reuben, a journalist on the BBC business desk:

Paul Singer says he sends his staff to find out about financial health of banks and they come back and shrug. Wants more disclosure. 

Mr. Singer's staff confirms the Bank of England's Andrew Haldane's observation that current bank disclosure standards leave them resembling 'black boxes'.

And why does Mr. Singer want more disclosure?  Because as an investor Mr. Singer knows that he should be responsible for all gains and losses on his exposures to banks.

Hence, he is looking for all the useful, relevant information in an appropriate, timely manner so he can independently assess this information and make a fully informed investment decision.

For banks, the useful, relevant information is their current global asset, liability and off-balance sheet exposure details.  What your humble blogger calls ultra transparency.

Why isn't this information available?

Prudential boss: global banking standards difficult because banks in countries where banking system didn't blow up are not interested.

It is not the banks that are uninterested, but it is the global financial regulators clinging to their information monopoly who are uninterested.

Here we are five years after the beginning of the financial crisis and Paul Singer's staff still cannot access all the useful, relevant information for making an investment in a bank nor is there any movement afoot to ever require banks to provide this information.

Everyone knows that ultra transparency is the "gold standard" for bank disclosure.  But it is more than that.  It is also gives banks in countries that adopt ultra transparency a competitive advantage.

The competitive advantage comes from the simple fact that ultra transparency allows market participants to independently assess the risk of each bank.  Since everything is disclosed, market participants can do a better job of assessing the risk and as a result can reward these banks with a lower cost of funds and a higher stock price.

All those banks in countries that don't require ultra transparency are at a competitive disadvantage.  Market participants know from the lack of disclosure that the banks are hiding something.  As a result, market participants punish these banks with a higher cost of funds and a lower stock price.

Ultra transparency is actually an easy global banking standard to adopt as there are no banks who would want to be at a competitive disadvantage.

So what do we have instead of ultra transparency?

We have the pursuit of the combination of complex rules and regulatory oversight.

This takes the form of legislation like the Dodd-Frank Act that was written by and for the banks (recently, I discovered that the Volcker Rule is essentially toothless as it was written so it doesn't apply to position held for more than 90 days ... proprietary bets can last months), we have financial regulators pursuing Basel III capital regulations that are too complex to enforce and we have policymakers pursuing ring-fencing.

This pursuit of the combination of complex rules and regulatory oversight shows that the first lesson of the financial crisis was not learned.  The first lesson is that the combination of complex rules and regulatory oversight failed.

The combination just didn't fail, it failed in a catastrophic manner as shown by our ongoing financial crisis.

Equally importantly, the financial crisis revealed that the combination of complex rules and regulatory oversight is prone to catastrophic failure.

Unlike Tim Geithner who believes that the combination of complex rules and regulatory oversight should be given another chance, your humble blogger does not believe in gambling with the stability of the financial system when it is your humble blogger and the other taxpayers who are going to be called on to bail out the financial system when this combination predictably fails again.

Ultra transparency restores stability to the financial system and does away with gambling financial stability on the success or failure of complex rules and regulatory oversight.

BoE's Robert Jenkins: Basel rules not up to the job

Reuters reports that Bank of England Financial Policy Committee member Robert Jenkins said that the Basel capital and liquidity requirements were not up to the job of protecting taxpayers.

Mr. Jenkins is simply confirming that the combination of complex rules and regulatory oversight doesn't work and is a wholly inadequate substitute for the combination of transparency and market discipline.

New global rules forcing banks to hold more capital and cash to shield taxpayers and make the financial system safer won't achieve their aim, a UK regulatory policymaker warned on Thursday. 

Robert Jenkins, a member of the Bank of England's Financial Policy Committee, said the Basel III accord, agreed by world leaders (G20) for implementation over six years from this month, does not go far enough. 

Basel III requires banks to more than triple the amount of capital they hold and have separate cash buffers so taxpayers are less likely to have to rescue them again should another financial crisis occur. 

"Will Basel III do the job? My personal opinion is that it won't," Jenkins told reporters. 

He said his view was echoed by a growing body of academics and others on the FPC such as Andrew Haldane, the Bank's director of financial stability. 

Haldane and other regulators such as Thomas Hoenig, vice-chairman of the U.S. Federal Deposit Insurance Corp, think the Basel accord is too complicated to work.

With liquidity coverage ratio, regulators repeat error that led to financial crisis

As pointed out by CNBC's John Carney, global financial regulators have repeated the same error that contributed to the financial crisis in specifying what assets qualified for the liquidity coverage ratio.

The error was that assets that were suppose to be low risk and liquid, aka AAA-rated structured finance securities and sovereign debt, turned out not to be either low risk or liquid as the prices on these assets drop dramatically and the markets on which they traded froze.

The only way to avoid repeating this error is to bring transparency back to all the opaque corners of the global financial system.  It is only when market participants have access to all the useful, relevant information in an appropriate, timely manner so they can assess and make a fully informed decision that markets remain liquid.

The expansion of the definition of high quality liquid assets will result in a high-level of demand for whatever types of assets have the highest haircut adjusted returns. A highly rated mortgage-backed security has a lower haircut than a similarly rated corporate bond, which will create additional demand for those mortgage-backed securities. Likewise, banks are likely to crowd into the lowest rated corporate bonds included in the bucket to increase the after-haircut yield.  

The market is likely to respond to these regulatory driven changes in demand by creating more of these assets. This increase in supply can happen in at least two ways. In the first place, lenders will make more of the preferred loans. That could be a positive for the housing market, although it risks being too positive—possible leading to another credit-driven bubble.  

What's more, the market can create more high quality liquid assets by gaming the ratings system—as we saw during the last credit bubble. Banks will seek to put riskier assets into safer categories, putting pressure on the ratings agencies to do the same. The fact that the new rules rely on the judgment of rating agencies—who screwed up royally during the bubble—should be ringing alarm bells around the world, but hardly anyone seems to have noticed. 

This brings us to the fat-tail problem with the liquidity coverage ratio. 

Banks and bank regulators have now agreed on what constitutes a high-quality liquid asset. The entire financial sector will quickly become more exposed to these assets than it would have been otherwise. We will generate more of these assets globally than we would otherwise. If the banks and the regulators are right that these assets are stable enough and liquid enough, then the system should be safer. 

But there is good reason to think that the banks and regulators are wrong. 

For one thing, as Nassim Taleb is constantly warning, the world is less predictable than their models assume, and unexpected changes have significant impacts. How can regulators possibly model the effects on asset quality of increased demand for their favored assets? Can they predict the deterioration of ratings quality? Have they modeled the fact that regulatory-driving pricing creates misinformation about risk?  

Which brings us to the overarching problem of financial monoculture. The entire financial system is rendered riskier when all of the largest institutions are cajoled by regulators into adopting a similar view of asset risk—which is exactly what led to our recent financial crisis. 

The cost of error is greatly increased. Instead of disparate failures, we invite system-wide failure from errors in risk assessment. (Arguably, the expansion of assets included in the liquidity ratio and the lowering of the outflow forecast somewhat reduce the monoculture problem. But only somewhat.) More worrisome still, there is no sign that the Basel folks or the bankers understand the monoculture problem at all.

The FDR Framework addresses the financial monoculture problem.

By combining the philosophy of disclosure with the principal of caveat emptor (buyer beware), the FDR Framework places the burden on each market participant to bear both the gains and losses from their exposures.  As a result, market participants limit their exposures to what they can afford to lose given the risk.

This builds resilience into the system.

Can complex regulations that require banks to hold similar assets undue the benefits of the FDR Framework?

No.

The reason is the market participants who are exposed to the banks, including the banks themselves, will limit each bank's exposure and the industry's exposure to these assets.  The way they will limit exposure to these assets is by increasing each bank's cost of funds to reflect its increasing risk from having higher exposure to these assets.

Neither the bankers nor the regulators understand how our last financial crisis was engineered.

Indeed, they seem incapable of anticipating even the highly predictable risks of worldwide financial homogenization outlined above. Which makes it very hard to take seriously their claims that the new rules the regulation peddlers have pulled from their sack will do very much to create a more resilient financial system.

Right.  They fail to understand that the last financial crisis showed that complex rules and regulatory oversight is not a substitute for transparency and market discipline.  Complex rules and regulatory oversight creates instability.  Transparency and market discipline creates a resilient financial system. 

King vs Osborne: a tussle over meaningless bank capital requirements

Against the backdrop of EU banks asking for a one year delay in the introduction of Basel III in light of the US not implementing Basel III in 2013, we have the spectacle of the Bank of England's Mervyn King fighting with UK Chancellor George Osborne over leverage on UK bank balance sheets.

Regular readers know that bank capital and any ratio involving bank capital is meaningless.

The OECD observed that bank capital is meaningless given the existence of regulatory forbearance that allows banks to engage in 'extend and pretend' with bad debt and the suspension of mark-to-market accounting.  Both directly manipulate bank book capital levels by overstating exactly how much book capital there is.

Capital ratios are an example of the combination of complex rules/regulations and regulatory oversight that are substituted for transparency and market discipline.

The financial crisis showed that this substitution contributes to financial instability and makes the financial system prone to failure.

Regular readers know that what is needed is to require 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 independently assess the risk of each bank and calculate capital ratios if they want to as part of this assessment.

Indeed, the more important clash is King v Osborne on the vital issue of the degree of leverage on UK banks' balance sheets. 

Vickers' panel was crystal clear: leverage should be capped at 25 times capital. But the chancellor has watered down that proposal, saying the government is happy to tolerate 33 times. 

To most outsiders, it looks as if Osborne has been swayed by the lobbying of the likes of Santander UK, which argues that a mortgage-dominated bank would be constricted by Vickers' harder limits. 

Of course the government is swayed by the lobbying of the industry.  There is no surprise here.

What is left unsaid is that both King and Osborne are swayed by the lobbying.  In particular, both of them are spending time arguing about a meaningless capital ratio when what is needed is to restore transparency to the banking system.

Vickers was unhappy about the watering-down and King sounds furious. 

The governor gave a blistering defence of the more conservative approach. International standards for calculating risk-weighted assets are too inflexible; risk weights move over time; and in major crises risks tend to interact. For those reasons, pure leverage ratios have proved the best guide to the strength of a bank in a crisis. 

As King pointed out, Northern Rock, while fully up-to-date with the Basel banking committee's finely tuned risk calculations, was still operating at 80 times leverage before its collapse. 

The argument over the right amount of leverage is nonsense.

The only relevant issue is how much risk the banks are taking so that market participants can adjust their exposure to each bank based on the risk of each bank and the market participant's capacity to absorb losses given this risk.

Setting sensible leverage ratios should therefore be at the top of the reform agenda. It's more important than the detail of which activities should lie, or be required to lie, within a ring-fenced bank.

Actually, what should be at the top of the reform agenda is requiring transparency.

If King, Vickers (and Tucker?) think 25 times is high enough and that Osborne is being too racy, that's a major concern. Let's hope the commission, which seems to be in a mischievous mood, kicks up a storm about leverage.

I am hoping the commission kicks up a storm about transparency which is what truly matters and is the only sensible reform.

UK regulator says regulators can only reduce frequency of bank crises and taxpayer bailouts

Bloomberg reports that Lord Turner, the chairman of the UK's Financial Services Authority, told Parliament that regulators are only capable of reducing the frequency of bank crises and taxpayer bailouts.

This is confirmation that relying on financial regulators is simply betting with financial stability and the taxpayers' money.

Fortunately, our modern financial system is designed so that it doesn't have to rely on the financial regulators.  As everyone knows, our financial system is based on the philosophy of disclosure combined with the principle of caveat emptor (buyer beware).

It is this combination that effectively prevented a financial crisis for over 7 decades until the financial regulators let the bankers create vast opaque areas of the financial system.  It was these opaque areas like banks and structured finance securities where the crisis occurred.

The solution to end the reliance on financial regulators for ending banking crises is to strip them of their monopoly on all the useful, relevant information on banks.  This is accomplished 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 independently assess the risk of each bank and then adjust both the amount and price of their exposure to each bank based on this risk assessment.

It is this ability to adjust their exposure based on their independent assessment of risk that allows market participants to exert discipline on the banks to restrain risk taking.

This ability to adjust their exposure also permanently ends taxpayer bailouts as it ends the risk of financial contagion.  Each market participant knows that they will not be bailed out and sets their exposure to what they can afford to lose given the risk of each bank.

Lord Turner has confirmed that complex rules/regulations and supervision are an inferior substitute for transparency and market discipline.  Therefore, Parliament should focus its attention on restoring transparency and market discipline.

“The honest truth is that if you believe you have forever completely destroyed the possibility of a taxpayer input, we’re probably fooling ourselves,” Turner said at a hearing of the U.K. Parliament’s Commission on Banking Standards in London late yesterday. 

“But if we are successful, we are reducing the periodicity of a taxpayer input from once every 50 years to once every 200 years.”

Transparency and market discipline have already shown themselves to be more effective.  The transparent areas of the financial system did not experience a financial crisis even as the opaque areas like banks and structured finance blew up.

Turner, seen as a potential candidate to succeed Mervyn King as Governor of the Bank of England, said it has been a “learning process” over the last four years and his thinking has changed as the true extent of the financial crisis emerged. 

He said there is a need for a “belt and braces” approach to regulation and the key issue is ensuring banks have an adequate level of capital to protect themselves. 

“The core of resolvability is primary loss-absorbing capacity and bail-in-able debt,” Turner said. “And provided you have enough of that, then if proprietary trading activities produce losses, we can make sure those do not fall on the taxpayer or on a systemic shock to the industry, but are absorbed by the appropriate bail-in-able senior unsecured debt. That’s very important.”

Actually, the "belt and braces" approach to regulation should be to have the analytical ability of the market support the regulatory process.

This is easily achieved when banks are required to provide ultra transparency.

Then, the regulators can ask market participants, including banking competitors, what they see as the biggest risks at each bank.  This can supplement the regulators' internal analysis of the risk at each bank and be used to bring regulatory pressure along with market discipline to restrain risk taking.

Turner said that there is a need for both “structural proposals” to strengthen banks, such as those put forward by the ICB on the ring-fencing of consumer units, and “robust proposals” on capital and liquidity in the aftermath of the crisis. 

“We have to recognize that it was deeper and more fundamental and with more adverse consequences than was apparent in 2009,” he said. “As this crisis and post-crisis has gone on, like many people I’ve been increasingly aware of what a deep set of problems there are in our banking industry.”

The crisis exposed a deep set of problems in the banking industry that are the result of the lack of disclosure by banks that leaves them resembling "black boxes".

For example, one problem was market participants relying on the regulators to both properly assess the risk of each bank and communicate this risk.

Regulators will never properly communicate how risky a bank is because of concerns with the safety and soundness of the banking system.  They fear that if they say a bank is risky it will trigger a run on the bank.

Turner also said it’s too simple to blame investment banking alone for a decline in the “culture” of banking. 

“The culture of classic commercial banking was probably contaminated by three different things -- one of which was an investment banking culture that everything is there to be traded and make money from in the short term,” he said. Still, there were other issues -- the selling of financial products to the public without “appropriate constraints” and a too-heavy focus on return on equity,’’ he said.

“In many sectors of the economy there is nothing wrong” with a focus on ROE, “but I think applied to banking that is potentially dangerous,” Turner said. “That’s because in banking the easiest way to boost return on equity is simply to boost leverage, either in direct open ways or in a set of hidden ways.”

Actually, the culture was a product of opacity.  Opacity provided a veil to hide misbehavior behind.  Lord Turner acknowledges this fact.

For banking regulation, simpler is better

The Bloomberg editors became the latest to call for simpler banking regulations observing that complex regulations can overwhelm the regulators.

Regular readers know that the simplest bank regulation with the biggest impact is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This simple regulation triggers a number of positive outcomes.

First, it subjects the banks to market discipline as market participants can now independently assess each bank and adjust their exposures accordingly.

In adjusting their exposures, market participants end the risk of financial contagion as they adjust their exposures to what they can afford to lose given the risk.

In adjusting their exposures, market participants restrain risk taking by the banks as higher risk will immediately translate into a higher cost of funds.

Second, it gives the banks an incentive to clean-up their balance sheets.  As a result, banks stop practicing 'extend and pretend' and deal with their bad debt.  This relieves the real economy of the debt service burden on the bad debt and this money can be redirected back to reinvestment and growing the economy.

Third, it brings in sunshine as the best disinfectant to eliminate bad behavior by bankers.

Fourth, it lets the regulators withdraw all those complex rules/regulation and regulatory oversight that were put in place as a substitute for transparency and market discipline.

More than four years after a financial breakdown plunged the world economy into the worst slump since the Great Depression, efforts to build a stronger global system of bank regulation are barely inching forward. Regulators seem overwhelmed by the complexity of their own reforms. 

To make faster progress toward a safer system, governments must aim for greater simplicity....

Nothing is simpler or more powerful than requiring ultra transparency.

As Andrew Haldane of the Bank of England recently explained, the [Dodd-Frank] rule-making could ultimately amount to 30,000 pages. Many of those pages are the result of banks’ efforts to insert exceptions and caveats. 

The worst effect of the growing complexity -- aside from delay -- may be that the rules, once written, won’t work. Rules that differ in myriad ways from country to country widen the scope for regulatory arbitrage. Beyond that, the financial crisis belies the idea that increasingly complex rules are the right way to control an increasingly complex system....

Transparency has been shown to work in the past.

In addition, the requirement for ultra transparency translates easily from country to country.

A balance must be struck, but it’s increasingly clear that regulators have erred too far in the direction of complexity.

Complexity that introduces opacity into the financial system when what is needed is simpler rules that reintroduce transparency into the financial system.

Ring-fence versus transparency: gamble versus sure thing

The more the UK financial regulators tell Parliament about their proposal to ring-fence the banks, the clearer it becomes that they are uncertain if it will work as intended.

Why would anyone adopt reform with an uncertain outcome when they could adopt reform with a known outcome?

With ring-fencing, the UK financial regulators are asking Parliament to gamble in the hopes that it will work.

In a Guardian article, John Vickers, the man behind the ring-fence idea, expresses his hope that it will work and that when combined with higher capital requirements it will get taxpayers 80% of the way to not having to bailout the banks again.

With ultra transparency where the banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, Parliament could adopt reform that is a sure thing.

With ultra transparency, taxpayers get 100% of the way to not having to bailout the banks again as the era of bailing out the banks for fear of financial contagion is ended.

Using this information, market participants can independently assess the banks and adjust their exposure to each bank based on both the bank's risk and the participant's capacity to absorb financial losses given this risk.  Since each participant can afford to absorb the loss on their exposure, there is no reason for the taxpayer to step in.

Ultra transparency also ends bailouts that result from the moral hazard that arises from financial regulators possessing an information monopoly, running stress tests and pronouncing the banks solvent.    When market participants have the same information as the financial regulators, they can run their own stress tests and therefore have no need to be bailed out after relying on what the financial regulators say.

It is very well known, including among financial regulators and academics, that sunlight is the best disinfectant.

Not only will ultra transparency bring an end to an era of bad behavior by bankers, but it will subject the banks to market discipline for the first time in at least three decades.

Market discipline that will restrain risk taking.

For example, it will virtually eliminate proprietary trading when combined with a Volcker Rule prohibition as market participants will enforce compliance.

It is also very well known that ultra transparency has other benefits.

It restarts the interbank lending market as banks with deposits to lend would have access to the information they need to independently assess the risk of the banks looking to borrow.  With the interbank lending market restarted an transparency into every trade, Libor can be based on actual trades and no longer be subject to manipulation by the bankers.

The UK Parliament faces a choice:  gamble with ring-fencing and hope this changes the culture and reduces the risks taken by the banks or adopt a sure thing with ultra transparency and know they have changed the culture and reduced the risk taken by the banks.

The architect of proposals to ringfence retail banking conceded on Monday that the government should retain the power to break up banks completely. 

But Sir John Vickers, who chaired the Independent Commission on Banking (ICB) which recommended ringfencing, also told MPs and peers that he believed ringfencing – and not total separation – would be effective. 

"I believe the ringfence will work. With the legal and other safeguards it will work, including on the cultural aspect," Vickers said to the parliamentary commission on banking standards.

It is unacceptable after the global financial crisis to adopt reform based on the "belief" it will work when there are proven alternatives.

He admitted that fear of an enforced breakup could be used to put pressure on banks that were trying to avoid the rules. 

The government is giving the banks until 2019 to put up a ringfence between their high street and investment banking arms.... 

Asked by Tyrie whether a full break up should be included in the legislation in the event banks fail to install the ringfence, Vickers said he could not "resist" the idea even though he believed the threat would not be needed.

Tyrie's commission on banking standards intends to "closely examine" whether the legislation needs to contain this element. 

Vickers said: "If the industry turned out to be unreformable, and I'm not so pessimistic as to think that, then it's possible that total separation would turn out, in due course, to be the better step to take." But he stressed he did not see ringfencing as a path towards full separation....

We already know that the industry is reformable if it is subjected to transparency.

This solution was implemented following the Great Depression and lasted for 7+ decades.

This solution would have prevented our current financial crisis if the financial regulators had kept opacity out of the financial system.

Vickers, regarded as a candidate to become the next governor of the Bank of England, made clear the he felt the ringfence went far enough to "improve banking stability and competition". 

"I am firmly with the recommendation we made. I believe that full separation would have had higher costs and for a gain that might not even be positive," Vickers said. He is concerned about the risk of having banks that solely focus on the retail sector.

The beauty of ultra transparency is that it does not require the banks to become solely focused on either the retail sector or investment banking.  They can do one or both.

What ultra transparency does do is restrain risk taking regardless of which sector banks chose to operate in by instilling market discipline.

The ringfencing proposals, along with demands by international regulators in Basel, Switzerland, for banks to hold more capital, were a "decent start" to stop another taxpayer bailout. 

Implemented altogether, Vickers said that "we are on a path … that would take us most of the way" – three quarters to 80% – to avoid a guarantee for the sector from the taxpayer".

Speaking for the global taxpayers, we are not interested in a "decent start" or even a start that gets us 80% of the way to avoiding another taxpayer bailout.

Based on recent past experience, we know banks will continue to gamble and we will be called on under the 20% that remains.

The only known, proven solution that gets 100% of the way to avoiding another taxpayer bailout is requiring the banks to provide ultra transparency.

Anything less is simply gambling with the taxpayers money.

Neil Barofsky with Bill Moyer: Normal functioning capital markets require transparency

In the second part of his interview with Bill Moyer, Neil Barofsky lays out how normal functioning capital markets rely on transparency that the Too Big to Fail banks are not required to provide (hat tip Jesse's CAFÉ AMÉRICAIN).

BILL MOYERS: It was puzzling to outsiders like me that you had TARP money being used to concentrate further the size of these banks. 

NEIL BAROFSKY: And the granddaddy of all those transactions, Bank of America acquiring Merrill Lynch. And the important thing to remember here is this is not banks gone wild, banks taking the money and saying, "Party time, we're going to consolidate." They did this with the encouragement of the government. And in Bank of America, a little bit with a gun to the head to complete that transaction. 

This was the government policy created by the architects, Ben Bernanke who is chair of Federal Reserve, Tim Geithner, who was then the president of the New York Fed before becoming Treasury Secretary, and Hank Paulson. Their solution originally was to further concentrate the industry, to make the too big to fail banks bigger. 

The theory was you take a healthier bank and mix it up with a failing bank and you get something somewhere in between, which is better overall for the system. Which may have had some validity in the very, very short term, but has put us on a path, I believe, to being even more dangerous. 

Because you have institutions now that are just monstrous in size, over $2 trillion in assets by certain measures, close to $4 trillion by other measures. Terrifying. The idea that any of these institutions could ever be allowed to fail is pure fantasy, at this point. 

BILL MOYERS: Are you suggesting that we could have another crash? 

NEIL BAROFSKY: I think it's inevitable. I mean, I don't think how you can look at all the incentives that were in place going up to 2008 and see that in many ways they've only gotten worse and come to any other conclusion. 

BILL MOYERS: What do you mean incentives in place? 

NEIL BAROFSKY: So in a normal functioning capitalist utopia, where, you know, most markets are that don't have this too big to fail, this presumption of government bailout if a firm like a Citigroup amasses massive amounts of risk. And in so doing, they keep razor-thin capital to absorb potential losses, which basically means they're just borrowing tons and tons of money. 

And not have a lot of their own money at stake, but it's mostly borrowed money. And it is very opaque. It's not very transparent about how they're running their business. 

You would expect that creditors, people lending them money, counterparties, those on the other sides of their transactions would either stay away or really exact a premium. 

But the presumption of bailout changes that on its head and actually makes it go in the other direction. 

So it removes the incentive of the other market participants to impose what's known as market discipline. Because that's ideally in a capitalist society what happens is that the lenders and creditors and counterparties say, "Hey, we're not going to do business with you unless you clean house, slim down, be more transparent." 

But when there's a presumption of bailout, that disappears. Because all those other market players can feel safe in the presumption that if anything goes bad at Citigroup, Uncle Sam is going to come in and make their bets whole. 

Then you have the very real incentive for the executives at that institution to then pile on risk. Because they know that if the bets go well in the short term, they get paid. And they get paid very richly. But if it blows up and the risks go bad, no worry, the taxpayer's going to be on the other side of that bill. 

That's what happened to Fannie Mae and Freddie Mac, before they collapsed. That's what happened to our biggest banks and global banks before they collapsed. And if you maintain that system, it is foolhardy to think that those incentives and pressures are not once again going to carry the day.

Please re-read the highlight text as Mr. Barofsky lays out the case for why we need to require the banks to provide ultra transparency if we are ever going to end Too Big to Fail.

As he says, with the current absence of transparency, banks are 'black boxes' remember, market participants would normally charge a very large premium for doing business with these banks or they would stay away from them altogether.

However, the policy makers' and financial regulators' willingness to let the banks continue to be black boxes and bail them out changes the behavior of market participants.  Knowing that the government is going to protect them if the banks collapse, market participants are willing to fund the banks at rates that are far below what the banks should pay given their risk.

This insures that we will have another financial crisis.

The only way to end this way of doing business is to require 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 independently assess the risk of the banks and adjust the amount and price of their exposure to each bank to reflect its risk and the market participant's ability to absorb losses given this level of risk.

This ends financial contagion and any excuse for a government bailing out its banks.

Top UK bank regulator wants to gamble with financial stability

In a dramatic display of how bank regulators blithely gamble with financial stability, Andrew Bailey, the man who will head up the Prudential Regulation Authority overseeing 300 UK banks, explained in a Telegraph article how the buck stops with him:

If I emphasise three things we should focus on in a firm and, as I occasionally get asked by supervisors, what if it is the fourth thing that blows the firm up. Well I've made that judgment. It may not be the right judgment in retrospect, but it is the one that I've made.

The wee problem with this statement is that if his judgment is not right in retrospect, the banking system will have blown up at enormous cost to the real economy and society.

It is entirely unacceptable to have the financial system dependent on one person's judgment. 

Particularly an individual who did not publicly predict our current financial crisis.  If he didn't have the foresight to predict the current crisis there is absolutely no reason to believe he will be able to predict the source of the next financial crisis.

Mr. Bailey was not alone in not predicting our current financial crisis. Prior to the crisis, all of the global bank regulators were saying how risk in the banking system had been reduced.  Clearly, this was not true.

One of the most important lessons learned from the financial crisis is that the financial system must not be dependent on regulatory judgment when it comes to assessing the risk of the banks.

Regular readers know that there is only one solution that eliminates dependence on regulatory judgment:  require that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, each market participant can use their own judgement of what to focus on when they independently assess the risk of the banks.  Based on the result of this assessment, market participants can then adjust their exposure to the banks according to the risk of each bank and not rely on bank regulators.

Are central banks' monetary policies a source of systemic risk?

Earlier this week, the Bank of England's Andrew Haldane said that economists share in the blame for the financial crisis and the ongoing recession.

Mr. Haldane is the executive director of financial stability at the BoE and a member of the BoE's Financial Policy Committee.  The FPC is suppose to focus on sources of financial instability and systemic risk.

As a result, my question is:  based on Mr. Haldane's comments are central banks' monetary policies a source of financial instability and systemic risk?

Regular readers know that your humble blogger's answer is yes.

As this blog has documented on numerous occasions, the economic headwinds created by zero interest rate policies and quantitative easing appear to far outweigh the benefits.  Not only that, but the policies have never be shown to promote economic growth (Japan is in its third lost decade when it comes to economic growth).

So why do central bankers pursue these policies that crush the real economy with what appears to be messianic zeal?

Mr. Haldane provided the answer in his observation that economists have come to believe in the assumptions underlying economics as if they were a "theological doctrine".  As a result, economists are on a crusade to prove they are right.

As this blog has documented, many of the assumptions that economists make are wrong.

For example, they assume that zero interest rates will force investors to reach for yield.  This is not true.  Investors see that pricing in the financial markets is distorted by the central bank policies.  As a result investors are now focused on return of their capital over return on their capital.  This deprives the real economy of capital it needs for growth.

This raises another interesting question:  given economists' religious belief in the assumptions underlying their models of the economy, are they fit to be central bankers?

The Telegraph's Jeremy Warner offered

Wanted: applicants for the post of Britain’s most powerful technocrat. 

Required qualifications include unmatched knowledge of macro and micro economics, in-depth experience of banking and the complexities of modern finance, natural authority, exceptional communication and media skills, outstanding administrative abilities, proven leadership qualities and a deity-like ability to transcend the political divide. 

It is small wonder that George Osborne is struggling to find a suitable candidate for the post of governor of the Bank of England, which falls vacant when Sir Mervyn King retires next June. 

By consolidating responsibility for banking supervision and financial stability under the same roof as the Bank of England’s existing monetary functions, the Chancellor has created a huge job and an almost impossible ask....

Imagine how much easier it would be to find qualified individuals if the requirement for 'unmatched knowledge of macro and micro economics' is dropped.

Whoever the Chancellor chooses will have to answer some profound questions about the future of central banking and the economy. 

Money is only a means of trade and exchange, yet over the last decade or two, it has been catastrophically mismanaged at almost every level. As custodians of the monetary system, central bankers have been a large part of this mischief. 

Nor, having messed up so spectacularly in the years before the crisis, is it clear they’ve got their response to it entirely correct either.

Which is exactly what Mr. Haldane observed.  More importantly, his observation in their belief in their assumptions suggests that economists are singularly incapable of correcting the response of monetary authority.  Doing so would require that they stop believing.  Hence the question:  are economists fit for central banking?

Tim Geithner's handling of the Libor scandal exemplifies why financial markets should not be dependent on regulators

A Wall Street Journal column looked at Treasury Secretary Tim Geithner's handling of the Libor scandal and concludes that it is a mistake to make the global financial system more dependent on regulators.

It is always nice to have the Wall Street Journal agreed with your humble blogger.

Timothy Geithner sure does lead a charmed life. As a powerful regulator [before], throughout the financial crisis and its aftermath, he gets to blame every mistake or scandal on the evil bankers while claiming he was hot on their case all along. 

This pose is wearing especially thin on the much-ballyhooed Libor rate manipulation scandal. 

Facing Congress this week, the Treasury Secretary stuck to his story that as president of the New York Federal Reserve in 2008 he was blowing the whistle on Libor manipulations even as he let everyone in the world continue to use Libor as a benchmark—including his own Fed. 

Mr. Geithner told a House committee that he "personally raised [the matter] with the Governor of the Bank of England" and later sent him "a very detailed memorandum" on how to fix the "incentive" and "opportunity" for banks to "underreport" their borrowing costs under Libor. 

Regular readers will recall that the email from Mr. Geithner to the Governor of the Bank of England failed to mentioned that a Barclays trader had told the NY Fed that its Libor submissions were fraudulent.

Regular readers will also recall that the very detailed memorandum on how to fix the "incentive" and "opportunity" for banks to "underreport" their borrowing costs under Libor was a series of six talking points from the banks that were manipulating Libor.

Naturally, none of the six talking points would have done anything to stop the ongoing manipulation of Libor.  Not one talking point suggested that Libor be based off of actual transactions.  Not one talking point suggested that banks provide far greater transparency so that market participants could see how the transactions included in Libor compared with all the transactions the banks did.

At the same time, however, he admitted that the Fed used Libor as the benchmark for several bailout programs because it was "the best rate available at the time." If a rate that the head of the New York Fed knew was subject to manipulation was "the best rate,"....

There really is not much more that needs to be said when one of the most important financial regulators makes the argument that a manipulated rate was 'the best available at the time'.

Not only that, but we know the other financial regulators agreed with him because he had told them Libor was manipulated and they still used it as the benchmark for several bailout programs.

The only conclusion that can be drawn from this statement and the related actions is that where ever possible, the stability of the financial system must be independent of whether or not the financial regulators perform their job.

Based on this conclusion, it is imperative that the financial regulators be stripped of their monopoly on all the useful, relevant information on each bank.  Stripping the regulators of their information monopoly requires that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, Libor can be based off of actual trades.

With this disclosure, market participants can end their dependence on the financial regulators and independently assess the risk of each bank.  With this assessment, they can adjust the amount and price of their exposures to reflect the risk of each bank.

With this disclosure, market discipline replaces regulatory oversight throughout the financial system.

With this disclosure, market participants can hold regulators accountable for doing their job.

Democrats are defending Mr. Geithner, which is consistent with their line since the crisis that every scandal is another excuse to blame the bankers and give even more power to the same regulators who missed or abetted the scandal. 

Clearly, the Wall Street Journal does not think it is a good idea to give more power to the same regulators who missed or abetted each scandal in the financial system.

Pending more evidence, we're inclined to think Mr. Geithner was more right in 2008 than he is now. But if Libor really was a vast criminal enterprise, then regulators need to be held accountable for doing so little about it for so long.

Former SigTARP Neil Barofsky suggested

Geithner and other regulators should be held accountable, they should be fired across the board.  If they knew about an ongoing fraud, and they didn't do anything about it, they don't deserve to have their jobs. I hope we see people in handcuffs. 

Spain trapped on bailout conveyor

Reuter's reports that Spain is about to announce the results of the audit of its banks and it will use these results as the basis for recapitalizing its banks.

Regular readers know that in a modern banking system with deposit guarantees and access to central bank funding banks are designed not to need government bailouts.

In fact, banks are designed to absorb the losses on the excesses in the financial system today and protect the real economy.  Subsequently, banks can rebuild their book capital levels through retention of 100% of pre-banker bonus earnings.

As RBS's Stephen Hester confirmed this with his observation that governments should use their money growing the economy and not bailing out individual banks.

Spain seems trapped on a conveyor belt carrying it toward a furnace - an international rescue of the euro zone's fourth biggest economy. 

Bad commercial loans, economic decline and sliding real estate prices are all aggravating problems at Spain's over-extended banks, which lent too much too freely during a credit fuelled property boom that lasted almost a decade. 

Madrid's euro zone partners are making available up to 100 billion euros to clean up the banks and, they hope, shield Spain from a debt crisis that has engulfed Greece, Ireland and Portugal and now threatens the single currency project itself....

Signs of the spending spree that began when Spain joined the euro on 1999 are everywhere - empty apartment blocks, unused airports, grandiose cultural centers and highways to nowhere. The house of cards collapsed in 2007-2008 leaving banks with 300 billion euros - equivalent to almost one third of annual economic output - of exposure to the property sector. 

The banks, and Spain's indebted regions have been economists' main focus in trying to fix the Spanish problem....

If the financial crisis has taught any lesson, it is that economists' do not have any idea what they are doing when it comes to advising on how to end a bank solvency led financial crisis.

It is no surprise that economists are focused on bailing out the banks.  It is simply confirmation that they do not understand how the modern banking system is designed (after all, they assume it works in their models).

In theory, the bank bailout agreed earlier this month should banish doubts over whether lenders can handle the fallout from economic recession....

Only an economist's theory would suggest that a bailout would banish doubts.

Everyone else knows that the only way to banish doubts is by requiring the banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.  This way market participants can independently assess what is going on.

A detailed independent audit of the banks by four major global accounting firms - due by September - may show companies from other business sectors have also been pushed to the brink of default. Banks are already seeing rising mortgage defaults and bad loans in non-property sectors.

Time is also of the essence. 

Actually, banks have all the time they need to generate the earnings to rebuild their book capital after recognizing all the losses hiding on and off their balance sheets.

What time is running out on is requiring banks to recognize the losses and providing ultra transparency to show that they did.

One banker who says the audit should find the banking system mostly sound still doubts it will come on time.

"What I'm not sure is whether it will be enough to recover market confidence, that it is not going to make things worse," he said, speaking on condition of anonymity because of the business sensitivity.....

Of course the results of the audit will make things worse.

Does anyone think the results will show that the Spanish banking system needs 400 billion euros to rebuild its banks' book capital levels (this is the amount of losses projected by Moody's and other independent analysts)?

Or does everyone expect that the results of the audit will somehow come in at less than the 100 billion euros Spain has been given to bailout the banks?

Update
The report from Oliver, Wyman says that Spanish banks need 62 billion euros in additional capital.

A result that will do absolutely nothing to end the crisis of confidence in the Spanish banking system.   But has the potential to further undermine the credibility of the Spanish government as it becomes known that the losses are well in excess of those assumed.

Spain is following in Ireland's footsteps.  We saw Ireland fail to require its banks recognize all of their losses and provide ultra transparency to let market participants confirm the fact and the failure to do so does not end well.

Andrew Haldane strikes again: Tails of the unexpected

The Bank of England's Andrew Haldane co-authored an interesting article called Tails of the unexpected. In it, he looks at the failure of risk models to properly price catastrophic risk and suggests that risk models must be torn up and a whole new way of thinking about risk implemented.

He proposes a number of solutions including as the Telegraph put it

If taxpayers are to be protected in future, financial regulators must put “in place robust fail-safes to stop chaos emerging”, such as UK plans to ringfence banks’ retail operations or US proposals to ban casino-like proprietary trading. 

Such “structural safeguards on worst-case outcomes” need to be accompanied by a massive increase in the “array of financial data available to regulators” provided by banks, he added. The extra information would allow regulators to build a “systemic risk map” not unlike a weather forecast that could “provide early warnings to enable defensive actions to be taken”. 

“In a complex, uncertain environment, the only fail-safe way of protecting against systemic collapse is to act on the structure of the overall system, rather than the behaviour of each individual within it,” he said. “Until then, normal service is unlikely to resume.”

Please re-read the highlighted text as Mr. Haldane is summarizing where the leading edge of regulators' and economists' thinking is.

And what they are thinking about on this issue is completely and utterly depressing as it shows zero understanding of how a transparency based financial system works.

We most certainly do need structural safeguards.  The first structural safeguard is to protect us from dependence on financial regulators.  It is well known that any system with a single point of failure is highly, highly, highly likely to fail catastrophically.

A quick look back to August 9, 2007 and the beginning of our current financial crisis confirms that financial regulators are perfectly capable of failing catastrophically.

Your humble blogger has been calling for a massive increase in the financial data available to market participants including the regulators.  If the data is only for the regulators, they have an information monopoly and hence they are a single point of failure.

While I think Mr. Haldane is brilliant, even he is capable of having a bad day and missing in his capacity as Executive Director Financial Stability at the Bank of England a tornado that could destroy a wide swath of the financial system and the real economy with it.

I happen to agree with his observation that the only fail-safe way of protecting against systemic collapse is to act on the structure of the overall system.  That is why I have said we need to shine the bright light of transparency into all of the opaque corners of the financial system.

It is only with access to all the useful, relevant information in an appropriate, timely manner that market participants can independently assess this information and adjust their exposures based on this risk assessment.

Under the FDR Framework, which is the transparency based financial system we currently have, market participants know they are responsible for all gains and losses on their exposures.  As a result, they adjust their exposure to higher risk investments to what they can afford to lose.

What brought about our financial crisis was the catastrophic failure of our regulators who loudly proclaimed that the risk in the financial system had been reduced due to financial innovation.  Since the regulators had a monopoly on all the useful, relevant information, market participants trusted them.  This led to massive mis-pricing of risk.

It also led to moral hazard as there is an obligation placed on the government to bailout investors who relied on representations made by the government when making an investment.

One of the primary reasons for requiring transparency is that it ends the government's information monopoly and reliance on the government's assessment of this information.  This delivers two benefits to the financial system:  ends the single point of failure and ends moral hazard.

Finally, I know one of the individuals who spearheaded the fight to create the Office of Financial Research (the US version of Mr. Haldane's financial weather service).  Once it had been created, he called me to apologize.  He realized that OFR and similar financial weather services for regulators are where transparency goes to die.

What he understood after the fact is that the weather service is not there to only use the data itself, but to share the data with anyone who wants it.

Following the lead of the US, UK and EU, Spain jeopardizes financial system and real economy by lying

In a must read Bloomberg article, the problems with pursuing the Japanese model for handling a bank solvency led financial crisis are laid bare.  At the top of the list is lying about the true condition of the banking system.

Spanish banks are masking their full exposure to soured property loans while they continue to prop up insolvent “zombie” developers, leading to credit-rating downgrades and plummeting share prices. 

Spain is trying to clean up its banks, requiring lenders to set aside more for possible losses on loans deemed performing to developers likeMetrovacesa SA (MVC), which hasn’t completed a project in more than a year and has none under way. 

While that represents about 30 billion euros ($38 billion) of increased provisions, it’s not enough because many of the loans said to be performing aren’t, said Mikel Echavarren, chairman of Irea, a Madrid-based finance company specializing in real estate. 

“Spain has engaged in a policy of delay and pray,” Echavarren said in an interview. “The problem hasn’t been quantified by anyone because there is huge pressure not to tell the truth.”

Please re-read the highlighted text as it confirms why banks must be required to provide ultra transparence and disclose their current asset, liability and off-balance sheet exposure details.

Without requiring ultra transparency, banks, their financial regulators and their host governments will lie about the condition of the banks by allowing them to engage in 'extend and pretend' practices....

There is a significant cost to the real economy from this practice.

Many Spanish banks are avoiding property sales so they don’t have to make “mark to market” valuations. Instead, they’re giving developers new loans to pay debt coming due to prevent defaults, said Ruben Manso, an economist at Mansolivar & IAX and a former Bank of Spain inspector. 

“The larger banks have been selling bits and pieces and can absorb the losses,” Manso said. “Smaller savings banks are acting in bad faith in their refusal to allow transactions and saying they can’t mark to market because there isn’t one.”...

In an environment of regulatory forbearance, banks have a number of ways of avoiding recognition of the losses on and off their balance sheets.

“The Irish property market had to collapse like the Spanish one because the economy was collapsing,” Kelly said. “Spain is looking like a re-run.” 

More than half of Spain’s 67,000 developers can be categorized as “zombies,” according R.R. de Acuna & Asociados, a real-estate consulting firm. They have combined debt of 180 billion euros that will lead to 104 billion euros of losses that hasn’t been fully provisioned for, Acuna estimates. 

“They aren’t officially bankrupt because they have been refinanced time and time again,” Fernando Rodriguez de Acuna Martinez, a partner at the company, said by telephone. “Their assets are worth much less than their liabilities, they struggle to repay loans and they haven’t revaluated them to reflect today’s prices.”

Confirming why all the strategies that failed in Ireland will also fail in Spain.

The Bank of Spain allows loans that are refinanced before turning delinquent and interest-only loans to be considered “normal” or “performing” on banks’ books, according to Manso. 

“You won’t find that data anywhere,” Manso said. “There has been a lot of cheating going on where banks have lent developers new money, classed as new lending, so they can pay off their original loans.” That’s masking delinquency, he said.

This is an example of what banks can do when there is regulatory forbearance and banks are not required to provide ultra transparency.

Refinancing the current and future zombie developers will cost 30 billion euros over the next two years, according to Acuna. The depreciation of those developer assets from 2012 onwards will generate a further 20 billion euros of losses in that time, he said. 

The Bank of Spain doesn’t publish data on the amount of restructured developer loans or interest-only paying loans that are classed as normal. The bank closely monitors refinancing to ensure that arrears aren’t being hidden, said a spokeswoman for the Bank of Spain who declined to be identified.

Please re-read the highlighted text as this is a partial estimate of the cost to the real economy from not forcing the banks to recognize their losses.

[Echavarren] forecasts that the larger Spanish banks with income from international operations will be able to pay for domestic real-estate losses within two years. The rest can’t take such a hit and will have to be nationalized, he said.

Confirming again that the government should not bailout the banks but should instead allow the banks to rebuild their book equity through retention of future earnings.

“We cannot continue to jeopardize the whole financial system by not telling the truth,” Echavarren said.

Bank regulators under spotlight as a result of JP Morgan's loss

The NY Times carried an article examining the question of where were the bank regulators while JP Morgan was putting on the trading positions that ultimately lost $2+ billion.

Regular readers know from previous posts (see here, here and here) that bank regulators do not approve or disapprove of individual positions.  At a minimum, it would be interfering with the allocation of capital which is suppose to be a function of the financial system.

Regulators also do not tell the market about the individual positions or the riskiness of these positions.  Not commenting would be okay if the banks were required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this data, market participants would have the positions and could independently assess the risk.

However, without ultra transparency, regulators have a monopoly on the information needed for assessing the risk of each bank.  As a result, the market is dependent on them to assess the risk and properly disclose it.

Finally, regulators try to insure that each bank has adequate capital to absorb any potential losses from its individual positions.  There is a fatal flaw to this strategy.  What happens if regulators underestimate the potential losses?

As market participants know, this strategy is simply gambling with financial stability.


The failure to accurately assess the risk combined with telling the market participants that risk in the financial system had been reduced by financial innovation was a primary contributor to the financial crisis.

Scores of federal regulators are stationed inside JPMorgan Chase’s Manhattan headquarters, but none of them were assigned to the powerful unit that recently disclosed a multibillion trading loss. 

Roughly 40 examiners from the Federal Reserve Bank of New York and 70 staff members from the Office of the Comptroller of the Currency are embedded in the nation’s largest bank. 

They are typically assigned to the departments undertaking the greatest risks, like the structured products trading desk. 

Even as the chief investment office swelled in size and made increasingly large bets, regulators did not put any examiners in the unit’s offices in London or New York, according to current and former regulators who spoke only on condition of anonymity. 

Senior JPMorgan executives assured the bank’s watchdogs after the financial crisis that the chief investment office, with hundreds of billions in investments, was not taking risks that would be a cause for concern, people briefed on the matter said. 

Just weeks before the trading losses became public, bank officials also dismissed the worry of a senior New York Fed examiner about the mounting size of the bets, according to current Fed officials. 

The lapses have raised questions about who, if anyone, was policing the chief investment office and whether regulators were sufficiently independent. Instead of putting the JPMorgan unit under regular watch, the comptroller’s office and the Fed chose to examine it periodically. 

The bank pushback also suggests that JPMorgan had sway over its regulators, an influence that several said was enhanced by the bank’s charismatic chief executive, Jamie Dimon, long considered Washington’s favorite banker. 

Now, as regulators scramble to determine whether the chief investment office took inappropriate risks, some former Fed officials are asking whether the investigation should be spearheaded by the New York Fed, where Mr. Dimon has a seat on the board. Some lawmakers and former regulators also have reservations about the comptroller’s office, which is investigating the trade and was the primary regulator for JPMorgan’s chief investment unit. 

“The central question is why Jamie Dimon was able to so successfully convince both its regulators that there was nothing to see at the chief investment office,” said Mark Williams, a professor of finance at Boston University, who also served as a Federal Reserve Bank examiner in Boston and San Francisco. “To me, it suggests that he is too close to his regulators.” 

Regulators, for their part, say they cannot micromanage a bank or outlaw its risk taking and did not bow to bank pressure when assigning examiners....

This is a matter of policy.

Long before the recent trading blunder, JPMorgan had a pattern of pushing back on regulators, according to more than a dozen current and former regulators interviewed for this article. That resistance increased after Mr. Dimon steered JPMorgan through the financial crisis in better shape than virtually all its rivals. 

“JPMorgan has been screaming bloody murder about not needing regulators hovering, especially in their London office,” said a former examiner embedded at the bank, adding, in reference to Mr. Dimon, “But he was trusted because he had done so well through the turmoil.” 

Even now, executives at JPMorgan disagree with some regulators over how quickly the bank should unwind the soured trade, according to people briefed on the negotiations. 

JPMorgan would like to be done with the bad bet that has resulted in at least $3 billion in losses already, but senior executives argue it is a delicate process, especially as traders and hedge funds on the opposite side of the trade seize on the fact that JPMorgan is under pressure to exit the position.

Senior staff members at the Federal Reserve want the bank out of the position “yesterday,” according to a regulator privy to the discussions who insisted on anonymity because the talks are private....

Regulators would like the bank to be out of the position because it shines a bright spotlight on what regulators do and don't do.

Current and former regulators said that lower-level officials at JPMorgan had at times tried to undermine their supervision of the bank. JPMorgan has a reputation for challenging regulators more forcefully than rival banks like Citigroup and Goldman Sachs, former New York Fed officials said. 

Long before the recent trade, an embedded examiner said he had asked for JPMorgan’s three- to five-year capital plan, and after waiting a couple of days was told that the bank’s management had gone over his head and “already sent it to my bosses.” By cutting out lower-level regulators, the bank officials telegraphed a message that those concerns were irrelevant, the former examiner said....

Your humble blogger has previously discussed exactly this problem of the bankers undermining supervision by making their case to the senior regulators.

The Nyberg Report on the Irish financial crisis sited this practice as one of the reasons that even when the risk of the real estate bubble was properly assessed senior regulators dismissed the assessment.

This is one of the reasons that the regulatory information monopoly must be ended and banks required to provide ultra transparency.  It is only with ultra transparency that market participants can assess for themselves what is really going on.

The Office of the Comptroller of the Currency is also facing scrutiny about whether it is too cozy with the banks it oversees. 

At JPMorgan, when media reports surfaced that the bank was making aggressive bets on credit derivatives, comptroller officials began taking a closer look, people briefed on the matter said. 

After thumbing through the bank’s own projections for the related risks in early April, the people said, the examiners pushed for more answers but saw no immediate need to change course. The agency notes that it does not bless specific trades.

Recall, it is not the regulator's role to interfere in the capital allocation process.

This simply confirms why banks must be required to provide ultra transparency.