Unfinished business in battle to fix banks...transparency

The Financial Times ran an interesting article in which it identified what it felt were the five principle reasons for bank failures ("low capital, weak funding structures, poor lending, poor trading investments and misguided mergers and acquisitions").

It concluded that 5 years after Lehman Brothers' collapse significant progress has been made using complex rules and regulatory oversight to address four of the reasons for bank failures and the fifth reason, poor lending, could not be addressed.

Left unsaid was the simple fact that transparency would successfully address all five of these reasons for bank failures.

Also left unsaid is the simple fact that it would not have taken five years to implement transparency and have each bank disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

In an attempt to gauge the merit of the glut of global reforms, the Financial Times has looked back at the 34 main banks and brokers that failed in the crisis, judging the principal reasons for failure from a menu of five – low capital; weak funding structures; poor lending; poor trading investments; and misguided mergers and acquisitions.

Each of these reasons is really a symptom of opacity.

For example, when banks don't have to disclose their current exposure details, they aren't subjected to market discipline to restrain their risk taking.  As a result, they reduce their capital levels in lock-step to what they can convince their regulators is adequate to handle any losses they might incur.

History shows that when banks disclose their current exposure details they have a higher level of book capital.  This higher level of book capital reflects both market discipline and the recognition that transparency requires a bank show it can stand on its own two feet.

Many failed for multiple reasons, though Royal Bank of Scotland is the only institution to which all five triggers applied. 

Any analysis of the precise causes of the global financial crisis, even after five years of reflection, is necessarily subjective. 

Please note, your humble blogger assessed and told everyone about the cause of the global financial crisis, opacity, before the crisis hit.

But if there were five main causes of failure, regulators can claim at least partial victory on four of them. 

Please re-read how the regulators can claim at least partial victory on addressing for of the five main causes of failure.

This is entirely unacceptable and is a damning indictment of complex rules and regulatory oversight.

By simply using the securities laws that have existed since 1930s, all five main causes of failure could have been addressed through requiring banks to provide transparency and disclose their current exposure details.

Capital levels in the system are more than three times higher than they were before the crisis as banks pre-empt the requirements of new Basel III global standards. 

Financing is more stable, with far less reliance on risky short-term market funding and new incoming rules demanding banks hold minimum levels of cash and safe assets. 

Big acquisitions are a thing of the past, too, with regulators making it clear such dealmaking is unwelcome. 

And the kind of complex structured investments that spread the contagion of US subprime mortgage losses around the world are close to extinct, the victim of regulators’ higher capital charges and banks’ lower risk appetites....

The one category of the FT’s five triggers of failure that is immune to regulation is bad lending – a perennial curse of banking since the Middle Ages and one that in the heat of the crisis, when the focus was on complex collateralised debt obligations, was often neglected. 

“The crisis was overspun as a markets problem,” says Robert Law, a former banks analyst and adviser to the UK’s recent parliamentary commission on banking standards. “There were major problems in traditional lending, too.” 

According to the FT’s analysis, this was the single biggest factor in the crisis. Of the 34 big banks that failed, three-quarters succumbed in large part because of the poor quality of basic lending – in particular to residential and commercial mortgage customers. 

There is little that the authorities can do directly in a market economy to curb foolish lending practices by private sector banks.

Authorities cannot do much directly about lending as they don't want to be in the position of allocating capital throughout the economy.

As a result, bank examiners don't approve or disapprove of any exposure taken or loan made by a bank.  Rather, bank examiners ask if the bank has enough capital to absorb any losses that are likely to result from the exposure or loan.

Hence, we have the following:

But reformers argue that a laser focus on capital, which can absorb losses, is the essential way to protect the system from further harm.

Unless regulators are willing to let banks take losses, something they have not done since the beginning of the financial crisis, capital is not the way to protect the system from further harm from foolish lending.

Rather, transparency is the way to protect the system from harm by foolish lending by private sector banks.  Transparency protects the system in two ways.

First, transparency allows market discipline which restrains banks making foolish loans in the first place.  It does this because market participants can see what loans the banks are making and can assess whether or not these loans are properly priced.

Second, transparency allows market participants to reduce their exposure to banks that make foolish loans.  By reducing their exposure to what they can afford to lose should a bank that makes foolish loans go under, market participants eliminate any possibility of contagion from the bank's failure.

Don't outsource bank risk management to global financial regulators

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

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

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

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

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

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

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

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

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

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

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

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

EU trying to harmonize definition of non-performing loan

Reuters reports that for the ECB's bank asset quality review test the EU is attempting to come up with one definition of what is a non-performing loan.

It is not surprising that there are several definitions of non-performing loans.

Since the beginning of the financial crisis bank, regulators have engaged in regulatory forbearance.  Under regulatory forbearance, banks are allowed to engage in 'extend and pretend' to turn non-performing loans into 'zombie' loans.

Naturally, each bank is going to engage in extend and pretend in a way that minimizes the non-performing loans on and off their balance sheets.

The current attempt to harmonize the definition of non-performing loans confirms what your humble blogger has said about the results of the bank regulator run stress tests as being meaningless.

The current attempt to harmonize the definition of non-performing loans also confirms what your humble blogger has been saying about the importance of requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, regulatory forbearance and extend and pretend is ended.  Markets will exert discipline by rewarding banks that clean up their bad debt exposures.

Banks across the European Union will be asked to use a single definition for bad loans in the upcoming review of their loan books, a senior EU regulatory source told Reuters, making it harder for banks to conceal the state of their businesses behind local conventions.... 

A senior EBA source told Reuters a key feature of the asset quality review will be harmonizing the way banks categorize loans. EU supervisors use a host of different ways to classify troubled or non performing loans, making it difficult to compare across jurisdictions.... 

The 2011 version of the stress tests, which relied entirely on national supervisors' submissions and definitions, was widely criticized for finding that Europe's 70 largest banks collectively needed just 106 billion euros ($140.62 billion). 

The EBA is keen to ensure this round of stress tests has more credibility, and sees consistency of definitions and transparency of information as a key way of ensuring this.

Bank earnings have never been more complicated

In his Fortune column, Allan Sloan asks the simple question of how can Washington regulate the big banks when the earnings release of a large bank like Citi is a 100+ page opaque document.

As shown by our current financial crisis, Washington cannot successfully regulate the big banks.

One of the reasons for requiring the banks to provide ultra transparency is it subjects the big banks to market discipline.  Market discipline that links a bank's cost of funds to the risk it is taking.

This market discipline also strengthens Washington's regulatory discipline and improves the chances that it is successful by allowing Washington's regulators to tap the market for analytical expertise in understanding exactly what the banks are doing.

After all, who better to analyze Citi than JP Morgan and visa versa. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Telegraph's Jeremy Warner's epiphany about banks and their regulators

The Telegraph's Jeremy Warner had an epiphany about banks and their regulators:  bankers run a pro cyclical business that is made even worse by their regulators.

The trouble with banks is that they are extraordinarily pro-cyclical beasts. 

During the good times they throw caution to the winds and lend with reckless abandon. 

During the bad times they do the opposite; in rebuilding capital to pay for the bad debts of the boom, they become highly risk averse. The priority is to reduce credit, rather than expand it, so that solvency can be re-established. 

This process is reinforced by regulators, who having been asleep on the job during the boom, then go violently into reverse and attempt to bullet proof the banks against all eventualities by insisting on much tougher capital and liquidity requirements. 

Only last month, Britain's Financial Policy Committee identified a further £25bn shortfall in UK banking capital, a deficit likely to be met by further shrinkage in bank balance sheets. 

A vicious cycle of credit destruction thus sets in. 

The madness of this regulatory over reaction is there for all to see the latest Basel III capital adequacy rules, which bizarrely require banks to hold much higher capital against corporate loans than mortgages. 

The inevitable consequence of such thinking is that the housing market is held up at silly valuations and the corporate market delevers even further. The impact on growth is terrible.

The only way to end this negative reinforcing cycle is by making the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balane sheet exposure details.

With this information, market participants can assess and restrain bank risk taking.

As a result, we won't get the extremes on the upside in lending nor will we get the regulators kicking in policies that hurt lending on the downside.

SEC battled with JP Morgan over its disclosures involving the "London Whale" trade

Reuters reports that the SEC engaged in a tug of war with JP Morgan to get it to make fuller disclosure to investors concerning its "London Whale" trade.

For months after JPMorgan Chase & Co executives first admitted that they had wrongly brushed off questions about the "London Whale" derivatives losses, officials at the U.S. Securities and Exchange Commission pressed the company to disclose more to investors about risks it was taking. 

The SEC's Division of Corporation Finance, which is charged with making sure companies provide investors with enough information to make good decisions, pushed the bank from at least July to February to revise disclosures about changes it had made in models used to calculate value it put at risk in its derivatives portfolio [emphasis added].

Please re-read the highlight text as it critically important.

The SEC's Division of Corporation Finance is charged with making sure companies provide investors with enough information to make good decisions.

What does this mean for a bank?

Your humble blogger and the banking industry in the 1930s answer that banks must provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Banks do not currently provide ultra transparency.  Instead, banks provide disclosure that the Bank of England's Andrew Haldane says leaves them looking like a 'black box'.

By definition, the contents of a black box cannot be assessed.  So investors do not have enough information to make good decisions.

Why is the SEC's Division of Corporation Finance allowing banks to be black boxes?  The correspondence between the SEC and JP Morgan provides the answer.

Correspondence between the SEC and the bank released on Wednesday shows the bank made incremental changes to increase its disclosures at the SEC's urging. 

The highly technical exchanges were conducted even as JPMorgan vowed to be more transparent with investors....

In July, the SEC told JPMorgan to expand its future disclosures about its risk models and to explain further what it had said earlier in the month about changes it was making in company risk controls. 

JPMorgan responded in a letter in August that described how it tracked risk and noted that it was disclosing more about its models in its new quarterly financial report. 

The SEC came back with more questions in November about JPMorgan's response and about the company's views on how much regulations require it to disclose about details of risk model changes. 

JPMorgan responded in December, received the last questions from the SEC in February and added more disclosure in its annual report....

Based on the correspondence, the reason that the SEC is allowing banks to be black boxes is the SEC does not know what is the information that investors actually want from a bank.  What investors really want to know is what each bank's exposure details are (ultra transparency).

Banks are black boxes because they hide their exposure details behind the veil of opacity provided by current SEC mandated disclosure requirements.

Why are investors interested in each bank's exposure details?

Because in order to make a good investment decision, an investor needs to be able to assess the risk of the investment.  It is the risk of these exposures that drives the riskiness of the bank.

Can investors actually use bank exposure details to assess risk?

Investors either have the expertise to use the exposure details to model the bank's risk themselves or they can engage a third party expert to model the bank's risk for them.  As a result, they do not need to know how the bank models its risk.

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.

Has the spirit of light-touch regulation ended with the UK regulator that embodied it?

The Guardian's Jill Treanor wrote an interesting column in which she talks about how it was not just the light-touch regulation practiced by the UK's Financial Services Authority, but also the interventionist policies practices by other western financial regulators that failed in the run-up to the financial crisis.

It is a very important point that regulatory oversight failed across the entire spectrum from light-touch to active interventionist.

The question is why?  Why did the combination of complex rules and regulatory oversight not prevent a financial crisis?

Regular readers know the answer is the combination of complex rules and regulatory oversight was used as a substitute for the combination of transparency and market discipline.  Not only was it used as a substitute, but the combination of complex rules and regulatory oversight created additional opacity in the financial system.  Opacity that eventually undermined financial stability.

Western financial systems are based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

This combination produces financial stability because it puts on each market participant the responsibility for losses on their investment exposures.  This responsibility creates stability because each market participant has an incentive to limit their exposure to what they can afford to lose.

Opacity interferes with the mechanism that makes the financial system stable.  It makes it impossible for investors to assess the risk of their exposures and therefore limit them to what they can afford to lose.

This is particularly true when it comes to the banking system and the role of the financial regulators.  As the BoE's Andrew Haldane says, banks are 'black boxes'.  They do not disclose the information needed by investors to assess their risk.

This lack of transparency is made even worse by the action of regulators.  Regulators who engage in activities like stress tests and proclaim the banks to be solvent.

How exactly is an investor suppose to determine the true risk of the banks and properly limit their exposures when the regulators are saying that insolvent institutions are solvent?

Which brings us back to light-touch regulation.  Whether it is light-touch or activist interventionist regulation, it is the focus on "regulation" that distracts from the primary responsibility of the regulators under the FDR Framework:  ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess and make a fully informed investment decision.

It was the watchdog that didn't bark. When the Financial Services Authority (FSA) was created in its current form by Gordon Brown, it was modelled on the all-powerful US regulators, but it is likely that it will be remembered for only thing: presiding over the near-meltdown of the UK's banking system. 

In its short life, the FSA failed to rein in the banks, and even encouraged the City to explode in the mid-2000s with a "light touch" approach to regulation. 

It did not notice that Northern Rock was built on such shaky foundations that it could easily run out of money, and failed to prevent the takeover of ABN Amro by RBS just as the credit crunch was biting in late 2007....

Please note that it is not the responsibility of the regulators to be the watchdog.  It is the responsibility of all the market participants to continue to monitor their investment exposures and make sure that their exposures do not exceed their ability to absorb losses.

Tearing up the FSA – which united the nine regulators that had existed before Labour was swept to power in 1997 – was one of the first key policy announcements by Osborne after the May 2010 election. 

But it has taken almost three years – much longer than expected – after he first pledged to disband Brown's regulator to fulfil the vision to create two new ones – the PRA (a subsidiary of the Bank of England to ensure banks have enough capital and liquidity) and the FCA (essentially charged with putting consumers at the heart of the matter when dealing with financial regulation)....

Do you notice how there isn't a regulator focusing on making sure that the banks provide transparency so that market participants can independently assess their risks?

Our current financial crisis showed that capital standards in the absence of transparency is hazardous for financial stability.  The reason it is hazardous is that risk is the important issue.  Without transparency, there is no way to measure risk.

While the FSA's legacy seems likely to be the banking crash, Kevin Burrowes, UK head of financial services at PricewaterhouseCoopers, acknowledges that the watchdog was not alone in missing the warning signs. "It's not apparent that any regulator from around the world can stand up and say they did a great job over this period," he says....

In the fallout from the crisis, they set about changing what Sants's predecessor, John Tiner, had described as principles-based approach to regulation. In 2006, reflecting the mood of the time, Tiner said: "Firms' managements – not their regulators – are responsible for identifying and controlling risks. A more principles-based approach allows them increased scope to choose how they go about this. In short, the use of principles is a more grown-up approach to regulation than one that relies on rules." 

But by 2009, Sants was saying, damningly: "A principles-based approach does not work with individuals who have no principles." 

Meanwhile, Turner was outlining to MPs what he saw as a major problem, telling the Treasury select committee: "It was not the function of the regulator to cast questions over overall business strategy of the institutions … You may find that surprising."

Thankfully, the new regulators are now being encouraged to be more curious and ask more questions....

German regulator finds flaws in how Deutsche Bank supervised Libor manipulation

Reuters reports that Bafin, the German market regulator, disapproved of Deutsche Bank's see no evil approach to supervising the manipulation of Libor.

It is standard operating practice at banks for senior managers to supervise in such a way that they can avoid taking responsibility by maximizing their use of the claim of plausible deniability.  As in, "we didn't know that the trader was telling the individual who made our Libor submission to submit false information".

The fact that Bafin is going to give Deutsche Bank a slap on the wrist for its involvement in manipulating Libor simply confirms that regulatory oversight is inadequate to prevent this type of behavior in the future.  The same is true for fines that are the equivalent of paying for a parking ticket.

Regular readers know that the manipulation of Libor highlights the need to bring transparency back to the financial system.

The only way to prevent Libor or similar benchmark interest rates from being manipulated in the future is for the banks to provide ultra transparency.

By disclosing their current global asset, liability and off-balance sheet exposures on an ongoing basis, banks that are looking to borrow make it possible for banks with deposits to lend to evaluate their risk and solvency.  This unfreezes and keeps unfrozen the unsecured interbank lending market.

With ultra transparency, it is also possible to based Libor and similar benchmark interest rates off of actual transactions.  Market participants can use all the transaction of a subset.

With ultra transparency, there is no need for complex rules or regulatory oversight of Libor or similar benchmark interest rates.

German markets watchdog Bafin is set to rebuke Deutsche Bank (DBKGn.DE: Quote, Profile, Research, Stock Buzz) over how it supervised its contribution to the setting of inter-bank lending rates at the heart of the international rate-rigging scandal, several sources familiar with Bafin's investigation said. 

However, the watchdog's report will focus on "organizational flaws" at Germany's biggest lender rather than placing blame on Deutsche's co-chief executives Anshu Jain and Juergen Fitschen, or their predecessor Josef Ackermann, one of the sources said....

"It won't be much more than finger-wagging," the person said of the report, whose preliminary conclusions are due to be passed on to Berlin by the end of the month....

German financial daily Handelsblatt also said on Thursday, citing "insiders", that Bafin was focusing in on organizational issues at Deutsche and that there would be no consequences for current or former board members.

Bankers get one last bonus season before ....

Reuters reports that this is the last season of unlimited bonuses for bankers before the EU regulations that restrict banker pay kick in.

At a minimum, we can expect bankers to make the most of it.

The article would have you believe that next year will be different and banker pay will be dramatically less.  But is there any reason to believe that bankers will not game the pay regulations like they game every other complex regulation?

So the bankers won't report large bonus numbers, is that any reason to believe that their pay will drop?

Regular readers know that your humble blogger does not object to bankers being well compensated when the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

What your humble blogger objects to is yet another example of the substitution of complex rules and regulatory oversight for the combination of transparency and market discipline.  Our current financial crisis stands as testament to the simple fact that this substitution never produces the intended results and creates financial instability.

What makes the regulation of banker pay particularly galling is that banker pay is addressing a symptom and not the core problem.   The core problem is opacity.

Banker pay is as high as it is because of opacity.  Bankers are able to profit because investors do not have the information they need to properly assess the risk that the banks are taking.  As a result, investors are funding the banks too cheaply and bankers are pocketing this mis-pricing.

Bankers in Europe will have one final bonus season before they are barred from awarding themselves payouts worth more than their salary, EU lawmakers agreed on Wednesday, paving the way for the first cap of its kind globally. 

The cap is designed to address public anger at a bonus-driven culture many European politicians believe encouraged the risk-taking that led to the near-collapse of some of the region's biggest banks.....

The new rules will make it harder to award large payouts such as the bonus worth more than 17 million pounds ($25.7 million) cashed in this week by Rich Ricci, the head of Barclays' investment bank.... 

The rules, part of a wider capital regime for banks, allow bonuses of twice bankers' salary if shareholders agree. They represent the toughest bonus regime anywhere in the world. 

The cap has been softened to allow banks to pay up to a quarter of a banker's bonus in share options, bonds or other non-cash payments which attract a premium after five years. 

Payments made after more than five years would qualify for a bigger discount when calculating the size of the bonus, to make the total payment slightly more generous than foreseen by the cap....

The rules are also a setback for European banks, which had long argued that the curbs would put them at a disadvantage to U.S. rivals. 

"If you want to restrict bonuses we should do it on a global level," said Christian Clausen, president of the European Banking Federation lobby group told Reuters. 

"We have the risk that customers will do business with American banks that still pay high bonuses."

Bernanke gets his wish, comeback of financial system's most toxic securities

The Retirement Plan Death Spiral has been overtaken as the most toxic side effect of Fed Chairman Ben Bernanke's zero interest rate policies by the comeback of the financial system's most toxic securities: synthetic collateralized debt obligations.

Regular readers will recall that these synthetic CDOs were at the heart of the financial crisis.  These were the securities that let Wall Street ,which knew that subprime mortgages were going bust faster than was assumed in the investors' pricing models, successfully "bet" on this knowledge.

The fact that these opaque, toxic securities which the regulators and market cannot value have re-emerged is the direct result of 5 years of zero interest rate policies.

Surely, investors and the financial system will have a better experience gambling on these securities this time around.

As reported by Bloomberg,

Derivatives that pool credit- default swaps to make magnified bets on corporate debt, popularized in the last credit bubble, are making a comeback as investors search farther afield for alternatives to bonds at record-low yields....

Synthetic credit, which amplified the financial crisis five years ago, is enticing investors after corporate-bond yields dropped to less than half the 20-year average. 

By betting on the degree to which a group of companies will default, a CDO may pay relative yields of more than 5 percentage points, four times that of a typical credit-swaps transaction on similar debt.

Please note the use of the word "betting".  An opaque security cannot be valued.  Therefore, buying it is simply an exercise in betting.

“That’s a valid strategy for this part of the credit cycle: Don’t stretch on credit quality, but rather leverage your exposure to better-quality credit,” Ashish Shah, the head of global credit investment at New York-based AllianceBernstein LP, which oversees $256 billion in fixed-income assets, said ....

Betting is not a valid investment strategy.  Betting is gambling.

The distinction between gambling and betting is subtle.

Gambling involves buying opaque, toxic securities and guessing what the value of their contents is.  Investing involves have transparency into all the useful, relevant information in an appropriate, timely manner so as to independently assess this information and make a fully informed decision.

“Investors are in a desperate search for yield,” said David Knutson, a credit analyst at Legal & General Investment Management America. “CDO products offer incremental yield to plain-vanilla transactions.”...

Bernanke's zero interest rate policies deliberately make investors desperate when it comes to yield.  They are designed to be coercive and force investors to take more risk.

However, there is a real difference between taking more risk while investing and simply taking risk by gambling.

Sales of bespoke synthetic CDOs are climbing after the market all but shut down during the financial crisis in 2008.

Bernanke's legacy is the revival of the synthetic CDO market that produced the following spectacular results:

After the amount of credit protection sold through CDOs in that period climbed to about $1 trillion, investors took losses of up to 90 percent on deals that bet heavily on financial firms that failed during the crisis, including Lehman Brothers Holdings Inc. and Icelandic banks. 

In the mortgage market, CDOs that packaged home-loan securities and were given top AAA ratings by S&P wiped out investors in a matter of months, according to a lawsuit by the Justice Department filed Feb. 4 in Los Angeles. 

Synthetic CDOs “enabled securitization to continue and expand even as the mortgage market dried up and provided speculators with a means of betting on the housing market,” the Financial Crisis Inquiry Committee wrote in a 2012 report. “By layering on correlated risk, they spread and amplified exposure to losses when the housing market collapsed.”

And thanks to Fed Chairman Bernanke's policies, this particularly toxic security has, like Dracula, come back to life to suck the lifeblood out of the real economy.

As the Federal Reserve holds its benchmark interest rate near zero for a fifth year, investors including pension funds and hedge funds are again seeking out more structured debt or derivatives that offer greater yields than the bonds or loans underlying them....

Your humble blogger doesn't mind if hedge funds gamble on these opaque, toxic securities.  This is what investors in hedge funds expect.

However, pension funds and insurance companies should never be allowed to invest in opaque, toxic securities.  Regulators for pension funds and insurance companies have had 5 years to adopt regulations that would prevent this from occurring.

Trading in synthetic CDOs will continue to rebound even after global bank capital rules and the U.S. Dodd-Frank Act make derivatives more expensive to trade and hold, Peter Tchir, founder of New York-based TF Market Advisors, said in a March 15 e-mail to clients. 

“There’s going to be this bigger search for yield and spread, and tranches are a natural way to do it,” he said.

As previously pointed out by your humble blogger, global capital rules do not stop gambling on opaque securities.  

As previously pointed out by your humble blogger, Dodd-Frank also did nothing to restore transparency to all the opaque corners of the financial system.  

As a result, investors have been coerced by the Fed to return to opaque areas where Wall Street can handsomely profit off of the investors inability to price the securities. 

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.

Anat Admati: "The Bankers' New Clothes", right fairy tale, wrong conclusion

In an American Banker column, Professor Anat Admati makes a very important observation about the gutting of financial regulation.  It tends to be good for bankers and bad for society.

The column is an excerpt from a book she co-authored with Martin Hellwig, "The Bankers' New Clothes: What's Wrong With Banking and What to Do About It."

Regular readers know that your humble blogger differs with Professor Admati on both the diagnosis of what is wrong with banking and what to do about it.

I see the problem with banking being opacity.

Opacity that let's bankers engage in bad behavior knowing that they are Too Big to Jail.

Opacity that makes the financial system unstable because market participants are dependent on financial regulators both correctly assessing and communicating the risk of each bank (something the regulators cannot do because of concerns about the safety and soundness of the financial system).

Opacity that prevents the market from exerting discipline on the banks and restraining their risk taking.

Opacity that creates moral hazards like bailouts because investors relied on the Fed's stress tests when making an investment decision.

Opacity that makes the banks such "black boxes" that banks with deposits to lend cannot assess the risk and solvency of the banks looking to borrow.

Opacity that has been made even worse by the response of policymakers and financial regulators.  They have decide we need more of what failed to prevent the financial crisis in the first place.  Namely, the combination complex rules and regulatory oversight.

Professor Admati has championed the notion that banks were holding too little capital going into the financial crisis and by simply upping capital standards all will be well.

This is knowably untrue.

The OECD has written extensively how due to the suspension of mark-to-market accounting and creation of 'zombie' loans under regulatory forbearance bank financial reporting and bank book capital is meaningless.

Opacity hides the true condition of the banks.  Who knows just how distorted each bank's financial statement is from reflecting its true financial condition?  After all, Dexia reported very high capital levels shortly before it needed to be nationalized.

Until there is ultra transparency and banks have to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, bank financial reporting and book capital will remain meaningless.

Ultra transparency is the necessary condition for Professor Admati's capital standards to be relevant.

Do we have to resign ourselves to having a fragile and dangerous banking system, one that harms the economy and requires government support when the risks turn out badly?

No.

As we have seen, there is not much prospect of dealing with failures of large and interconnected banks, particularly those that are active internationally, without imposing large costs on the economy.

Actually, there is a simple solution for dealing with these banks without imposing large costs on the economy.  Require the banks to provide ultra transparency.

Like all market participants, banks know that when they have access to all the useful, relevant information in an appropriate, timely manner they become responsible for all losses on their exposures.

In practical terms what this means is that the banks will independently assess each of the other banks that they have dealings with and they will adjust their exposure to what they can afford to lose should the other bank fail.

With ultra transparency, the cost of failure of a bank is absorbed by investors (including other banks) and not the real economy or society.

Ultra transparency is very important as it also ends the mechanism of financial contagion.  Each bank manages its exposures so that it can survive the failure of the other banks.

The economy is also harmed when many banks are distressed at the same time and do not make sufficient loans because of their overhanging debts.

There is a common misconception that a distressed bank stops making loans.  This is untrue.  I must be too old, but I distinctly remember that in the US Savings & Loan crisis, the management of these institutions gambled on redemption by making large real estate development loans.

As a practical matter, bank lending and the funding of these loans has been separate for at least 40 years.  The reason that they are separate is that holding a loan on a bank balance sheet is not the only option for the bank.  It can sell the loan to a bank syndicate, a hedge fund, an insurance company or a pension fund for example.

It is therefore important to focus on preventing banks and other financial institutions from running into distress or insolvency....

Please re-read the highlight text as Professor Admati has nicely summarized a point that your humble blogger has been making since the beginning of the financial crisis.  We need to take actions that prevent a financial institution from running into distress or insolvency in the first place.

This is why banks must be required to provide ultra transparency.

Investors know that with access to the information they need to independently assess the risk of each bank comes the responsibility for absorbing the losses on their investment exposures.  As a result, investors have an incentive to exert discipline on management so that management does not let the bank become distressed or insolvent.

For this purpose, we need better regulation and supervision.

True, but better regulation does not necessarily mean more regulation and better supervision does not necessarily mean more regulatory oversight.

If the banks' own incentives with respect to the risks they take and the extent of their reliance on borrowing were aligned with those of society, banking regulation would be less important. 

As it turns out, however, the incentives of banks with respect to the risks they take and to their borrowing are perversely conflicted with those of society.

This is only true because of the opacity of the banks.

If banks were required to provide ultra transparency, there would be much more alignment with the incentives of society.  This alignment would occur because investors would no longer be in a position where gains are privatized and losses are socialized.

With ultra transparency, investors know they will get hit for losses should a bank fail.  As a result, investors have an incentive to restrain the risk taking of the banks.  Restraining the risk taking results in banks focusing on supplying the credit the real economy needs and not on taking proprietary bets.

In the last few years, many proposals have been made to address the risks that the banking system imposes on society. Very few, however, have been implemented. 

Most proposals have been rejected, diluted, or delayed, some of them endlessly it appears, because the banks have convinced policymakers, regulators, and sometimes the courts that the regulations might be too expensive.... 

Please re-read the highlight text again as Professor Admati makes a very important point.

Regular readers might recall that before the financial crisis the SEC ran a cost/benefit analysis on bringing observable event based reporting to structured finance securities and concluded that the cost of transparency could not be justified.

Today, a cost/benefit analysis easily justifies bringing observable event based reporting to structured finance securities and ensuring that they are transparent.

Better Markets would argue that our financial system is based on the philosophy of disclosure and therefore transparency should never be subjected to a cost/benefit analysis.

From the bankers' perspective, any regulation that constrains their activities or might reduce their profits is expensive. 

What is expensive for the banks, however, need not be expensive for the economy. 

The costs to the banks are important, but other costs must be considered as well, particularly the costs to everyone else resulting from financial crises or bank bailouts....

When bankers complain that banking regulation is expensive, they typically do not take into account the costs of their harming the rest of the financial system and the overall economy with the risks that they take. 

Public policy, however, must consider all the costs and not simply those to the bankers. 

The point of public intervention is precisely to induce banks, or dye producers, to take account of costs they impose on others. 

For society, such intervention can be very beneficial. 

Appropriate banking regulation is available that would reduce the potential for harm to the financial system without imposing any costs on banks other than the loss of subsidies from taxpayers....

Actually, ultra transparency would cost the banks much more than the loss of their subsidies from taxpayers.

It would end their ability to profit from engaging in illegal activities like manipulating benchmark interest rates like Libor.

It would significantly reduce the profitability of their proprietary trading as market participants could trade against them to minimize their gains while maximizing their downside.

It would reduce their ability to profit from the mismatch between what regulators lead investors to think is the risk profile of the bank and what is actually the true risk profile of the bank.

It would reduce their ability to profit from engaging in regulatory or tax arbitrage.

The fact that this is beneficial and not costly for society is all too often obscured by flawed and misleading claims, what we refer to as the bankers' new clothes.

The bankers' new clothes are simply opacity.

Like the fairy tale Emperor, banks should not be hiding anything.

Stress tests don't mean the banks are OK

In his Bloomberg editorial, Mark Whitehouse debunks the notion that passing the Fed's stress tests actually says that the banks are OK.

Mr. Whitehouse along with individuals like Professor Anat Admati would argue that the banks are not OK until such time as they a) pass the stress tests and b) have book capital equal to 20% of assets.

Regular readers know that you still don't know if the banks are OK if both of these conditions are met.

Why don't you know?  Because in the absence of ultra transparency and ongoing disclosure by each bank of its current global asset, liability and off-balance sheet exposure details, you don't have the information needed to independently confirm that the banks are OK.

Please recall that at the beginning of the financial crisis, for all practical purposes, bank financial reporting was rendered meaningless (a fact highlighted by the OECD).  This was the direct result of the suspension of mark-to-market accounting, the adoption of mark-to-unicorn (thank you Bloomberg's Jonathan Weil), and the adoption of regulatory forbearance under which the banks were allowed to engage in "extend and pretend" with their non-performing assets and create "zombie" loans.

There is a reason that the Bank of England's Andrew Haldane refers to banks as "black boxes".  Only management and the bank regulators know what is inside.  Nobody else does.

Now, would you trust management and the bank regulators to provide an accurate representation of their true financial condition?

I don't for a simple reason.  Until a bank provides ultra transparency (this was the industry standard as recently as the 1930s and signaled that a bank could stand on its own two feet), the bank's management is waving a big red flag saying they have something to hide.

Sheila Bair is not a substitute for market supervision

In his NY Times Economix column, Professor Simon Johnson argues that it is important to appoint Sheila Bair to the vacant post of Fed Vice Chairwoman for Supervision because without filling this vacancy the Fed faces a potential crisis of legitimacy for its handling of the Too Big to Fail banks.

While there is much to recommend his column, Professor Johnson misses two critical facts.

First, a major reason for the financial crisis was the failure of regulatory supervision.  There is little that has happened since the beginning of our current financial crisis to indicated that the reasons that regulatory supervision is not a viable substitute for market discipline, including regulatory capture, have been fixed.


Second, the Fed has a long running policy of financial failure containment and its corollary the Geithner Doctrine (from Yves Smith, nothing should be done that hurts the profits or reputation of a big or politically connected bank).

As regular readers know, banks are not subject to market discipline because they are, in the words of the Bank of England's Andrew Haldane, "black boxes".  When market participants do not have the information they need to independently assess the risk of the banks, they cannot exert discipline on the banks by adjusting both the amount and price of their exposure based on each bank's risk.

Leading up to the crisis and even now market participants rely on the regulators' representation about the riskiness of the banks.  This reliance is the result of the simple fact that the regulators have access to all the useful, relevant information on each bank in an appropriate, timely manner and investors don't.

Unfortunately, this reliance is misplaced as the regulators have to both correctly assess this information and accurately communicate the results of this assessment to the market.  By definition, regulators cannot accurately communicate the results because of concerns over the safety and soundness of the financial system (the regulators won't say anything bad about the banks).

This problem is compounded by the moral hazard creating Dodd-Frank Act mandated stress tests.  Each year, the Fed performs a stress tests on the banks and pronounces them solvent under extreme economic conditions.  This announcement effectively makes the taxpayer obligated for bailing out the investors for any solvency related losses.

Why?  Where is there the investor who is going to argue with the Fed given that the Fed has better access to information than the investor?

That the government making investment recommendations creates moral hazard has been well known since the 1930s.  FDR warned about it and specifically said that the government should stay out of the business of making investment recommendations as this create a moral hazard to bailout investors who relied on the government's recommendation.  The Fed's stress tests are nothing less than the government making an investment recommendation.

More troubling is that former Treasury Secretary Tim Geithner pledged the full faith and credit of the US to provide the banks with all the capital they need as a guarantee to investors that they would not suffer any losses from investing based on the stress test findings.

The policy of financial failure containment was in place back when I worked for the Fed and can be seen in the handling of Continental Illinois and the Savings & Loan crisis.

This policy has already destroyed the Fed's legitimacy when it comes to dealing with the Too Big to Fail banks.  Everyone knows the Fed will not do anything to control them and prevent them from taking outsized risks.

Rather, the Fed will come along and try to "mop up" after one of these banks blows up again.

If the Fed were truly interested in having the Too Big to Fail banks subjected to appropriate levels of supervision, the new Vice Chairwoman for Supervision would be leading the charge 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 ultra transparency, the banks would be subjected to both market supervision and market discipline.  Supervision that would be far superior in terms of both manpower and resources than anything that our regulators can offer.

The Dodd-Frank Act created the position of the Vice Chairwoman for Supervision at the Fed precisely because Wall Street knows that the Fed will never support ultra transparency.  Supporting ultra transparency means giving up its information monopoly.

It also means that the market could exert discipline on the Fed in its performance of is supervisory duties.  The last thing the Fed and its economists would ever be willing to do would be to put themselves in a position where they could be held accountable for their actions or lack thereof.

Standard Chartered: estimates its cost of complying with new regulations at upwards of $800m/annually

As reported by the Guardian, Standard Chartered's chief executive Peter Sands said

new regulations including tougher liquidity and capital rules and a UK bank tax were costing it "well north" of $500m a year, and could be near $800m. [The bank reported its 10 consecutive year of record profits; 2012 pretax profit $6.9b.]

Many banks have said extra global regulations, brought in to make them safer after the 2008 financial crisis, are hurting profitability and could restrict their lending. But few have quantified the impact on their bottom line. 

Hoping to make the financial system less prone to a crisis, policymakers responded to the financial crisis with a significant increase in the combination of complex rules and regulatory oversight.

Rules and regulatory oversight that the banks helped to write so they can be easily gamed (see capital and liquidity) and that won't make the financial system safer.  A point that Mr. Sands drives home by focusing on the cost of the new rules and regulatory oversight.

If he saw the rules and additional regulatory oversight as valuable, he would not talk about the "cost" of compliance without mentioning all the benefits.

A European Union proposal to cap bankers' bonuses at double their salary was also a worry, the bank said. 

"We are concerned about it because we are a global bank and 97% of our staff are outside the EU and we are concerned about our ability to be competitive in attracting and retaining talent," chief executive Peter Sands said.

Again, the EU proposal to cap bankers' bonuses is just another rule to be gamed.

UK regulator admits negligence on Libor, but says it wasn't it job to spot manipulation

The Guardian reports that the UK's Financial Service Authority admits that there was widespread knowledge of Libor manipulation among its employees, but says it wasn't a major regulatory failure because it wasn't its job to intervene.

Please re-read the highlighted text as it summarizes why financial regulators by themselves are not up to the task of exerting adequate discipline to control banker behavior or bank risk taking.

Financial regulators are not up to the task because of the way their job is defined.

Regular readers know that financial regulators do not express an opinion over any of the bank's security or loan exposures.

They do not do this because this would involve them in the allocation of capital across the financial markets.  It would also make them responsible for the performance of the banks.

Regular readers know that this definition of what is not the regulators' responsibility is not bad.  The reason it is not bad is there is a financial market participant who is suppose to care about the risk that a bank is taking with its various exposures.

The financial market participant responsible for exerting discipline on the banks over the risks they take and discouraging bad banker behavior are the investors.

However, investors cannot do this job so long as the banks remain opaque "black boxes" where only the financial regulators have access to all the useful, relevant information in an appropriate, timely manner.

As your humble blogger has said repeatedly since the beginning of the financial crisis, banks are currently not subjected to any market discipline because they operate behind a veil of opacity.

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, banks become subject to market discipline.

They become subject to market discipline because investors can independently assess the risk the banks are taking and adjust the amount and pricing of their investments in the banks to reflect this risk.  In addition, investors can catch bad behavior like the manipulation of Libor and other benchmark interest rates.

Staff at the chief City regulator should be cleared of negligence despite failing to spot clues that banks were manipulating interest rates to generate millions of pounds in bonuses and profits, an internal report into the Libor rigging scandal has ruled. 

The Financial Services Authority said staff did not have responsibility for monitoring Libor submissions, which were collected and published by a separate regulator, the British Banking Authority. 

An internal audit of 97,000 documents also found that 26 items related to Libor fixing and only two phone calls with Barclays gave a clear indication that the practice was widespread across the industry. 

The documents referred to artificially lowering the key interbank lending rate, a practice that made banks appear more secure during the financial crisis but also suggested that Libor was being manipulated by traders for profit at other times....

Andrew Tyrie, the Tory MP who heads the Treasury select committee, said the report showed the FSA was slow to act. 

"The FSA has admitted it had 26 warnings that this appalling practice was taking place. It also had other information that, taken cumulatively, ought to have set alarm bells ringing.
"It is concerning that no action was taken; that it wasn't tells us something may have been amiss at the FSA."...

Actually, what it says is that the veil of opacity hiding the banks' activities prevented interested market participants from having access to the useful, relevant information in an appropriate, timely manner.

The London interbank rate (Libor) was collated by the British Bankers Association from submissions by UK banks. Unknown to most people outside a small group in the City, traders would set the rate according to their own requirements. 

In the three years before the financial crash it became commonplace for them to lift rates to increase profits and bonuses. Following the collapse of Northern Rock and the onset of the credit crunch, when banks were fearful of lending to each other and Libor was soaring as a result, bank rate setters came under pressure from traders and senior executives to depress rates supplied to the BBA. 

Between January 2005 and June 2009, Barclays derivatives traders made 257 requests to fix Libor and Euribor, the eurozone's equivalent. ... 

Turner said: "There are important lessons to be learnt about effective handling of information. A particularly important lesson is the need to have staff focused on conduct issues even when the world rightly assumes that the biggest immediate concerns are prudential; and vice versa. The new 'twin peaks' model of regulation will deliver this."

The important lesson is that regulators should not have a monopoly on all the useful, relevant information in an appropriate, timely manner when it comes to banks.

Banks should be required to provide ultra transparency.

The new 'twin peaks' model of regulation will not solve the problem as regulators are not responsible for approving or disapproving the individual exposures on and off a bank's balance sheet.

Bankers prefer complex regulations governing their pay over providing transparency

Do you think that bankers would rather provide ultra transparency and disclose their current exposure details or try to get around complex regulations on bank pay?

Trick question.

Of course the bankers prefer complex regulations as they have an ability to influence how the regulations are drawn up so that their earnings are not interrupted.

The Guardian provided an example of the bankers' ability to influence how the regulations are drawn up.  It reports that

The Chancellor, George Osborne, goes to Brussels on Tuesday in what looks like a forlorn attempt to prevent the European Union from imposing swingeing curbs on bankers' bonuses in the City.

The bankers in London say jump and the Chancellor says how high.

It makes for great political theatre, but will have no impact on the bankers.

Regular readers know that the bankers won when it comes to their pay when they got the policymakers to focus on complex regulations to solve the problem.

The focus on complex regulations to solve the problem meant that more effective solutions were not considered.  Specifically, there was no consideration given to making the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With ultra transparency, banker pay would dramatically decrease.

There are several reasons for this including

• The cost of funds to each bank would reflect the risks it took and therefore banks would lose the subsidy provided by the combination of financial regulators' information monopoly and their statements about the level of risk at each bank.

• Market participants could trade against proprietary bets in such a way as to minimize a bank's upside from taking a proprietary bet while maximizing its downside.

Capping banker bonuses is treating a symptom not cause of excessive risk taking by banks

In yet another display of treating the symptoms and not the cause of the problem, EU financial regulators have tentatively agreed to cap banker bonuses beginning in 2014.

The justification for capping bonuses is to limit risk taking by banks.

At best, capping bonuses is a one off solution for reducing risk taking.  The thinking behind why capping bonuses will work to reduce risk taking going as follows:  if bankers can earn less, then they have an incentive to take less risk and as a result they will take less risk.

Forgive your humble blogger for not having a lot of faith in this reasoning as its success if dependent on the combination of complex rules and regulatory oversight.

Don't kid yourself that the rules on banker pay are not going to be complex.  Bankers receive compensation in many different forms including base salary, short-term cash bonus, long-term cash bonus and stock.

Simply changing one component of banker compensation is not going to change their incentive to take risk.  Bankers will still take risk and privatize the gains while socializing the losses by simply changing where in their compensation they are awarded for taking risk.

Regular readers know that you humble blogger despises any solution that relies on the use of the combination of complex rules and regulatory oversight when there is a better, simpler alternative.

In this case, the better, simpler alternative is to stop focusing on banker pay and instead focus on limiting their ability to take risk.

The way to limit their ability to take risk 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 assess the risk each bank is taking and adjust the amount and pricing of their exposure to each bank to reflect its risk.  When risk and cost of funds are linked, banks are subject to market discipline to reduce their risk profile.

For example, banks are subject to market discipline at the proprietary trading level.  When all market participants can see what a trader is gambling on, they can trade against the trader in such a way as to minimize the potential upside of the trade while maximizing the downside.  Market discipline acts to restrain, if not eliminate, proprietary trading.

"For the first time in the history of EU financial market regulation, we will cap bankers' bonuses," said the European Parliament's head negotiator, Austria's Othmar Karas, in a statement. 

"The essence is that from 2014, European banks will have to set aside more money to be more stable and concentrate on their core business, namely financing the real economy, that of small and medium-sized enterprises and jobs." 

The bonus cap was part of a package of financial laws hammered out between EU officials, the European Commission and representatives of the 27 member states in negotiations led by Ireland's Finance Minister Michael Noonan. 

The goal is to prevent bankers from taking excessive risks, which can shake the financial industry. 

"This overhaul of EU banking rules will make sure that banks in the future have enough capital, both in terms of quality and quantity, to withstand shocks," Noonan said. "This will ensure that taxpayers across Europe are protected into the future."

It is far from clear that capping banker bonuses will achieve this outcome.

What is clear is that requiring banks to provide ultra transparency would achieve this outcome.