More rhetoric: UK's George Osborne and electrifying the ring-fence

Since the beginning of the financial crisis, global policymakers have been long on rhetoric describing how they will save the taxpayers  from a future bank bailout through yet another example of the combination of complex rules and regulatory oversight.  The latest example is an electrified ring-fence.

Regular readers know this is hot air as the global policy is "financial failure containment" and not "financial failure prevention".

The basic idea behind ring-fencing is that it separates investment banking from retail banking and makes it possible to let the investment bank fail.

Why is this separation necessary?

So that the failure of the investment bank doesn't drag down the retail bank too.

This is nice in theory, but given the global financial regulators' concerns with financial contagion there is no reason to assume it will actually be used in practice.  Does anyone think the global financial regulators will not use taxpayer money to bailout an investment bank that is larger and potentially more interconnected than Lehman Brothers?

Please note, ring-fencing is focused on financial failure containment, what happens should an investment bank fail, and not on preventing the financial failure in the first place.

Apparently, global policymakers have never heard the expression:  an ounce of prevention is worth a pound of cure.

The focus has to be on preventing the investment or retail bank from failing in the first place.

There is only one way to prevent failure and contain the fallout should failure occur.  The only solution is to require that the financial institutions disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert discipline so that the financial institutions reduce their risk profile and therefore become less likely to fail.

Equally importantly, with this information, market participants can independently assess the risk of each financial institution and adjust their exposure to the financial institution based on the market participant's ability to absorb any losses on their exposure.  By limiting their exposure to what they can afford to lose, market participants contain the fallout from failure and eliminate the need for taxpayer funded bailouts.

George Osborne's rhetoric on ring-fencing as reported by the Guardian,

"My message to the banks is clear: if a bank flouts the rules, the regulator and the Treasury will have the power to break it up altogether - full separation, not just ring fence," ... 

"Any bunch of politicians can bash the banks, chase the headlines, court the populist streak. But what good would that do our country? The jobs, the investment, the banking system we all need would go with it. Let's take the anger we feel about the banks and turn it into change to build the banking system that works for us all," said Osborne.

The starting point is requiring the banks to provide ultra transparency.  Until this occurs, the bankers will continue to privatize the gains and let the financial regulators put the losses on the taxpayers.

UK's John Vickers: Volcker Rule too difficult to police

As reported by Bloomberg, John Vickers does not think that the UK should adopt the Volcker Rule because it is too difficult to police.

Regular readers know that there are two components to every regulations:  the rule and how it is enforced.

Regular readers also know that enforcement for the Volcker Rule is simple:  require every bank 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 every trading position and see if it is simply there for market making or is there as a proprietary bet.

If it is a proprietary bet, the bet is subject to every trader's worse nightmare.  The market can now trade against the position to minimize its upside while maximizing its downside.  Traders know this and it acts as discipline so that the traders don't engage in proprietary betting.

As for the Vicker's Rule which separates investment (casino banking) from retail banking, it too needs an enforcement mechanism.  Again, the best enforcement mechanism is requiring the banks to provide ultra transparency.

With this information, market participants, including the financial regulators, can see if the banks are taking risks they are not suppose to inside the ring-fence.

Please note that in the absence of requiring the banks to provide ultra transparency so the rules can be enforced, we are left with the combination of complex rules and regulatory oversight.

The combination of complex rules and regulatory oversight is known to increase the risk of future financial crises.  This lesson was learned with our current crisis where the combination of complex rules and regulatory oversight failed to prevent a bank solvency led financial crisis.

U.K. banks shouldn’t be restricted from proprietary trading in a way similar to the U.S.’s so- called Volcker rule because it would be too complicated to police, said John Vickers, chairman of Britain’s Independent Commission on Banking. 

The distinction between market making and a bank trading with its own money is ill-understood and would sap too much time from regulators, Vickers, 54, told the U.K.’s Parliamentary Commission on Banking Standards today.

With ultra transparency, there is no need to make the Volcker Rule complex nor to sap too much time from regulators.  The Volcker Rule could stay as it currently is:  banks are prohibited from making proprietary trades.

With ultra transparency, market participants can decide what is market making and what is a proprietary trade.

Shielding banks’ consumer units from their investment banking operations as recommended by the ICB is preferable, he said.

Federal Reserve Chairman Paul Volcker, 85, who helped devise the U.S. rules, told Parliament in October that Vickers’s own proposals will be difficult to maintain and financial institutions will seek to unwind separations over time....

The Vicker's Rule also needs ultra transparency for enforcement.  There is no reason to believe that the financial regulators can do a good job of enforcing the separation as Glass-Steagall collapsed in the face of bank lobbying.

“If one had ring fencing and Volcker there would be two boundaries to police,” Vickers said. “Volcker draws the line in a very difficult, almost excruciatingly difficult, place.” 

If proprietary trading is banned from banking, it could “move elsewhere” where there may be fewer rules to govern it, Vickers said. 

Banks holding bonds and shares to sell to clients, so-called market making, is indistinguishable from proprietary trading, where a firm takes its own positions in securities for its own gain, he said. 

It would be “very difficult” for a regulator to tell the difference between market making and proprietary trading, Vickers said. “People at the top of banks themselves have not known what was going on in terms of the kind of trading, and the regulator is at a disadvantage even relative to them.”

Mr. Vickers makes a strong case for ultra transparency.  Market participants like traders at other large global banks and hedge funds don't have trouble distinguishing between market making activities and proprietary bets.

France moving forward to separate investment and commercial banking

The Wall Street Journal reports that French bank reform is focusing on separating investment from retail and commercial banking.

France's banks are lobbying against this saying the separation will hurt economic growth.

I can clearly see how it will hurt banker bonuses, but I fail to see the direct connection between separating the two businesses and hurting economic growth.  The reason I don't see a direct connection is that the two businesses still exist after they have been separated.

Regular readers know that your humble blogger sees reform efforts focused on separating investment from retail and commercial banking as a best a distraction and at worst a barrier to real reform of the financial system.

The starting point for real reform of the financial system 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.

Not only does ultra transparency address the issue of reducing the riskiness of the investment and retail/commercial banks, but it also ushers in cultural change as sunlight is the best disinfectant for bad behavior.

The French government-planned reform of the banking industry, which seeks to separate speculative and highly risky activities from retail and commercial operations, is ill-timed, the head of the French Banking Federation said Saturday. 

Implementing the reform, which was an electoral pledge of socialist president Francois Hollande while the country is facing strong economic headwinds could further limit banks' profitability and ability to help foster growth, Jean-Paul Chifflet said in an interview with France Inter radio. 

In the U.S., banking reforms have been put on the back-burner because of the economic slowdown, Mr. Chifflet said.

Actually, in the US, bank reform was put on the back-burner by the Obama administration and the passage of the Dodd-Frank Act.  The administration didn't want to reform the banks and Dodd-Frank was written by and for the banks by their lobbyists.

The French government last week presented a bill forcing French banks to create specific units to house risky speculative operations, in a bid to address one of the causes of the financial and economic crisis that started in 2007 and to protect retail activities and customers' savings. 

The project, however, has been watered down from Mr. Hollande's original plan to split the banks into two and end the combined model of commercial and investment bank.

Parliamentary Commission worried about future bank lobbying

Reuters reports that the Parliament Commission on Banking Standards has issued its final report which concludes that reform of the banking system needs a shield to protect the reform from future bank lobbying or politicians.

The report recommends providing regulators with the power to break-up investment and commercial banking if the banks or politicians try to create holes in the ring-fence being set up to separate investment and commercial banking.

There are two reasons to believe that this solution for protecting reform will not work.

• Regulators are concerned with the safety and soundness of the financial system and breaking up the banks could threaten this.
• As demonstrated by the financial crisis, regulators are captured.

Regular readers know there is a far better solution to protect ring-fencing:  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 of the banks regardless of where the risk is held.

With this information, market participants can exert discipline and restrain risk taking regardless of how much lobbying the banks do, the degree of regulatory capture or politicians poking holes in complex regulations.

Ultra transparency is the safety net if the rest of the current reform proposals fall short of what is needed.

Britain needs to introduce legislation that could break up banks if standards slip because current reform proposals fall short of what is needed, an influential parliamentary panel said. 

The Parliamentary Commission on Banking Standards also said on Friday the government could set tougher rules for how much leverage banks were allowed, adding that the committee itself would consider whether to propose banning proprietary trading. 

Britain, going further than most countries in pushing through change, is forcing banks to separate, or "ring-fence", their domestic retail arms from riskier investment banking. 

"The proposals, as they stand, fall well short of what is required. Over time, the ring-fence will be tested and challenged by the banks," PCBS chairman Andrew Tyrie said. 

"That is why we recommend electrification. The legislation needs to set out a reserve power for separation; the regulator needs to know he can use it."... 

Osborne appears unlikely to go as far as the PCBS wants. 

A previous Commission, led by John Vickers, said a full break-up of banks was not needed, and Osborne may decide that if the ring-fence plan proved to be flawed, the Treasury could then introduce fresh legislation to strengthen it....

The only way to prevent a repeat is with ultra transparency.

It is only when the market has the information it needs to discipline the banks that effective restraint on risk taking by the banks will come to pass.

The PCBS, asked to assess government plans before their introduction, said legislation should be introduced now because banks had to be discouraged from gaming the new rules for the ring-fence to succeed. 

"All history tells us they will do this unless incentivised not to," Tyrie said, adding politicians could be lobbied to put holes in the ring-fence too. 

"Additional powers are essential to provide adequate incentives for the banks to comply not just with the rules of the ring-fence, but also with their spirit," the Commission said in its 146-page report....

"I would be concerned ... that a future, politically-motivated government or regulator could take draconian action with impunity. It would be putting in place a simple mechanism for banks to be picked on and to be broken up," Investec Securities analyst Ian Gordon said. 

"One could argue that threat is there anyway and could be implemented," he said, adding the PCBS had added to uncertainty about reforms....

The beauty of ultra transparency is that it provides a very strong incentive for the banks to comply with both the both the rules of the ring-fence and their spirit.

In a concession to most banks, the PCBS said banks should be allowed to sell simple derivatives within their ring-fenced operation, which had been a point of contention....

Yet another reason for requiring ultra transparency.  It is important to monitor the risk of the operation inside the ring-fence that the taxpayer is obligated to support in the future.

Tyrie said the market rigging and corruption shown this week at Swiss bank UBS "beggar belief. It is the clearest illustration yet that a great deal more needs to be done to restore standards in banking....

What needs to be done is require ultra transparency.  It is well known that sunlight is the best disinfectant.

It said it was concerned too many reforms will be left to the discretion of the future regulator, and said the power to force bondholders to take losses when a bank hits trouble should be included in primary legislation.

Until such time as banks are required to provide ultra transparency, bondholders will be protected by the taxpayers.

Current disclosure by banks leaves them as "black boxes".  Nobody is going to invest in the bonds of a bank where they cannot assess its risk.

The only reason investors bought bonds before the crisis was the government's saying the banks were low risk.  This statement created a moral hazard which meant that the taxpayer would have to ride to the bondholders' rescue if risk turned out to be greater.

Ending this moral hazard and getting bondholders to take on the risk of loss requires that banks provide ultra transparency.  With this information, investors can assess the risk of the banks and adjust their exposure according to what the investor can afford to lose given the risk.

Banking can be made honest and fail-safe

In case no one has noticed, everyone who has testified before the Parliament's Commission on Banking Standards has concluded that the combination of complex rules/regulations and regulatory oversight will neither make banks honest nor fail-safe.

This list of high-powered witnesses includes the UK Chancellor, George Osborne, the Governor of the Bank of England, Sir Mervyn King, a leading contender as next Governor of the BoE, Paul Tucker and former Fed Chairman Paul Volcker.

As an example of why the combination of complex rules/regulations and regulatory oversight will neither make banks honest nor fail-safe, each of them looked at the flaws in the proposals to separate investment and retail banking using the Volcker Rule, ring-fencing or complete separation.

Your humble blogger was thrilled that all of these distinguished individuals confirmed what I have been saying all along about the combination of complex rules/regulations and regulatory oversight is not an effective substitute for transparency and market discipline.

Everyone knows that requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details would make the banks honest.

Sunshine is the best disinfectant.

Everyone also knows that transparency makes the banks fail-safe.

With access to the information disclosed through ultra transparency, market participants can independently assess the risk of each bank.  With this risk assessment, market participants can adjust the amount of their exposure to each bank to what they can afford to lose given the risk of each bank.

As a result, a bank is both subject to market discipline to restrain its risk taking and, if it ignores this restraint, can fail without fear of financial contagion.

Hopefully, the commission members will see that substituting the combination of complex rules/regulations and regulatory oversight for transparency and market discipline doesn't work.  And they will conclude that reform needs to focus on bringing transparency to all the opaque corners of the financial system.

BoE's Paul Tucker: splitting retail and investment banking won't make system safe

Speaking to the parliamentary commission on banking standards, the Bank of England's Paul Tucker observed that splitting retail and investment banking won't make the system safer.

His reason for making this statement is that he thinks that investment banks are fully capable of blowing up the financial system.

Combine this with the historic fact that retail banks are fully capable of blowing themselves up (see: US Savings & Loan for example) and it is clear that pursuing regulations that would create a ring-fence or full separation is unproductive.

What is needed is reform that would actually make the financial system safer and financial crises far less likely to occur.

Regular readers know that there is only one reform that achieves this goal:  bring transparency to all the opaque corners of the financial system.

That this works can be easily seen by the simple fact that

• the parts of the financial system characterized by opacity, including complex rules/regulations and regulatory oversight, were the parts that ceased functioning and haven't resumed functioning since the start of the financial crisis.

• the parts of the financial system characterized by transparency and market discipline have continued to function throughout the financial crisis.

As reported by the Guardian,

Paul Tucker, the frontrunner to become the next governor of the Bank of England, has told MPs he does not want to see the full separation of retail and investment banks. 

Speaking to a parliamentary committee on banking standards, Tucker warned that even if the separation of banks was forced by law, the economy would still be at risk of being "blown up" by non-retail banks and other financial institutions.

Tucker said: "The thing that has worried me most about this debate from the beginning ... is that people fall into thinking, 'if only we could make retail banking safe, the financial system will be safe', and frankly I think that is nonsense. I think the financial system and the economy will be capable of being blown up by vast wholesale dealers and non-banks."...

Please re-read Mr. Tucker's comments as he effectively explains why transparency is the solution that works rather than the combination of complex rules/regulation and regulatory oversight.

With transparency, nobody assumes that the financial system is or will be safe.  Rather, all market participants know that they still have the obligation to independently assess the risk of each of their exposures and to not have a larger exposure than they can afford to lose given the risk.

That this occurs is not surprising as the FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Clarity, he said, was crucial to avoid banks lobbying the regulator. "For the regulator to be effective, it has to be able to use judgment. But if judgment ends up simply as a negotiation between the regulator and the regulated bank, there's only one winner in that and I think that will be a very bad outcome."

While Mr. Tucker was talking about ring-fencing, I think his comment is applicable to the entire idea of  substituting the combination of complex rules/regulations and regulatory oversight for transparency and market discipline.

The combination of complex rules/regulations and regulatory oversight is doomed to failure as it ultimately ends up as a negotiation between the regulator (who can be pressured by politicians) and the regulated banks that the regulated banks will win.

Ironically, transparency is all about bringing clarity and avoiding having banks lobbying the regulator.

Take ultra transparency for example.  Under ultra transparency, banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This disclosure brings clarity to all market participants on the risks each bank is taking.

With ultra transparency it is no longer the regulator negotiating with the bank over the riskiness of the bank, but the regulator judging the riskiness of the bank using the analytical capabilities of the market (the regulator can ask other banks how risky they think each bank is for example).

UK Chancellor urges Parliament not to "tear up" bank approved reforms

The Guardian reports that George Osborne, the UK's Chancellor, asked a parliament committee not to "tear up" the consensus on banking reform.

He asked the committee to support the idea of ring-fencing rather than complete separation of investment and retail banking.

In addition, the Chancellor asked the committee to focus on how banks could adopt something akin to the ethical standards of other professions like medicine.

Regular readers know that the committee can accomplish the goals of ring-fencing and enforcing ethical standards in the banking industry by simply requiring the banks to provide ultra transparency.  Under ultra transparency, the banks would be required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, banks would stop taking proprietary bets as they would worry about market participants trading against their positions.  This easily achieves a major goal of the Vicker's commission of separating gambling from insured deposits.

With this disclosure, the culture of banks would be radically changed as sunlight is the best disinfectant.  Without the veil of opacity to hide their bad behavior, bankers would not engage in activities like manipulating Libor.  Ethical standards would effectively be forced on bankers and the market would act as a disciplinarian for violating these standards.

George Osborne, the chancellor, has urged the independent commission on banking standards to avoid "tearing up" the consensus on financial reform by pushing for a more radical separation of retail and investment banking. 

Appearing before the cross-party commission, chaired by the Conservative MP Andrew Tyrie, Osborne firmly rejected the idea that the reforms proposed by Sir John Vickers to "ringfence" retail banking will fail to tackle the culture that led to the crisis. 

"We have spent two years getting to this point … We are now on the verge of implementing ground-breaking legislation," he said on Wednesday. "I don't think this is the moment to tear up everything that's been done over the last two years."

Since all that ground-breaking legislation does not involve requiring the banks to provide ultra transparency, it is most likely worthless.

The legislation is probably just like the Dodd-Frank Act in that it substitutes a combination of complex rules/regulations and regulatory oversight for transparency and market discipline.  A combination that our current financial crisis shows is prone to not working.

Everyone knows that transparency and market discipline works.  All you have to do is look at the financial system and see that the areas that broke down during our current crisis are characterized by opacity, much of it in the form of complex rules/regulations, and regulatory oversight.

The Chancellor is effectively asking Parliament to gamble with UK taxpayer funds and endorse a known failure (the combination of complex rules/regulations and regulatory oversight) rather than a proven success (transparency and market discipline).

Rather than questioning the Vickers reforms, the chancellor urged the committee instead to examine how bankers could adopt something akin to the ethical standards imposed on other professions. 

"In the medical profession and the teaching profession, we expect certain standards, but which are administered by the profession," he said. 

Barclays, whose conduct in the Libor scandal prompted Downing Street to set up the commission on banking standards, has proposed a new professional body to police the ethics of finance workers....

No surprise that Barclays would recommend a complex rules based solution that protects opacity in the financial system and allows the bankers to continue to engage in misbehavior.

Frankly, no one cares about the ethics of finance workers.  It is easier to put in place a system that removes the need to rely on their ethics.

The system is requiring the banks to provide ultra transparency.  With this system, the bankers know if they do anything that might be ethically questionable they could find themselves on the front page of the news tomorrow.

Lord Turnbull, a former permanent secretary to the Treasury, warned that the so-called "enabling legislation" tabled by the government to implement the ringfencing of banks' retail operations gave too little detail about how the new regime would work. 

"You're not just asking us to buy a pig in a poke, you're just asking us to buy a poke – because there's not much pig in it at the moment," he said. 

The chancellor said it would be up to individual banks to decide what operations, in addition to customer banking, should sit inside the ringfence, which will enforce much stricter rules on how much capital they must hold....

But he said these specific demands could not be directly enshrined in legislation, because it would be a mistake to create a "Maginot Line", reflecting how banks operate in 2012, which could later be subverted, or become irrelevant, as the operation of the financial sector changed.

Don't you love the idea of banks shuttling pieces inside and outside the ring-fence.

One of the nice features of ultra transparency is that it adjusts to how the banks operate.  Regardless of where they have an exposure it is fully disclosed.  No ifs, no ands, no buts.

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.

Discussion of bank ring-fence failure misses point; ultra transparency is a better solution

The Telegraph carried an article on how Martin Taylor became the second prominent regulator, after the Bank of England's Andrew Haldane, to observe that if ring-fencing fails, the banks should be broken up.

Why should we be experimenting where the cost of failure could be substantial when there is a simpler alternative solution that we know works and achieves the same result?

In the case of ring-fencing, ultra transparency is a much simpler, more effective solution.

By making the banks disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details, proprietary trading is effectively ended.  In addition, we bring about a culture change as ultra transparency ushers in sunlight to act as the best disinfectant (no more manipulation of Libor and other rates).

Britain's lenders will have to be broken up if the ring-fence to protect their retail banking operations from “casino” investment banking proves to be “permeable”, warned Martin Taylor, one of the policy’s architects . 

By definition the ring-fence will be permeable.  The question is how many loopholes there will be in the complex rules implement ring-fencing.

Martin Taylor, who sat on the Government’s Independent Commission on Banking (ICB) that proposed ring-fencing, said “there would be a case for going further” if the firewall was “unworkable”....

Given that the bank lobbyists were able to undermine Glass-Steagall, you can rest assured that the firewall will prove "unworkable".

Asked by the Parliamentary Commission on Banking Standards whether full separation would have been preferable, Mr Taylor, a former Barclays chief executive, said ... “If the industry is unreformable, then a full split will be necessary.”...

We already have confirmation through the customer conduct issues and the manipulation of Libor and other interest rates that the industry is un-reformable.

While welcoming the Government’s decision to adopt ring-fencing, Mr Taylor said the Chancellor had made a “mistake” in watering down other proposals. 

Letting banks build balance sheets that are 33 times their capital base, rather than the 25 times recommended, was “simply a mistake”, and allowing derivatives inside the retail bank was “the thin end of the wedge” as such complex instruments could be used to breach the rules. 

“I prefer prohibition. It’s very simple,” Mr Taylor said. “Because I want to keep the ring-fence impermeable, I want to keep things simple.”...

If Mr. Taylor wants simplicity, then he should love requiring the banks to provide ultra transparency.

When market participants can see what the banks are doing, it is easy for market participants to exert discipline and restrain the banks from risk taking and bad behavior.

Mr Taylor also claimed that regulation has not helped by treating the industry as a “rapacious” animal that need to be “tied up in red tape” rather than focus a “duty of care to clients”. 

“We have dangerous dogs walking around with muzzles on. What I would like to see is some family pets as well.”

Regular readers know that complex regulation and regulatory oversight are a substitute for transparency and market discipline.

Transparency and market discipline are much more effective at turning banks into socially useful organizations.

Paul Volcker: Ring-fencing is flawed and UK bank reforms will be hard to achieve

In his testimony before the UK parliamentary inquiry on banking standards, Paul Volcker observed that   successfully reforming the banks by putting the theory of ring-fencing in practice will be hard to achieve.

Regular readers know that the Blob (aka, politicians, financial regulators, Wall Street and City banks and their lobbyists) blunts reform by adopting solutions that require complex rules and regulatory oversight to implement as a substitute for transparency and market discipline.

Ring-fencing is a classic example of this type of solution.  It is this need for complex rules and regulatory oversight that Mr. Volcker sees as the reason that ring-fencing will fail.

Compare and contrast ring-fencing with requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ring-fencing is going to take hundreds of pages of rules while ultra transparency take one simple rule on one page.

Ring-fencing leaves the banks subject to only regulatory oversight while ultra transparency leaves the banks subject to market discipline.

It is common sense that ultra transparency will be more effective for far longer than ring-fencing.

Paul Volcker, the former chairman of the Federal Reserve, has told British MPs that their plans to force banks to separate retail services from risky investments were a welcome approach but would be hard to achieve....

[S]eparating the two types of banking would be "effective to a considerable extent" in allowing risky parts of banks to fail without damaging the main business. 

But he told a parliamentary inquiry on banking standards that putting the theory into practice was not easy. 

"Based on the American experience, the concept that different subsidiaries of a single commercial banking organisation can maintain total independence either in practice or in public perception is difficult to sustain," Volcker told the Parliamentary Commission on Banking Standards. 

Banking reforms in the United States, Britain and Europe all require "careful regulatory definitions and supervisory oversight" to ensure functions are kept separate, he said....

Banking reform dies because of the focus on these 'careful regulatory definitions and supervisory oversight'.

Volcker said there were holes in such a system that "are likely to get bigger over time". 

Reform based on complex rules by definition has holes that will grow bigger over time.  That is why the Blob wants it.

"It's all kind of awkward," he said in regard to setting up separate subsidiaries. "I don't know what it means to have an independent board that is a subsidiary of another board."

It means that the Blob has an opportunity to undermine true bank reform.

The biggest hole in how banking reform is being done is that it substitutes complex rules and supervisory oversight for transparency and market discipline.

Update
From the Guardian,

One of the world's most experienced financial regulators said plans to ringfence investment banking arms of banks from high street operations would encourage bosses to seek loopholes... 

That is why the Blob prefers this type of bank reform solution over ultra transparency which is both simple to understand and simple to implement.

Volcker said a ringfence was complex and difficult to regulate compared with simply splitting investment banking operations into a separate firm. 

"When you adopt a ringfence, pressures from inside the organisation tends to weaken the restrictions," Volker said. 

"I'm not saying it will be totally ineffective, but the Vickers report says it is going to have a ringfence with exceptions, and once you go down that road of having exceptions the [banking] organisation is going to push for more exceptions and widen the limits," he said.... 

He said the UK had adopted an outmoded view of banking services that categorised services designed to support business customers with the casino activities that brought about the crash. 

He also told the commission that the UK had chosen to ringfence the wrong parts of the bank. 

"While I would leave lots of services in the core of the bank, I would separate proprietary trading into a separate firm, which can go bust if it gets the risk management wrong," he said.

Frankly, by simply requiring the banks to provide ultra transparency, you can end their proprietary trading and not engage in the ring-fencing exercise.

Banking reform fails because focus is not on valuation transparency

Since the early 1930s, the financial systems of most western nations have been based on the FDR Framework.  This framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Banking reform since the beginning of our current financial crisis has failed because it does not embrace this framework.

To date, banking reform, particularly as exemplified by the Dodd-Frank Act in the US, the Vickers Commission in the UK and most recently the Liikanen Commission in the EU, has substituted complex rules and regulatory oversight for disclosure and transparency.

This banking reform has substituted knowably weaker prohibitions on proprietary trading (the Volcker Rule) or ring-fencing for disclosure and transparency.

Does anyone really believe that it was Glass-Steagall which separated commercial and investment banking and not the combination of the philosophy of disclosure with the principle of caveat emptor that kept the financial markets functioning smoothly for the 7 decades preceding our current financial crisis?

If there is anyone who thinks the credit belongs to Glass-Steagall, they should look at which portions of the financial system froze and remain frozen as a result of the current financial crisis.

A hint:  interbank lending and private label mortgage-backed securities.

What characterizes these two areas of the financial system and all the others that are not working properly is opacity.  The Bank of England's Andrew Haldane says current disclosure practices by banks leaves them resembling 'black boxes'.  Your humble blogger says current disclosure practices by structured finance securities leaves them resembling 'brown paper bags'.

What characterizes the areas of the financial system that functioned throughout the financial crisis and are still working is the existence of disclosure and valuation transparency.

Regular readers know that with valuation transparency market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess an investment and make a fully informed investment decision.  This is also the necessary condition for the invisible hand to work properly.

With valuation transparency, market participants can successfully complete the first step of the investment process:  independently assess the risk and value of an investment.

The second step in the investment process is to compare this independent assessment of value against the price being shown by Wall Street or the City.

The third and final step in the investment process is to make a buy, hold or sell decision based on the difference between the independent value and the price shown.

It is this investment process that allows the market to exert discipline.  The investment process does this by putting downward pressure on stock prices and upward pressure on the cost of debt for firms whose risk exceeds their expected returns.

Returning to bank reform, we see that the reforms effectively substitute regulators for market discipline.

If there is any lesson to be learned from our current financial crisis, the lesson is that by design regulators are subject to being captured by the banks.  For example, regulators have political masters who are easily captured by the banking lobby.

Because they are subject to capture by the banks, regulators are the very last market participants to be able to exert discipline on the banks.

Since the beginning of the financial crisis, I have been advocating bringing valuation transparency to all the opaque corners of the financial system.  Not only will this unfreeze these frozen markets, but it will also bring in the benefits of sunshine as the best disinfectant and address the culture of bad banker behavior.

The Guardian ran an article that highlighted why complex rules and regulatory oversight don't work.

The government is facing mounting pressure to spell out precisely what activities it regards as high-risk "casino-style" investment banking – which are to be ringfenced from traditional savings and loans to safeguard the banking system. 

Publishing a draft banking reform bill , Treasury minister Greg Clark said: "We want to ensure that taxpayers are protected whilst retaining our status as a global financial centre....  

But Andrew Tyrie, the MP leading the scrutiny of the government's banking reforms as chairman of the parliamentary commission on banking standards, is annoyed at the lack of clarity in the bill. ... 

"The draft bill appears to leave a lot of detail to be determined in secondary legislation. We will press vigorously to find out what that is going to contain. Only by doing so will anyone – the industry, bank customers, parliament and the public – be able to find out what this legislation really means for them." 

Despite the importance of this legislation, MPs have less time to scrutinise the proposed laws than is typical as all sides recognise the need to get the bill into law as quickly as possible.... 

Last month Volcker told one newspaper: "In my experience ring-fencing is not terribly effective ... It only works in fair weather, but doesn't work in foul weather. They have already run into problems and they are bound to run into more. 

"John [Vickers] and I have the same concerns in mind. But the logic would be to separate the two parts of banking, not to keep them within the same institution. I find it puzzling to suggest that within one organisation you can have a branch that is entirely independent of another subsidiary, with the confidence that never the twain shall meet?"

Andrew Haldane: banks lying about value of their assets weighs on banks' access to new capital

In his Financial Times column, the Bank of England's Andrew Haldane looks at how to improve bank valuations and therefore their access to new capital when the banks are "prevaricating" about the value of their legacy assets.

He suggests that unbundling the banks might make them worth more because of difficulty valuing their separate business lines.

Mr. Haldane recognizes that the legacy assets on the banks balance sheets are acting as an anchor that prevents higher valuations.  To address this problem, he proposes eliminating the uncertainties over the valuation of legacy assets by having the regulators value the assets.

Your humble blogger thinks that the better and simpler solution 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 value each bank's exposures including their legacy assets.

With this information, market participants can value each bank's business lines.

Perhaps more importantly, with this information, market participants can exert discipline on the banks and restrain excessive risk taking.  With excessive risk taking restrained, banks can return to their socially useful functions of providing credit to support the real economy and payment services.

My solution is simpler than Mr. Haldane's because it does not require complicated rules to implement the ring-fence nor does it require the regulators to value the legacy assets.  My solution is better because it relies on the market to value assets.

Back in 2000, financial markets valued global banks at two or three times the book value of their equity – saying, in effect, that an investor who had placed $1 with a bank had doubled, perhaps trebled his stake. It should have been no surprise that investors flooded in, resulting in a threefold rise in global banks’ balance sheets in less than a decade, in what was perhaps the largest bank bubble in financial history. 

When that bubble popped in 2007, so too did market valuations. Today, most global banks are valued at a discount – many at a small fraction – of their equity book value. Today, an investor who had placed $1 with a bank would on average have seen that return as little as 50 cents. Once a value-creation machine, banks have become a value-destruction machine; in response, bank investors are seeking shelter and bank balance sheets have begun a crash diet.

Like similarly opaque structured finance securities, there was a pre- and post-bubble popping in 2007 valuation for banks.

Pre-2007, investors saw rapid growth in bank earnings and valued them accordingly.

Post-2007, investors, knowing the legacy assets exist, are asking the question of which banks are solvent and which banks are not.  To answer this question, market participants need the information that banks do not currently provide, but that would be provided under ultra transparency.

So what has gone wrong, and what can be done? 

Lowly bank valuations are in part a legacy of the past and in part a prophecy about the future. 

The legacy is the overhang of overvalued bank assets. There are several reasons for this. 

One is forbearance on past loans, which appears to be both large and latent. Quite how large and latent is unclear. Near-zero global interest rates, actually and prospectively, have encouraged forbearance by lowering the costs of prevarication. 

Market participants know that bank balance sheets, both asset valuations and book capital levels, are prevarications.

Because the financial statements are a prevarication, most investors won't buy the banks' securities and those that do demand a risk premium.

Global accounting rules have also contributed to an overvaluation of legacy assets, as they prevent banks adequately provisioning for future loan losses. International efforts to rectify this are at risk of stalling. 

There is a strong case for regulators stepping in to lessen the uncertainties over valuations.

But the question is what should the regulators do?

That might mean calculating prudent valuations across banks’ balance sheets, as the Bank of England’s Financial Policy Committee recently suggested with respect to UK banks.

These prudent valuations would help in removing residual uncertainty about banks’ legacy portfolios. They could thereby spur private investors to return to banks, when they might otherwise be fearful of paying for yesterday’s mistakes. That would boost bank valuations and support bank lending....

Regulators should never take on publicly valuing bank assets. If regulators value an asset, they are effectively guaranteeing what it is worth.  If they are wrong and overvalue the asset, there is a moral obligation to bailout the investor who relied on the regulators' valuation in their purchase decision.

In addition, regulators valuing bank assets is an example of regulators replacing the financial markets.  The role of financial markets is to value assets.

It is far better to have the financial markets value sovereign debt securities held by the banks than for regulators, who still categorize sovereign debt as risk free, to calculate a prudent valuation.  After all, what prudent value would a regulator assign to debt from Spain, Greece, Ireland, Portugal, Italy or France.

If the regulators want to do something to address the overhang of overvalued legacy assets, they should require the banks to provide ultra transparency.  With this data, the market would value the banks' assets.

Many of the legacy assets are opaque toxic structured finance securities.  Valuing these securities is impossible because of a lack of transparency that makes valuing structured finance securities equivalent to valuing the contents of a brown paper bag.

To bring transparency to the structured finance market for legacy assets, regulators have to go one step further.

They need to pay to have observable event based data on the underlying assets collected and reported to the market before the beginning of the next business day.  This data covers all the activities like a payment or default involving the underlying collateral and is needed by investors so they can know what they are buying or know what they own.

Many large universal banks are a complex portfolio of franchises. It is very difficult to value any individual component of that portfolio in the current environment. And it is almost impossible to value the portfolio as a whole. For example, in the current environment are investment banking revenues a hedge or a headache?...

The reason it is difficult to value the individual components of a universal bank or the portfolio as a whole is the fact that banks are 'black boxes'.

Market participants do not have the information they need to value them (see discussion of overvalued legacy assets above).

If there was ultra transparency, then market participants could assess the risk of the banks and value them.

The problem for investors appears to be not so much too-big-to-fail as too-complex-to-price....

Actually, the problem is a lack of transparency.  Without ultra transparency, investors are being asked to blindly bet on the contents of a black box.  

If the black box is split in half, legacy assets and high street banking go one way and casino banking goes another, investors are still being asked to blindly bet.  After ring-fencing, investors just have to make two blind bets and not one.

It should come as no surprise that investors are unwilling to pay a lot to make a blind bet.

To break up or not to break up the banks is a distraction, the issue is requiring them to provide transparency

To give regular readers some idea of just how powerful the Blob (aka, financial regulators, bankers and their lobbyists) is, five years after the financial crisis began we are still debating whether to break up the banks or not.

Regular readers know that the issue of breaking up the banks is nothing more than a distraction.  The real issue is requiring the banks to provide ultra transparency and disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is only with this information that market participants can exert discipline on the banks and get them to refrain from excessive risk taking in both the retail and casino parts of the bank.

It is only with this information that market participants can assess the risk of each bank and adjust their exposure to each bank to a level that the market participant can afford to lose given the risk of the bank.  It is this adjustment of each market participant's exposure that ends the risk of contagion.

As discussed by the Guardian,

In January 2010, the then chancellor, Alistair Darling, was asked about breaking up banks to make them safer. He had just pumped around £65bn of taxpayer funds in to the banks and replied: "I have always thought to separate banks doesn't deal with the full problem … It is the connections between institutions that cause problems not the legal entity. The large bank/small bank division, experience shows, does not answer the question either of Lehmans."

The problem of connections between institutions can only be solved with ultra transparency.

It is the information that banks with deposits to lend need to independently assess the risk of banks looking to borrow.

It is the information that banks entering into a derivative contract need to independently assess the risk of the counter-party bank.

With the independent assessment of risk, the banks can adjust their exposures to each other to a level where they can afford to absorb the loss on their exposure without failing themselves.

Banks will do this because of market discipline.  Banks that are at risk of failure from the collapse of another bank will see a much higher cost of funds and lower stock price than banks that are not at risk of failure from the collapse of another bank.

Roll on September 2012 and Labour, now in opposition and under new leadership, is baiting the coalition government for not going far enough in implementing the ringfencing proposals outlined by the Independent Commission on Banking. 

Chaired by Sir John Vickers, who has expressed disappointment that the government has not endorsed the proposals in full, the ICB calls for a ringfence to be erected between high street banks and investment banks, dubbed casinos.

Ring-fencing will do nothing to address the interconnectedness of the banks.  Without ultra transparency, banks will still not be able to independently assess each other's risk, let alone tell which banks are solvent and which are not.

The shadow chancellor, Ed Balls, had made it clear in December that he would support what he described at the time as "these important banking reforms" and called for no "backsliding, foot dragging or watering them down". 

By June, among the areas watered down was the leverage ratio – one of the ways to measure the risks banks take – and allowing the bits of the banks inside the ringfence to sell derivatives....

This just shows that the Blob knows how to play the game.  Get proposed regulations to focus on your issue and then lobby to get the regulations water-down.

Meanwhile, on Tuesday it is the turn of a panel set by European commissioner Michel Barnier to give its verdict on the merits – or not – of breaking up banks. The report by Erkki Liikanen, governor of the Bank of Finland, will be read closely by the heads of banks across Europe. 

The heads of banks across Europe will be looking to confirm that Erkki Liikanen restricts the discussion to breaking up or not breaking up the banks.

The heads of banks across Europe know they are in trouble if the question is asked if this is the most effective way to restrain risk taking or financial contagion.

Extraordinary, really, that four years on from the banking crisis politicians and policymakers are still arguing about the ideal shape for such a critical industry.

As I said, arguing about the ideal shape for the financial industry is a distraction.

If you require high street and casino banks to provide ultra transparency, the market will figure out what is the ideal shape for the industry.

Ed Milibrand shows how the Blob huffs and puffs and does nothing to reform banks

As reported by the Guardian, UK Labour leader Ed Milibrand says he would push through the modern day equivalent of Glass-Steagall and separate the 'casino' operations from the retail operations.

"Either they can do it themselves – which frankly is not what has happened over the past year – or the next Labour government will, by law, break up retail and investment banks. 

"The banks and the government can change direction and say they are going to implement the spirit and principle of Vickers to the full. That means the hard ringfence between retail and investment banking. We need real separation, real culture change. Or we will legislate."

Mr. Milibrand said he was sincere about pursuing this policy.

Critics of such a policy argue it would lead the banks to abandon the UK as their base. 

The Labour leader told BBC1's Andrew Marr show he did not believe that would happen but said that, if it did, he was ready to face them down. 

"I think what the British people want is a prime minister that will do the right thing for the country," he said. "Do you want somebody who will stand up to the powerful vested interests in our country or not? 

This whole position would be great except for one small problem:  ring-fencing is a solution endorsed by the Blob (aka, financial regulators, bankers and their lobbyists).

No less an authority than Paul Volcker has already said that it will not work in a time of financial crisis.

Regular readers know that ring-fencing is simply another way of substituting complex regulations and regulatory oversight for transparency and market discipline.

Without requiring both 'casino' and retail banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, how can any market participant independently assess how much risk is being taken?

Ring-fencing doesn't help in the assessment of risk and ultimately, as Mr. Volcker observed, breaks down at a time of crisis.

The one area where ring-fencing is helpful is drawing attention away from the fact that ultra transparency is needed to truly reform banks.

Paul Volcker: ring-fencing won't work

In an exclusive interview with the Telegraph, Paul Volcker said that when a financial crisis hits ring-fencing retail from investment banking won't protect the financial system.

As a practical matter, neither will the current version of the Volcker Rule which relies on complicated rules and regulatory supervision to protect the financial system.

Regular readers know that combining either the Volcker Rule or ring-fencing with ultra transparency would protect the financial system.

By requiring the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants could exert discipline on the banks to restrain their risk taking.

Restraining risk taking happens to not be in conflict with market making.  Banks will still be able to make markets, they will just be restrained when it comes to making proprietary bets.

In an exclusive interview with The Daily Telegraph, Mr Volcker said that plans to force banks in the UK to ring-fence their traditional retail arms from "casino" investment divisions would not work in the event of a bail out. Ringfencing, he said, would only work in "fair-weather" conditions but not when banks were under pressure. 

"In my experience ring-fencing is not terribly effective," said Mr Volcker. "It only works in fair-weather. But doesn't work in foul weather. They have already run into problems and they are bound to run into more." ...

Mr Volcker said: "John (Vickers) and I have the same concerns in mind. But the logic would be to separate the two parts of banking, not to keep them within the same institution. I find it puzzling to suggest that within one organisation you can have a branch that is entirely independent of another subsidiary, with the confidence that never the twain shall meet?" 

Mr Volcker said that it was unclear how the two parts of banking could be entirely independent when under ring fencing they would be subordinated to the holding company. 

"I think they bowed to practicality. But Vickers will now have to define what is allowed in the relationships between the two subsidiaries. 

"Ultimately, there is a natural instinct to have a close relationship within a bank. And this is particularly true when the bank is under pressure. By the time the banks look at Vickers they will think that Volcker looks better."

In the US, the "Volcker Rule" – the precursor to Vickers - advocates an outright ban on all forms of risky investment activity on the bank's own account, such as proprietary trading. 

The rule, part of the Dodd-Frank act is yet to be finalised and has drawn scathing remarks from banking bosses.

Whether you try to split the banks into subsidiaries or try to ban proprietary trading, what ultimately is most effective in reducing the risk of the banks is to require them to provide ultra transparency.

With ultra transparency, market participants can independently assess the risk of each bank and adjust the amount and price of their exposures to each bank to reflect this risk.  Banks with more risk will pay a higher price to attract funds.

Update
Confirmation that publicizing trade position under ultra transparency will reduce if not completely eliminate proprietary trading comes from a Risk magazine article.

Real-time or near-real-time [think before the beginning of the next business day] publication of transaction data, as proposed in a review of the Markets in Financial Instruments Directive, could cause market makers to shy away from less liquid trades and shrink trade size of over-the-counter derivatives. The motivation would be to avoid revealing trading positions. 

Gold-plating bank regulation to mislead public about doing something

The Telegraph carried a column on UK policymakers gold-plating bank regulation by adding on extra regulation in an effort to appease an angry public.

Regular readers know that your humble blogger thinks that 80+% of the banking regulations passed since the beginning of the solvency crisis in 2007 are essentially worthless because they do not do anything that would have prevented the current crisis.

These regulations look even worse when they are compared to requiring banks to provide ultra transparency.  Most of the regulations try to solve in a one-off manner something that ultra transparency addresses directly.

For example, we have the Basel III capital requirements.  This blog has extensively documented how bank capital ratios are meaningless, especially when regulatory forbearance results in overstating both the assets and the equity amounts.

Even if the the financial statements were not distorted, the Bank of England's Andy Haldane suggests that calculating Basel III capital ratios might take upwards of 6 million calculations.  Many of these calculations rely on assumptions provided by the bank.  It is safe to say that banks will not make assumptions that would be unfavorable for their capital ratios.

Requiring ultra transparency allows market participants to apply their own assumptions and calculate bank capital ratios however they would like.  More importantly, it allows market participants to assess the risk of the bank and adjust both the amount and price of their exposure based on this assessment.

Market discipline will drive banks to reduce their risk relative to their capital.  Banks with high risk and low capital will pay a premium to attract funds.  Banks with low risk and high capital will be able to access funds at a much lower cost.

Even when the regulation could have had a positive impact, like the Volcker Rule, it is mind-numbingly complex and so full of loopholes as to effectively neuter the regulation.  The lesson from MF Global is that there are a whole lot of ways to take a proprietary trading position using repurchase agreements.  An area completely untouched by the Volcker Rule.

Instead of the Volcker Rule, ultra transparency requires banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  This exposes the proprietary trading in the repurchase agreements.  More importantly, it exposes this trading to all market participants so that they can use it to adjust the amount and price of their exposures accordingly -- market discipline works to limit the proprietary trading.

The proposed Volcker Rule takes upwards of 300 pages of regulations.  The regulation for ultra transparency can be done in 3 pages or less.

Finally, all these regulations these regulations, including those proposed by the Independent Commission on Banking to ring-fence retail and investment banking, are expensive for the banks to comply with.  The cost estimate for ring-fencing alone runs 7 billion pounds a year.

By comparison, ultra transparency is very, very low cost as it can be done globally for every bank for less than the annual cost of the UK's ring-fencing alone.

Unlike all the proposed regulations, ultra transparency is simple, inexpensive and very effective.  What is there for market participants other than banks not to like?

At 3.30pm on Monday, the Chancellor will rise to his feet in the House of Commons and deliver in comprehensive detail the Government’s response to Sir John Vickers’ Independent Commission on Banking. 

The document that will be published at the same time will be 80 pages long and will go through each recommendation the ICB made on constructing a safer British banking system. It will include a timetable for implementation and pledge that all primary and secondary legislation will be passed before the end of this Parliament – that is, 2015....

The main course tomorrow will, of course, be the Government’s thoughts on the major structural changes the ICB proposed for the UK’s banking sector. This brings us to the knotty problem of the ring-fence, Sir John’s halfway house solution to the structural separation of retail banking and investment banking. 

Under the ICB’s plan, retail operations would be protected behind a “fence” and would have a separate funding structure including equity capital of at least 10pc of risk-weighted assets. There would also be limits on leverage and separate boards.... 

Other special measures unique to the UK include higher levels of loss-absorbing capital (bail-in bonds) than presently proposed by the international Basel III requirements. 

It is such “super-equivalence” – the idea that Britain needs extra protection not contemplated anywhere else in the world – where Mr Osborne’s argument comes unstuck. 

When the Chancellor first launched the ICB process with a view to finally settling the matter of banking reform, it appeared that the UK was bouncing back from recession. Gloom has since descended. 

The Government will admit that the ICB’s structural reforms will increase costs for banks – some argue by as much as £10bn a year though the Government estimate will be nearer £7bn....

There is also the issue of regulatory overload. As the old saying goes, when a regulator sees light at the end of the tunnel, its response is to build more tunnel. 

An opportunity has been missed here ...

As the Financial Services Authority’s report on RBS revealed last week, the authorities could have halted the disastrous acquisition of ABN Amro, but chose not to. 

Suggesting very strongly that financial stability requires an end to reliance on the regulatory system performing its job.  It is only with ultra transparency that this can be achieved.

Regardless of whether there is regulatory oversight or not, market discipline will still be present with ultra transparency.

The ICB was not tasked with looking at broader failures in the financial services sector. It should have been.

They would have undoubtedly found that the financial system failed everywhere there was opacity - structured finance, banks - and nowhere there was transparency - stocks, corporate bonds.

Coincidently, the Lords and Commons joint committee inquiry into macro-prudential regulation will also be published tomorrow. It will raise serious concerns about putting the Governor of the Bank of England in overall charge of the financial regulatory system. The Bank has published nothing about its role in the financial crisis. Transparency is not its strong suit. 

Which is why the Government has to require ultra transparency.

There are certainly problems in the financial services sector, more to do with failures of governance and action rather than failure of the actual regulatory rules. The Government should have been brave enough to say so and put the ICB to rest. That it hasn’t is more to do with politics and pandering to the gallery than the proper functioning of the City.

Actually, the proper function of the City requires the Government to adopt ultra transparency and make it a requirement for any financial institutions doing business in the UK.

George Osborne rejects "financial stability of graveyard"

According to a Telegraph article, George Osborne rejected the idea that bank reform can't wait.

Specifically, he reject Financial Policy Committee member Robert Jenkins suggestion that the Vicker's Commission proposals should be implemented in 24 months.

Mr. Osborne instead said that it would be a mistake to include these proposals in pending legislation.  Instead, it should go into its own legislation....[where the bank lobbyists will have a chance to dilute the proposals].

One of the reasons that I have recommended requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure detail is that it is a very simple requirement.

If the UK adopted this requirement, it would also set the gold standard for bank disclosure.

Investors, given their choice between a bank offering utter transparency or a bank that hides its balance sheet exposures in a black box, will reward the bank with utter transparency with both more access to funds and a lower cost to those funds.

Yes the banks will push back against utter transparency, that is the role of Wall Street's Opacity Protection Team after all.

However, everyone can understand that the sunlight of disclosure is the best disinfectant of the financial system and what is needed for assessing the risk of each bank.

It is also possible for each bank to comply with the disclosure requirement in 24 months.

Now why are we trying for something more difficult that is not necessarily as effective as disclosure?

George Osborne has rejected calls for tighter bank legislation to be introduced more quickly by warning that Britain does "not want the financial stability of a graveyard."...

The Chancellor confirmed that the radical banking reforms recommended by the Independent Commission on Banking (ICB) would not be included in the Finance Bill. He said it would "be a mistake" to try to "shoe-horn" the rules on ring-fencing retails banks from investment banks into the Bill. Instead he pledged that the Government would publish "by mid-December" details of how the ring-fence will work. Then the reforms would be brought forward in separate legislation. 

Mr Osborne insisted he was "committed to Vickers" despite the long timetable and that legislation would be drafted "this Parliament". He said the reforms would be "good" for banks, the City and the UK. 

The 2019 deadline was a "backstop" for the reforms and that some "features" would be implemented sooner, he said. 

Bank reform can't wait

In a column in the Guardian, Robert Jenkins, a member of the BoE's Financial Policy Committee, flatly states that bank reform can't wait.

Absolutely true.

He then goes on to urge the implementation of the Vicker's Commission proposals.

This just goes to show that once again the banking industry can count on economists and regulators to get in the way of bankers adopting the only reform that matters - ongoing disclosure of their current asset, liability and off-balance sheet exposure details.

Let us imagine that banks fully comply with the Commission's proposals over the next 24 months.

Will banks be any closer to telling which of their competitors are solvent and which are insolvent?

Where does the excess leverage and bad debt that currently exists in the financial system go under Vickers?  This includes sovereign debt, consumer debt (including mortgages), commercial real estate debt and those toxic subprime securities.

Given the massive amount of regulatory forbearance that has occurred to date, is there any reason to believe that all the losses will be recognized over the next 24 months?

If these losses are not recognized, how can market participants tell if the "bank" inside the ring-fence is solvent or not?

In his Independent Commission on Banking report, John Vickers produced a good plan. It should be implemented within 24 months. Such a timetable will shock several bankers ... Why wait? 

The coalition moved quickly to create the commission and Vickers began its work in mid-2010. The objectives were formidable. These included: reduce systemic risk; mitigate moral hazard; reduce the likelihood and impact of bank failure; shrink subsidies to investment banks; and increase competition in retail banking.... 

All of which would be better achieved by simply requiring current disclosure of each bank's asset, liability and off-balance sheet exposure details.

With this disclosure, market discipline, which has been blocked by the regulators' information monopoly for the last 80 years would be reintroduced to the banking industry.

Systemic risk would be reduced as each bank adjusts the amount and price of its exposure to other banks to reflect these banks' riskiness and the chance of loss.

Moral hazard would be mitigated because each bank would know that the government is not going to bailout any of the banks and that they are responsible for the losses on their exposures.

The likelihood of bank failure would be reduced as an increase in a bank's cost of funds as it adds risks acts as a disincentive to add risk.  In fact, market discipline would push banks to reduce their risk profile as high returns with low risk is what the market will pay a premium for.

The parts of investment banking focused on proprietary trading and not market making would be reduced as everyone could see the bank's positions and potentially trade against or front run the purchase or sale of this position.

The Vickers proposal, published in September, goes a long way towards meeting these challenges. It places the interests of depositors ahead of equity and bondholders. It largely "ringfences" retail and small business banking from investment banking. And it calls for the ringfenced entity to be better capitalised than currently required. In short, it seeks to make safer that part of banking critical to households and businesses....

Really?  How can a market participant know if the part of banking critical to households and businesses is safer if they cannot tell if it is solvent or not?

There are only two possible justifications for delay. The first is the risk of adversely affecting the supply and cost of credit to an important sector of the economy at a time of financial fragility. The commission's analysis suggests it will not. A separate report by accountants Ernst & Young concurs.

Oops...Lord Turner, head of the Financial Services Administration has recently come out and said that requiring banks to reach a 9% Tier I capital ratio is adversely affecting the supply of credit and there is nothing that regulators can do about it (see here).

The second reason is that banks would be unable to execute the reorganisation within the foreseeable future. This is absurd....

This is not to say implementation will be easy. There will be contracts to rewrite, legal vehicles to establish, and boards to recruit. Most of all, there will be choices to be made between what activities go where. Such choices will require thought – but no more or less than that which goes into any number of routine strategic reviews. And yes, there will be many unanticipated problems – there always are. But the sooner we start the sooner we will resolve them....

Why would you want to jump through all of these implementation difficulties when simply requiring on-going detailed current disclosure gets the same benefits without the headaches?

Why are we timid when it comes to financial reform? Is it that we are intimidated by those for whom the reforms are destined? 

Given that the Vicker's Commission did not adopt requiring banks to make ongoing detailed current disclosure, the evidence is clear for either cognitive capture by Wall Street's Opacity Protection Team or both timidity and intimidation.

Remember, FDR publicly invited the wrath of the bankers as opposed to deferring to the bankers when it came to disclosure.

There is one major danger in implementing Vickers quickly: that having taken this bold step we will be lulled into thinking the regulatory job is over. It will not be. Over-leveraged banks operating outside the ringfence will still threaten financial stability. But knowing this should not deter us from solving those problems we can fix now... 

Unlike the implementing Vickers, implementing detailed current disclosure also addresses the over-leveraged banks operating outside the ringfence that could threaten financial stability.

Which raises the question of why would you risk being lulled into thinking the regulatory job is over by implementing Vickers?