Paul Krugman explains how academics from well-known universities effect policy response to financial crisis

In his NY Times blog, Professor Paul Krugman does a great job of explaining how academics from well-known universities have influenced the debate on how to end our current bank solvency led financial crisis.

Regular readers know that your humble blogger thinks their biggest contribution is to crowd out discussion of alternatives to end the financial crisis.

Professor Krugman explains how this crowding out mechanism works with Reinhart/Rogoff and austerity.

But before looking at his post, I would like readers to ask themselves one question: why were these or any academics listened to in the first place?

There are two reasons:

1. The reputation of the institution that they work at; and
2. The idea that a professor at one of these institutions in finance or economics would actually have some idea what they are talking about.

Between Reinhart/Rogoff's error filled paper supporting austerity and the finance and economics professions' failure to loudly warn let alone predict the financial crisis, it is clear that the idea finance or economics professors know what they are talking about isn't true.

Reinhart/Rogoff's paper confirmed that when it comes to peer reviewed papers in finance and economics there effectively is no minimum hurdle or standard they have to get over to get published.  So any fundamentally flawed idea can be published.

Regular readers first encountered this with Yale Professor Gary Gorton using bank demand deposits as an example to illustrate his concept of informationally insensitive debt (hint: deposit insurance is information as any 6-year old opening a bank account can tell you).

Reinhart/Rogoff's paper also confirmed Cullen Roche's observation that every single school of economics exists to promote a political agenda.  In this case, the authors were well paid shills for the austerity agenda.

One other point before I return to Professor Krugman's blog.  The reputation of the institutions acts to magnify the importance of what these professors say.  Do you think the austerity agenda would frequently cite the work of a junior college professor or a random blogger?

No!  Policymakers who are predisposed to these fundamentally flawed ideas want to wrap themselves in the mantle of the institution's reputation.  If a Harvard professor says its so, well then....

Let me return to Professor Krugman's blog, but let me show how the call for banks to hold more capital is simply a repeat of the call for austerity as it is based on a similarly ill-conceived idea.  

Robert Samuelson tries to minimize the significance of the Reinhart-Rogoff affair; and that, I realized, offers an interesting window into why, in fact, the affair matters so much. 

Samuelson starts by excusing R-R on the grounds that the economic crisis predates their blooper... 

But while R-R obviously had nothing to do with the start of the crisis, the question is how they played into the response. For the remarkable thing about this ongoing slump isn’t so much that we had a financial crisis as the fact that we responded to it, not by applying what macroeconomists thought they had learned, but by repeating all the policy errors of the 1930s....

The same argument could be made about bank capital.

Everyone knows that bank capital is an easily manipulated accounting construct.

Banks can manipulate it by how they reserve for bad debt.  Regulators can manipulate it through regulatory forbearance and allowing banks to use 'extend and pretend' to turn bad debt into zombie loans.  Politicians can manipulate it by pressuring accountants to suspend mark-to-market accounting for opaque, toxic structured finance securities.

Everyone knows that more capital does not mean a bank is safer.

What makes a bank more or less risky is the risk of its on and off balance sheet exposures.

Everyone knows that more capital does not mean a bank is solvent.

Since the beginning of the financial crisis, there have been numerous banks that have shown high capital ratios and been nationalized shortly after passing a solvency focused regulatory stress test.  A prime example of this being Dexia.

Finally, everyone knows that calling for more capital when the banks are hiding massive losses is counter-productive.  The banks need to recognize their losses upfront and then rebuild their book capital.  Recognizing losses first means that banks don't pay the bankers cash bonuses until the bank book capital levels are rebuilt.

By putting increasing book capital ahead of recognizing losses, not only do bankers get paid their cash bonuses, but increasing book capital levels takes precedent over recognizing losses on the bad debt.  The result of this is to repeat Japan's experience and end up with Japan-style economic malaise.

Still, R-R can’t have mattered here, says Samuelson, because politicians were going to do what they were going to do regardless....

Maybe politicians are going to do what they are going to do regardless, however, academics promoting fundamentally flawed ideas are giving them intellectual cover.

For example, let's look at who is championing the idea that banks need to hold more capital.  At the head of the cue we find former and current regulators.  Individuals who had a responsibility for acting before the financial crisis, but failed to take the steps necessary to prevent the financial crisis.

Standard academic obscurity? Reinhart-Rogoff instantly became famous. Reinhart gave star testimony to the Senate Budget Committee on Feb. 9, 2010; the paper was cited everywhere in the spring of 2010.

Sounds a lot like a book written on the need for banks to hold more capital.

OK, so what is the real story here? Austerity policies would probably have proceeded without Reinhart-Rogoff ... But the paper certainly helped sell the policies. 

And anyway, the important story isn’t about the sins of the economists; it’s about our warped economic discourse, in which important people seize on academic work that fits their preconceptions.

Please re-read the highlighted text as Professor Krugman makes an extremely important point about how these professors are warping the economic discourse.  I call this crowding out.

Had these professors not offered their fundamentally flawed ideas, the discussion could have focused on solutions that would have ended our current financial crisis (the Swedish Model) and prevented a future crisis (transparency).

Even if you don’t think Reinhart-Rogoff made much difference to actual policy, the meteoric rise and catastrophic fall of their reputation speaks volumes about why this slump goes on and on.

The slump goes on and on because the academic community continues to provide intellectual cover to policy makers' worse instincts. 

NRA demonstrates that capture of lobbying organizations by manufacturers not limited to just Wall Street's sell-side

In his Sports Illustrated column, Peter King showed that the capture of lobbying organizations like the American Securitization Forum which claims to represent all participants in the structured finance market is not limited to just Wall Street's sell-side.

Read this by Augustus Busch IV, the Anheuser-Busch heir and, for years, one of the biggest National Rifle Association advocates. 

He resigned his "lifetime'' membership in the NRA last week in the wake of the Senatorial inaction, and he wrote this in his resignation letter, among other things, that the NRA was going against the will of its members by hand-grenading the background-check issue. 

He also wrote in his letter renouncing his NRA membership: "I am simply unable to comprehend how assault weapons and large capacity magazines have a role in your vision. 

The NRA I see today has undermined the values upon which it was established. 

Your current strategic focus clearly places priority on the needs of gun and ammunition manufacturers while disregarding the opinions of your four million individual members ... One only has to look at the makeup of the 75-member board of directors, dominated by manufacturing interests, to confirm my point. 

The NRA appears to have evolved into the lobby for gun and ammunition manufacturers rather than gun owners."

John Kay explains why next Keynes is unlikely to have a PhD in economics

In an interview in the Actuary, Professor John Kay explains why the next Keynes is unlikely to have a PhD in economics.

Kay is not the only critic of mainstream economists, and it would seem patently obvious that economics has failed as a predictive and explanatory tool. 

After all, it failed to predict our current financial crisis and it has failed to provide a policy solution that actually works.

Was the profession changing? 

Could there be an Einstein moment approaching, where the mainstream realises that the cranks were right? 

No, says Kay. Unlike subjects such as physics, you cannot definitively prove economics wrong. “The rewards structure of the economics profession is basically a common value system,” he says. 

Small marginal improvements are rewarded, critics are considered cranks and ignored.

In short, even though the economics profession has been thoroughly debunked, it is incapable of making the changes necessary to become relevant again.

INET: the state of economics

The Institute of New Economic Thinking has a wonderful summary of the current state of the economics profession:

Theory is when you know everything & nothing works.

Practice is when everything works & no one knows why.

In our lab, theory and practiced are combined:  nothing works & no one knows why.

However, outside of the economics profession's lab, there are people who know why nothing is working when it comes to the response to the bank solvency led financial crisis.

The question is:  will the economics profession show the necessary humility and listen to what these people are saying?

Doubtful given a) the economics profession's failure to predict the financial crisis and b) the economics profession's unwillingness to admit the failure of all their recommendations to address the financial crisis and its fallout.

 

 

Italian bank derivative scandal shows that transparency and discretion in bank supervision cannot co-exist

As reported by the Wall Street Journal, the lesson from the Monte Paschi derivative scandal is that transparency and discretion in bank supervision cannot co-exist and therefore, discretion must be ended.

This is an incredibly important point.

The choice we have is between a stable financial system based on transparency and market discipline or an unstable financial system based on opacity, complex rules and regulatory oversight.

In the stable financial system, investors are responsible for the losses on their investments and hence they have an incentive to use the information disclosed to independently assess the risk of each bank.  Specifically, investors link the amount of their exposure and the return they require on this exposure to each bank's risk.

This results in market discipline as banks with higher risk have to pay more to attract funds.  This also results in ending financial contagion as investors limit their risk to what they can afford to lose.

In an unstable financial system, investors are not responsible for the losses on their bank investments as they have to rely on bank supervision for the assessment and disclosure of risk at each bank.  Bank supervision that is concerned with the safety and soundness of the banking system and therefore exercises discretion in its disclosures about the riskiness of the banks.

This results in banks not being subject to market discipline as the price they are able to access funds at is substantially less than what it would be if investors had transparency and could assess the risk for themselves.

This also results in financial contagion as investors, including other banks, have far greater exposure to each other than they can afford to lose.

Finally, this results in moral hazard and the need to bailout the investors who relied on the bank supervisors' disclosure of the risk of each bank.

Your humble blogger thinks that a stable financial system is preferable.  Achieving this requires having the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

I recognize that this will end the bank supervisors' information monopoly and will limit their ability to exercise discretion.  This is a feature and not a bug in a stable financial system.

There is no reason that bank supervisors should be able to exercise wide discretion.

As I have previously said, bank supervisors don't approve or disapprove of any exposure that a bank takes on.  Bank supervisors don't do this because they do not see it as their job to allocate capital across the economy.

Bank supervisors attempt to focus on one question:  does the bank have enough book capital to absorb the expected losses on its exposures.  Bank supervisors focus on this question because they are attempting to protect the taxpayers by limiting losses that the taxpayers might have to cover because of the deposit guarantee.

The irony here of course is that if banks are required to provide ultra transparency, the bank supervisors could harness the market's analytical power to assess the banks and market discipline to restrain the banks' risk taking.  Both of these would lower the risk to taxpayers of losses on deposit insurance.

Ultimately, the real issue bank supervisors would like discretion on is when to resolve a bank.

Bank supervisors would like this discretion because a bank can be insolvent (the market value of its assets is less than the book value of its liabilities) at one moment in time and can subsequently earn its way back to solvency (the market value of its assets exceeds the book value of its liabilities).

However, this discretion over when to resolve a bank is not needed in a stable financial system.

Requiring banks to provide ultra transparency is not incompatible with letting a bank continue operating and earn its way back to solvency.  In fact, ultra transparency helps in this situation by eliminating the possibility that bank management will 'gamble on redemption'.  An insolvent bank that takes on more risk would see its cost of funding rise substantially.

In a financial system with deposit guarantees and banks providing ultra transparency, the only banks that need to be resolved are the banks that cannot generate pre-banker bonus earnings.  All the rest of the banks should they be temporarily insolvent have the ability to earn their way back to solvency.

The recent trouble at Banca Monte dei Paschi di Siena ... highlights potential vulnerabilities in plans for a new single European bank supervisor. 

The Tuscan lender, which bills itself as the world's oldest bank, used complex derivatives to tweak its balance sheet that have now triggered massive losses contributing to a €3.9 billion ($5.23 billion) black hole to be filled by taxpayers. Many of these derivative schemes are now the subject of judicial probes.

It wasn't the use of derivatives to tweak its balance sheet that was the problem, but rather that it hid the derivatives so that market participants did not know about them.  As a result, the bank's financial statements did not present a true picture of the bank's condition.

The Bank of Italy admitted its supervisors were aware of the schemes, fueling demands for a wider investigation. 

The Bank of Italy is under pressure because it exercised its discretion and it too did not disclose the existence of these derivatives.

So here is a bank supervisor with concerns about safety and soundness of the banking system supporting the mis-representation of the true level of risk at the bank.

In reality, the BOI's freedom for maneuver was limited. One problem was that the derivative deals did not violate accounting rules. 

While international accounting standards require that a seller of credit default swaps mark their position to market, that's not the case for "structured repos"—an innovative transaction that achieves the same effect—for which historical costs can be used. 

Monte dei Paschi took advantage of this loophole to issue structured repos, thereby spreading out accrued losses over a longer period even though the bank remained fully exposed to fluctuating liquidity risks. 

Thanks to this ruse, the bank posted a profit in 2009, enabling it to pay a dividend—which it had secretly promised to creditors that had subscribed to preferred shares used to bolster the capital base. 

Although the BOI was critical of the structured repos, it was hamstrung because no rule was broken.... 

The fact that the derivatives deals did not violate accounting rules does not mean that the Bank of Italy could have have publicly questioned the quality of Monte Paschi's earnings and mentioned the use of these structured repos in achieving these earnings.

But the way in which [the BOI] has handled the affair has led to allegations of subterfuge that have pulled in Mr. Draghi, now president of the European Central Bank. 

Those charges may be wide of the mark, but the political fuss is a timely reminder that bank supervision is a highly charged activity requiring delicate judgments to balance competing interests. 

One of the benefits of requiring banks to provide ultra transparency is that it eliminates the need for bank supervisors to balance competing interests.

With ultra transparency, bank supervisors can concentrate on protecting the taxpayers.

Mr. Draghi will be fully aware just how much more politically sensitive banking regulation will become when conducted cross-border by the ECB as part of the euro zone's proposed banking union. 

Indeed, the discretion required for bank supervision sits uncomfortably with the transparency the ECB deploys in the conduct of monetary policy where clear communication is essential to the management of expectations. 

By requiring banks to provide ultra transparency, we end bank supervision discretion.  As a result, the ECB can continue to provide clear communication about its conduct of monetary policy.

Davos: the attempt to market the idea that the financial crisis is over

The pompoms are out and the Davos cheerleaders can be heard chanting:  the financial crisis is over, the financial crisis is over.  There is just one small problem.  The financial crisis isn't over.

If the financial crisis were over, why is the UK economy performing worse than it did during the Great Depression?

If the financial crisis were over, why is youth unemployment in Greece and Spain in excess of 50% and climbing?

If the financial crisis were over, why are central banks around the world pursuing zero interest rate policies and pushing liquidity into the financial system through quantitative easing?

If the financial crisis were over, why are central banks buying up the low risk assets in an attempt to force investors to buy riskier securities?

If the financial crisis were over, why haven't the financial regulators required the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposures so that market participants could see they have purge their dud exposures and are keeping their risk down?

If the financial crisis were over, why is Japan, which followed the same policies after its financial crisis, still in an economic slump 2+ decades later and threatening to start a currency war in an attempt to get its economy moving?

If the financial crisis were over, why is there any talk about cutting back on government social programs to reduce the debt as between the natural shrinkage in the economic stabilizer programs and increased tax revenue more should be generated in revenue than is being spent?

Unfortunately, the financial crisis is not over and because of the policies that are currently being pursued there is no end in sight for the financial crisis ever to be over (see Japan's 2+ decades of dealing with its financial crisis).

I know that the 1% that went to Davos would like the financial crisis to be over because there is likely to be a backlash against them and their policies when it becomes apparent that the financial crisis isn't over.  However, that doesn't change the simple facts that the financial crisis hasn't ended.

The chanting the financial crisis is over does effect one group though (from a Bloomberg article):  money managers who are worried about missing a move up in the financial markets.

There is no official declaration, or even a formal survey. But the chatter at the World Economic Forum in Davos, Switzerland, is about the end of the financial crisis that began in 2008 and dragged on through last summer’s spike in Spanish and Italian government bond yields. 

“There’s a crystallization of thought that the financial crisis is over,” says Scott Minerd, managing partner and chief investment officer of Guggenheim Partners, a Santa Monica (Calif.) firm with about $160 billion under management. 

“I was riding around in a van last night with two guys whose names you’d recognize,” Minerd said. “They were comparing notes and hearing the same thing. The conclusion has sort of gone viral. It’s an interesting social-networking phenomenon.” 

It has real-world consequences, too. “When thought leaders leave an event like this, they take the message with them, and it affects the way they behave.” That is, they’ll buy.

Which will give the 1% a chance to unload their shares.

Discussion of Bank of England's authority highlights need for guarding the guardians

It has taken five years since the beginning of the financial crisis, but the conversation has finally turned to the issue of 'who guards the guardians' of the financial system and what sort of authority should they actually be given.

As reported by the Guardian, former Monetary Policy Committee member Kate Parker observed

Treasury plans to hand the Bank of England extra powers to oversee the banking system will give unelected officials too much power... the steady erosion of democratic control over regulation of the financial system would accelerate under proposals by the coalition government to create a super-watchdog in Threadneedle Street.

She said oversight should be the job of the Treasury, based on advice from the Bank of England and other bodies involved in banking regulation. 

Echoing fears among many MPs that Bank of England governor Sir Mervyn King and his successors will control an unwieldy empire of regulatory committees that could challenge the Treasury's democratic mandate, Barker criticised government plans to create a financial policy committee (FPC) alongside the Bank's monetary policy committee (MPC), which sets interest rates. 

"More policy decisions should be left in the hands of the chancellor, rather than unelected officials at the Bank of England. Mervyn King's successor will be appointed to an unduly powerful role for an unprecedented eight-year term," she said. 

The FPC differs from the work previously carried out at the Financial Services Authority because it aims to "assess and steer the financial system as a whole, rather than focusing on individual organisations, which will now become the responsibility of the Prudential Regulatory Authority", she says. For example, FPC members will have the power to restrict mortgage lending if there are concerns about a possible credit bubble, as there was before the 2007 banking crisis. 

Barker criticises the Treasury for delegating unpopular decisions to the FPC that should be made by parliament.

This discussion of the authority of the Bank of England is not restricted to the UK.  It also applies in the EU where the ECB is seeking to gain bank supervision responsibility and the US where the Fed is responsible for bank supervision and also sits on the Financial Stability Oversight Council.

In his Telegraph column, Damian Reece seconds Kate Parker's conclusion.

Legislation is passing through Westminster that will usher in a new Bank Governor with too much power and not enough accountability. 

Sir Mervyn King, and his successor, may be called Governor but their job is not to govern. 

Barker’s report should prove useful to MPs trying to reverse some of the Chancellor’s plans which will delegate yet more authority to the Bank – authority which should stay within the remit of politicians. 

The problem is acute when it comes to macro-prudential regulation – basically controlling the economy’s safety valve to stop it overheating. It’s proposed this is done by yet another Bank of England committee – the Financial Policy Committee, which is every policy wonk’s fantasy come true....

In the US, macro-prudential regulations is the responsibility of the Fed and the Financial Stability Oversight Council.

The Financial Stability Oversight Council in not just every policy wonk's fantasy come true, but is also every Wall Street CEO's fantasy come true.  The Council is run by the US Treasury Secretary.

As thoroughly documented by Neil Barofsky in his book, Bailout, the US Treasury is an advocate for Wall Street's and not Main Street's interests.  As a result, through its control of the Financial Stability Oversight Council, Treasury is now able to push Wall Street's interests onto the very organizations that are suppose to be regulating Wall Street.

Outside of Washington DC, it is common sense that the Financial Stability Oversight Council is unfit for purpose of protecting the real economy.

Far from giving the Bank more power to run our economy, we should be insisting on No 11 taking that responsibility. The resident of that address is accountable to Parliament and removable every five years, rather than a Governor who changes every eight years and then by an opaque selection process.

Mr. Reece did not learn a key lesson from the Nyberg Report on the Irish banking crisis.  The key lesson is that elected officials have an incentive to not lean against the wind.  When the real estate bubble was growing, it generated lots of tax revenue that the elected officials could use on their favorite programs.  No elected official would want to cut the growth in tax revenue when there is no apparent danger.

On the other hand, Mr. Reece does understand that there is a problem anytime that there is opacity involved.

Opacity in selection process for the next Governor of the Bank of England means it is highly unlikely that this individual will have to document that they predicted the current financial crisis.  Without having predicted this crisis, it is highly unlikely this individual could predict a future crisis or develop policies that will get us out of the current crisis.

The solution to guarding the guardians is to bring transparency to all the opaque corners of the financial system.

If banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants can independently assess the risk of the banks and adjust the amount and price of their exposure accordingly.

The ability to independently assess what is going on means that market participants can exert discipline on both the banks and their regulators.

It also means that the collective result of having each market participant limiting their investments to what they can afford to lose is stability in the financial system.

Parliament Libor Report: Both Banks and Regulators need to change

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

How dumb is that?

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

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

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

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

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

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

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

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

Justice Department finds 'no viable basis' to prosecute Goldman for its activities involving sub-prime RMBS

CNN reports that despite a Senate inquiry recommending legal action against Goldman for its sub-prime RMBS activities, the Justice Department has decided to take no action.

The Justice Department says after a "careful review" it has determined there is no basis for bringing a criminal prosecution against Goldman Sachs or its employees in regard to allegations set forth in a congressional report.

This is not a surprising conclusion as the Justice Department has consistently managed to minimize the number of individuals or companies prosecuted in connection with the financial crisis.

In an unsigned statement from the Justice Department issued Thursday night, it said the department conducted an exhaustive review for more than a year examining allegations in the Levine-Coburn Report. 

Headed by Sen. Carl Levin, D-Michigan, and Sen. Tom Coburn, R-Oklahoma, the 635-page report in 2011 singled out Goldman and Deutsche Bank as examples of Wall Street firms that reaped huge profits by marketing securities backed by subprime mortgages as safe investments to clients, even as the banks bet against these very same securities. 

"In my judgment, Goldman clearly misled their clients and they misled Congress," Levin told reporters on a conference call in April 2011. The Senate subcommittee, which spent two years on the investigation, based its report on thousands of internal company documents and e-mails, as well as hundreds of interviews and congressional testimony....

So the firm that paid $550 million for its role in the Abacus deal and sold other deals like Timberwolf walks away...

Goldman Sachs spokesman David Wells said in a statement, "We are pleased that this matter is behind us."

No kidding.

Elizabeth Warren: Libor fraud shows Wall Street's rotten core

In her Washington Post column, Elizabeth Warren looks at the financial system and asks does Wall Street have so many friends in Washington and London that it cannot be fixed.

Everyone knows that all of the problems that have emerged in the financial system over the last few years have come from the opaque, corners of the financial system (structured finance securities, banks and now, Libor).

Opaque areas that exists because as Yves Smith at NakedCapitalism says, 'no one on Wall Street was ever compensated for creating low margin, transparent products'.  Opacity is the key to Wall Street current level of profitability and hence bonuses.

Opacity lets Wall Street engage in bad behavior in pursuit of their bonuses (think Libor manipulation and treating clients who think there is a fiduciary relationships as counter-parties for zero-sum trades).

Regular readers know that your humble blogger refers to Wall Street's friends in Washington and London as Wall Street's Opacity Protection Team. It is not just the banks, but the regulators and policymakers who are complicit in allowing Wall Street to create and maintain large opaque areas in the financial system.


Everyone knows that transparency and hence sunshine is the best disinfectant.  However, sunshine would make it harder for Wall Street to make money as everyone would have access to all the useful, relevant information in an appropriate, timely manner for making a fully informed investment decision.


Ms. Warren's question is really does Wall Street have so many friends in Washington and London that will help it protect the profits it makes from opacity that transparency, trust and integrity cannot be restored in the financial system?

The Libor scandal is more than just the latest financial deception to come to light. It exposes a fraud that runs to the heart of our financial system. 

The London interbank offered rate is a benchmark for a range of interest rates, and the misdeeds making headlines have to do with how those rates are set. If insiders can manipulate the basic measurement of a loan — the interest rate — there is rot at the core of the financial system. 

The British financial giant Barclays has admitted to manipulating the rate from 2005 to at least 2009. When the bank made a bet on the direction in which interest rates would turn, the Barclays employees who submit data for calculating interest rates would fake their numbers to help Barclays traders win the bet. Day after day, year after year, bet after bet, Barclays made money by fixing bets for its own traders.... 

It is also clear that many of those who didn’t have a fixer — including consumers, community banks and credit unions — lost money. 

Barclays padded its bottom line by taking money from everyone else. It won when it shouldn’t have won — and others lost when they shouldn’t have lost. 

The amount of money involved is staggering. On any given day, $800 trillion worth of credit-related transactions are linked to Libor rates. 

In most markets, consumers could simply take their business elsewhere once they learned that the scales were rigged. But interest rates are different. Everyone who borrows money on a mortgage, credit card, student loan, car loan or small-business loan — basically, everyone — is affected by a crooked market on Libor....  

Even those who didn’t borrow but saved for retirement or their children’s future got hit with interest rates that had been faked. 

It gets worse. During the financial crisis, Barclays and other banks also appear to have consistently manipulated Libor to show lower-than-real borrowing rates to convince the world — and their regulators — that the bank was stronger than it really was. In other words, they rigged the interest-rate reports so that no one would know exactly how much trouble they were in. 

With a rotten financial system once again laid bare to the world, the only question remaining is whether Wall Street has so many friends in Washington that meaningful reform is impossible....

Going forward, the rules would be changed so that Libor is calculated on actual borrowing costs, not estimated or claimed costs....

An idea your humble blogger presented to readers as part of requiring banks to provide ultra transparency.  Under ultra transparency, banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This allows Libor to be calculated off of actual trades.

This allows market participants to assess the riskiness of each bank on an ongoing basis and adjust the amount and price of their exposures to each bank based on this assessment.  It is this ability to make ongoing risk assessments that unfreezes the interbank lending market and keeps it from freezing in the future.

But the heart of accountability lies deeper. It rests on acknowledging that we cannot trust Wall Street to regulate itself — not in New York, London or anywhere else. The club is corrupt.

When Mitt Romney says he will move to repeal all of the new financial regulations, he supports a corrupt system. When members of Congress grill regulators for being too tough on Wall Street and slash the budgets of the regulators charged with overseeing Wall Street, they prop up a corrupt system. 

Financial services are critical to the economy. That’s why everyone — every family and every business — has a stake in an honest system. The fantasy that reducing oversight of the biggest banks will make us safer is just that — a dangerous fantasy. The Libor fraud exposes rot at the core. Now, who will stand up to fix it?

Who will stand up for bringing transparency to all the opaque corners of the financial system.

Libor scandal highlights the question: who will guard the guards

As the various regulators make the rounds explaining why their agency was not responsible for the failure to put a stop to the manipulation of the Libor interest rate, a bright light is now being shown on the question of who will oversee the regulators to ensure they perform their function?

Regular readers know that under the FDR Framework, the role of overseeing the regulators falls to the market.

The reason the market can oversee the regulators is because of transparency.  With transparency, market participants have access to all the useful, relevant information in an appropriate, timely manner. This includes,

• For banks, this means the banks are required to disclose on an ongoing basis all of their current global asset, liability and off-balance sheet exposure details.

• For structured finance securities, this means that these deals report on an observable event basis all activity, like a payment or default, that occurs involving the underlying collateral before the beginning of the next business day.

By eliminating opacity from all of the currently opaque corners of the financial system, market participants are in a position to monitor what is happening and see if the regulators are doing what they are suppose to do.

As reported by the Telegraph,

The latest instalment of the Libor fiasco aired today .... it also raised key questions about how the Bank will operate and whether it’s fit for the job. 

Sir Mervyn King and Paul Tucker – the Bank’s Governor and his deputy – and Financial Services Authority chief Lord Turner were the latest heavyweights called before MPs. 

Between them, they contrived to paint a damning picture of financial regulation and oversight. 

The FSA’s inadequacies were laid horribly bare – it failed to spot attempts to rig Libor and has subsequently mishandled the fallout. 

As Lord Turner admitted on Monday evening, the regulator was warned 13 times by Barclays that banks were “low-balling” Libor. Clearly an unlucky number, because the warnings never reached the top of the FSA..... 

Compare that with events in the US when a Barclays employee told a regulator that the bank had been under-reporting Libor. The message was passed to senior managers at the New York Federal Reserve and subsequently found its way on to the desk of Tim Geithner, then heading the organisation.....

Where it effectively died as he wrote a cover his backside email to the Bank of England without informing it what the Barclays employee had said.

The conclusion to all of this must be clear – even to the FSA. The Libor story has laid bare the need for better supervision of the Bank when it takes on the regulator’s remit next year.  

The same holds true of the Fed. 

Libor manipulation undermines the whole premise of Dodd-Frank that regulators will use their expanded powers to protect the system

The number one casualty from the Libor interest rate manipulation scandal is the whole premise underlying Dodd-Frank and the Vickers Recommendations that financial regulators will use their expanded powers to protect the financial system.


What we saw with the manipulation of the Libor interest rates are regulators who didn't use their current powers and sat by and watched the banks engage in conduct that was detrimental to the financial system.


Their excuse was they were willing to overlook criminal conduct out of concern that exposing this conduct would make the financial crisis worse.

Of course, this defense does not address the question of why the financial regulators did not bring up the manipulation of Libor interest rates prior to the debate over the Dodd-Frank Act or to the UK's Independent Commission on Banking.


It would appear that the financial regulators were covering up for the banks and by doing so dramatically effected how the Dodd-Frank legislation or the Independent Commission on Banking recommendations reshape the financial system.


After all, look what happened after Barclays confessed to manipulating Libor.


The Financial Times' Martin Wolf showed how the recommendations for reshaping the financial system would have been changed had the Libor interest rate manipulation been disclosed.  To the list of reforms championed by the Vickers Commission, he added transparency.


Transparency is needed not only to prevent bad behavior by bankers, but to ensure good behavior on the part of regulators too.

Guardian's Heather Stewart calls for 'proper banking inquiry'

In her Guardian column, Heather Stewart calls for a 'proper banking inquiry', think Pecora Commission, based on the simple fact that the extraordinary hold banks have gained over politicians makes them incapable.

Regular readers know that since the beginning of the financial crisis, there has not been a true, properly funded inquiry into the financial system in either the US or UK.

As a result, without a true understanding of what gave rise to the financial crisis, we have had policymakers and financial regulators covering their backside by proposing all sorts of new regulations approved of by the banking industry that have not addressed the underlying problem.

Your humble blogger has been saying since the beginning of the financial crisis that it is a crisis caused by opacity and the solution is transparency.  Transparency that provides market participants with all the useful, relevant information in an appropriate, timely manner so they can make a fully informed investment decision.

Supporting evidence for this diagnosis is abundant.  Examples include, but are not limited to,  opaque, toxic structured finance securities, JP Morgan's credit default swap trade, and now the manipulation of Libor.

Should the UK engage in a 'proper banking inquiry', just like the Pecora Commission in the 1930s, it will find that opacity is the underlying problem and call for the sunshine of transparency, rather than a mountain of new regulations, to act as the best disinfectant of the financial system.

The Treasury select committee's ineffectual clash with the former Barclays boss shows just why MPs might not be best placed to investigate the financial sector. 

Watching Wednesday's gruelling (for viewers) three-hour Treasury select committee hearing, .... We certainly learned more about the state of parliamentary democracy in 21st-century Britain than the inner workings of Barclays. 

For one thing, the links between the mighty financial sector and the men and women who are meant to represent the public are deep and complex.....

The inescapable conclusion to draw .... that a Commons inquiry, even one chaired by the independent-minded Andrew Tyrie, would be too weak, and too hamstrung by private interests and political point-scoring to succeed. 

The extraordinary hold Britain's banking sector has gained over Westminster and the reins of economic power over the past 25 years is a story that transcends political parties and extends before and beyond the financial crisis of 2008-9. 

For Thatcher's Tories, unleashing the City in the Big Bang reforms of 1986 meant building a more go-getting, entrepreneurial economy where capital would flow freely and "wealth creators" could flex their muscles. 

For Labour, which consciously wooed the money men to win their confidence in the early 1990s, a strong City meant bumper tax revenues to be spent on the health service, schools and infrastructure. Both parties enjoyed the swagger that came with attracting some of the world's best-known financial firms – Goldman Sachs, Lehman Brothers, UBS – to the heart of the City and the gleaming towers of Canary Wharf. 

Yet not only did those freewheeling financial capitalists not bring the new, shiny economy and the permanent prop for the public finances the politicians hoped for, they also skewed and corrupted business and society in their image.....

And it wasn't just their double-shot lattes and graph-paper shirts the American bankers brought with them. A big bucks, heads-I-win-tails-you-lose bonus culture, which took root on trading floors in the 1980s (seeLiar's Poker) and was given a sheen of respectability by business school neologisms such as "incentivisation", led to a pay explosion as profits soared. 

Once bankers were raking it in, other bosses who had once held their own with the City boys wanted to get in on the act, and the age of remuneration consultants, "golden parachute" rewards for failure and seven-figure bonuses had well and truly arrived across corporate Britain. 

But out in the real world, meanwhile, little of the money being churned around London's financial markets found its way into productive investments to build up the capacity of the economy for the long term. 

Some went to fuel an unsustainable property boom, convincing hundreds of thousands of people they could be buy-to-let millionaires; but much of it was just lent back and forth between a handful of giant financial players placing ever riskier bets. 

And those tax revenues that were so useful for Gordon Brown in the age of "prudence" and "stability" went up in smoke when taxpayers were forced to spend tens of billions of pounds bailing out the financiers, who were anything but grateful, let alone humble. 

The public deserves a thoroughgoing, independent inquiry into the culture, structure and economic impact of banking, because they know that politicians of all stripes – just like the rest of us – have been taken for a ride.

"Neither Left, Right nor centre has good ideas" for fixing economy, but this blog does

In his Telegraph column, Charles Moore looks at the George Osborne scoring political points and asks why can't we get someone who will fix what is wrong with the economy.  Mr. Moore's points apply equally well in the EU and US.

We have had a credit crunch for nearly five years. We have endured scandal after scandal in British banking. We are in a double-dip recession. We are threatened by the calamity of the eurozone. We have rising unemployment, punitive taxes and a crisis of confidence. Our Chancellor of the Exchequer seems to think that the best answer to all this is to attack Ed Balls.... 

In the US, we can see this in Democrats and Republicans focusing on scoring political points.

If there is one thing obvious about the whole history of the credit crunch, it is that almost everyone important got it wrong, in almost every important country in the world. 

With a few striking individual exceptions, international institutions, governments, central banks, banks, fund managers, hedge funds, Eurocrats, economists, financial journalists, and, yes, the Conservative and Unionist Party, failed to notice in time what was happening. 

The answer to the Queen’s famous question, “Why didn’t anyone see it coming?”, will be found by historians to lie in some fatal combination of groupthink, greed, hubris and the loss of collective memory which afflicted three quarters of the population and 99 per cent of our rulers. 

Please re-read the highlighted text as it nicely summarizes our current situation where the people who did not see the financial crisis coming and have a vested interest in the policies that made the financial crisis possible are now being asked to developed policies that will fix the situation.

So there is something banana-republic about politicians [not] spend[ing] all [their] waking hours trying to put things right....

We, the British public, have reached a painful moment. We are getting poorer. We feel we cannot trust our banks, and that no policies for economic recovery are making much difference.... 

A motion that would be seconded in a heartbeat in the EU and US.

The mantra of this column since the credit crunch is Everything Is Different Now. It means what it says....

The last time that the Western world faced colossal problems was in the Eighties. Enough time has now elapsed to see that the relevant leaders in that era rose to the challenge. Although they often disagreed, Ronald Reagan, George Bush senior, Margaret Thatcher, Helmut Kohl, François Mitterrand, Mikhail Gorbachev, FW de Klerk and Pope John Paul II all took decisions which helped secure for the next generation a free and prosperous way of life. 

That next generation has spent a frighteningly large part of its legacy, literally as well as metaphorically. 

And so far, it has not produced a single leader with a bold new analysis of where it went wrong. 

The world believed four years ago that Barack Obama had such an analysis, but in fact his economic remedies involve nothing that Keynesians had not thought of half a century ago, and his global message is one of retreat rather than leadership.... 

But we all sense now, if we didn’t at first, that our leaders at the top of British politics today are, in mind and character, part of the generation that failed rather than prophets of the one that will eventually succeed. They are able, moderate, decent enough, but just politicians. 

In good times, this does not matter much. But these are not good times. 

Neither Left, Right nor centre has good new ideas; neither international institutions, nor the European Union, nor independent nation states are functioning as they should.

Regular readers will recall that your humble blogger was one of the handful of individuals who did see the financial crisis coming.  So there is some chance I have an insight into how to fix what is wrong with our economy.

Regular readers are very familiar with my analysis of where it went wrong.  Where it went wrong is the global financial regulators allowed the bankers to create tremendous areas of opacity in the financial system.  These areas include the banks themselves as well as structured finance securities (think opaque toxic securities).

Regular readers are very familiar with my idea for how to fix what is wrong with our economy:  bring transparency back to all of the opaque corners of the financial system.

This includes requiring banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.

This includes requiring structured finance securities to provide observable event based reporting.  All activities, like a payment or default, involving the underlying collateral are reported before the beginning of the next business day.

As I predicted at the start of the financial crisis, until we bring transparency to all the opaque corners of the financial system, we are going to continue to see a decline in the real economy.

Bob Diamond confesses: Barclays falsified Libor to protect bank during crisis

As reported by the Telegraph's Harry Wilson,

Barclays chief executive Bob Diamond has admitted for the first time that the bank made a conscious decision to falsify Libor rates in order to protect the bank at the height of the financial crisis. 

The revelation in a letter to the Treasury Select Committee will put increasing pressure on Mr Diamond to reveal whether the decision was taken at board level. 

“Even taking account of the abnormal market conditions at the height of the financial crisis, and that the motivation was to protect the bank, not to influence the ultimate rate, I accept that the decision to lower submissions was wrong,” he stated. 

In the most detailed account so far on how the Libor rates were manipulated, Mr Diamond said fixing of Libor rates was carried out by individual trades and, separately, by the bank itself. 

He said traders attempted to influence the rate in order to benefit their own desks’ trading positions. The bank made the decision in order to protect shareholders’ interests, he said..... 

In the letter Mr Diamond appeared to try and defend elements of the practice by pointing the finger at other banks. 

Addressing the market turbulence at the height of the financial crisis he wrote: “The unwarranted speculation regarding Barclays’ liquidity was as a result of its LIBOR submissions being high relative to those of other banks. At the time, Barclays opinion was that those other banks’ submissions were too low given market circumstances.” 

He also said individuals within the bank raised concerns about Libor rates with authorities including the FSA, Bank of England and US Federal Reserve.

The simple fact is that neither Barclays nor any other bank should ever be put in a position where they can and have an incentive to lie about their financial condition.  At the same time, no financial regulator should ever be put in a position where it might appear that they either encourage or condone a bank lying about its financial condition.

The only way to prevent either of these from occurring in the future is to require all banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

With ultra transparency, market participants have the facts and lying would be for no benefit.

Spain losing access to capital markets as capital markets signal don't bailout banks

The Wall Street Journal reports that according to Spain's budget minister the country is losing access to the capital markets and needs the EU to bailout its banks.

Regular readers know that this interpretation of why Spain is losing access to the capital markets solely reflects bankers' worries over whether or not they will be paid their bonuses.

The capital markets know that bailing out the banks is unnecessary.

Under a modern banking system with deposit guarantees and access to central bank funding, banks are designed to absorb all of the losses on the excesses in the financial system today.  Subsequently, banks can continue to operate and make loans to support the real economy while they rebuild their book capital levels through retention of future earnings.

The IIF published a report that indicated it will take less than 4 years for Spain's banks to generate sufficient earnings to rebuild their book capital levels.  Four years suggests that recapitalizing the banks today is much ado about nothing.

The capital markets are worried that the Spanish government will undermine the perceived strength of its deposit guarantee by recapitalizing its banks and as a result, trigger a bank run.  This occurred in both Ireland and Greece.

Spain's Budget Minister Cristobal Montoro on Tuesday urged euro-zone partners to act faster to help support its enfeebled banks, saying that the government has effectively lost access to capital markets because of steep risk premiums demanded by sovereign bond investors.

In making this dramatic admission, Mr. Montoro joined recent calls by the Spanish government for direct aid from European Union institutions for Spanish banks as the government hopes to avoid a full-blown bailout package... 

As discussed above, Spain's banks do not need the bailout.

What we are talking about here is that bankers in other EU countries would like Spain and its banks bailed out.  If Spain and its banks are not bailed out, there is some chance that the banks in other EU countries will have to recognize a loss on their Spanish exposure.  This loss might prevent the bankers from being paid their bonuses.

"What this premium tells us is that the state, and Spain as a whole, has a problem when it comes to accessing markets, when we need to refinance our debt," Mr. Montoro said in a radio interview. "What that premium says is that Spain doesn't have the market's door open, as such, the challenge is to open that door and regain the confidence of those markets, our creditors."

Regaining confidence is a function of requiring ultra transparency from the Spanish banks and not getting an EU bailout.

The warning from Madrid was reminiscent of similar alarms over prohibitive borrowing costs sounded by Greece, Portugal and Ireland before entering into bailout talks with such international lenders as the European Union and the International Monetary Fund.

History shows that those bailouts did not work out for the countries involved.  They did work out well for the bankers in the countries that lent money.  They were effectively bailed out of their bad decisions.  As a result, they not only got a bonus for making a bad lending decision, they also get a bonus for the bailout.

Heads the bankers win, tails everyone else in the EU loses.

Matt Taibbi: How Wall Street killed financial reform

Returning to the Opacity Protection Team theme, I thought readers might find Matt Taibbi's article on how Wall Street killed financial reform interesting.  In the following excerpt, Matt sets the stage for financial reform.

Please notice how the need for disclosure is identified, but is excluded from the Dodd-Frank Act.  As a good friend of mine says, true political power is not in the ability to block legislation, but in the ability to block the discussion in the first place by keeping the topic off the agenda.

The first advantage the banks had lay in the fact that for all Obama's bluster, Dodd-Frank was never such a badass law to begin with. 

In fact, Obama's initial response to the devastating financial events of 2008 represented a major departure from the historical precedent his own party had set during the 1930s, when President Franklin D. Roosevelt launched an audacious rewrite of the rules governing the American economy following the Great Crash of 1929. 

Upon entering office, FDR was in exactly the same position Obama found himself in after his inauguration in 2009. 

Then, as now, the American economy was in tatters after the bursting of a massive financial bubble, brought on when speculators borrowed huge sums and gambled on unregistered securities in largely unregulated exchanges. This mania for instant riches led to an explosion of Wall Street fraud and manipulation, creating a mountain of illusory growth divorced from the real-world economy: Of the $50 billion in securities sold in America in the 1920s, half turned out to be worthless. 

Roosevelt's response to all of this was to pass a number of sweeping new laws that focused on a single theme: protecting consumers by forcing the business of Wall Street into the light.

Please re-read the highlighted text as it emphasizes that the thrust of Roosevelt's response was disclosure.

This blog has expanded on the role of disclosure in the financial system in the FDR Framework.

The Securities Act of 1933 required all publicly traded companies to register themselves and offer prospectuses to investors; the Securities Exchange Act of 1934 forced publicly traded companies to make regular financial disclosures...

Prospectuses and regular financial disclosures dealt with the issue of providing market participants with access to all the useful, relevant information in an appropriate, timely manner that the participants needed to make a fully informed investment decision.

Your humble blogger refers to this as valuation transparency.

Investors need valuation transparency in order to independently value a security before making a portfolio management decision (buy, hold or sell) at the price being shown by Wall Street.

FDR also created the FDIC to protect bank depositors (through an insurance fund paid for by the banks themselves) and passed the Glass-Steagall Act to separate insurance companies, investment banks and commercial banks.

This blog has discussed that a modern banking system has two critical components:  deposit insurance and access to central bank funding.  With these two components, banks have the ability to operate for years providing loans to the real economy even if they have negative book capital levels.  As a result, banks are designed to absorb all the losses on the excesses in the financial system without requiring a bailout.

Post-New Deal, if you put money in a bank, you knew it was safe, and if you bought stock, you knew what you were buying.

 Please re-read the highlighted text as Matt makes the point far better than I do.

This reform strategy worked for more than half a century – and it offered Obama a clear outline of how to respond to the crash he faced.

What made 2008 possible was that Wall Street had moved its speculative frenzy away from the regulated exchange system created by FDR, and into darker, less-regulated markets that had coalesced around brand-new financial innovations like credit default swaps and collateralized-debt obligations. It wasn't that the old system had broken down; Wall Street had just moved the playground. 

All Obama needed to do to rescue the economy and protect consumers was to make sure that the new playground had some rules.

Rules that at a minimum should have resulted in 'if you bought any security, you knew what you were buying.'

That meant moving swaps and other derivatives onto open exchanges, making sure that federally insured banks that dabbled in those dangerous markets retained more capital, and coming up with some kind of plan to prevent the next AIG or Lehman Brothers disaster – i.e., a plan for unwinding failing companies that wouldn't require federal bailouts.

Despite having identified the importance of knowing what you are buying, Matt misses disclosure.

The strength of Wall Street's Opacity Protection Team is in its ability to refocus the discussion away from disclosure (it certainly overwhelmed the call for disclosure from Nobel prize winning economist Joseph Stiglitz and myself).


Please notice how virtually every reform in Dodd-Frank could have been better achieved by requiring ultra transparency so market participants would know what they were buying.

For example, raising capital requirements for banks.  Requiring ultra transparency would do more to change banks risk exposures than raising capital requirements.  Please note how all the capital on fortress balance sheet JP Morgan didn't stop it from taking significant risk in its synthetic credit trade.  Had there been ultra transparency, this trade is likely to never have occurred.

The initial proposal for Dodd-Frank addressed most of those concerns....

And completely avoided bringing sufficient disclosure to all the opaque corners of the financial system that market participants would know what they were buying.

Then, behind the closed doors of Congress, Wall Street lobbyists and their allies got to work.

Actually, Wall Street lobbyists and their allies had gotten to work in writing the initial Dodd-Frank proposal.

Sir John Gieve argues for UK regulators toning down bank regulation to help economic recovery

The Telegraph reports that Sir John Gieve, former Deputy Governor and head of financial stability of the Bank of England, said

Britain's regulators should tone down their attacks on the banks, slow the introduction of new financial rules and clarify the future structure of the industry to encourage lending and stimulate growth.

He defended this position by observing

Pressure on liquidity and capital, plus continued debate on what is an allowable banking model, is pushing them to deleverage more than they might be forced to anyway. I think this is an area where the US managed, by being rather over generous on any objective basis, to get their banks out of crisis mode and back into lending mode more than we have. 

"I would be seeing if there were things we could do... that would be more effective than denouncing them for continuing to pay dividends and bonuses, which is a perfectly valid point but in macroeconomics the job is to get the aggregates to move." 

Sir John said banks have been led to believe they must boost their safety buffers, in part by cutting credit. "The rhetoric has been one which says we want to see you go faster and further," he said. Banks have already cut lending to UK companies by £151bn since December 2008, according to official figures. 

Lack of clarity about how banks should be structured in future is not helping, he added. 

With this observation, Mr. Gieve calls into question the whole thrust of regulatory and policymaker efforts to reform the financial system.  Simply put, he sees these efforts as being an obstacle to economic recovery.

Since the beginning of the financial system reform effort, your humble blogger has consistently said that if we do not analyze the causes of the crisis first, we are highly unlikely to adopt policies and regulations that address the causes and are beneficial.  Instead, we are likely to adopt policies and regulations that reflect existing biases.

For example, regulators are biased to the idea that banks holding more capital is the solution and are pushing this forward.  As Mr. Gieve observes, this bias leads to banks shrinking their balance sheets by cutting lending.  As a result, economic recovery is a victim of the regulatory bias.

Was the lack of capital a cause of the financial crisis?  Nowhere is there evidence that this is true.

Discovering the causes of the financial crisis is not hard.  Front and center in the causing the financial crisis were opaque, toxic mortgage backed securities.  These securities gave policymakers and regulators a hint as to where they should start their reform:  addressing the issue of opacity.

Was opacity a cause of the financial crisis?  Everywhere you look there is evidence that this is true.  

However, it is an issue that policymakers and regulators have never addressed (for their part, I have given up on economists other than Joseph Stiglitz making a case for eliminating opacity as these economists don't recognize that valuation and not price transparency is THE necessary condition for the invisible hand to work properly).

Imagine where the economy would be if valuation transparency had been the sole focus of financial reform.

• Structured finance securities could actually be valued by market participants and as a result the buyers' strike in the ABS market would be over;

• Banks would be subject to market discipline and as a result they would be reducing their risk profile while selling newly originated loans in the ABS market;

• Bailouts for banks in a modern financial system would not occur as the banks are designed to absorb the losses on all the excesses in the financial system today and rebuild their capital through retention of future earnings.  Having Wall Street rescue Main Street would have saved the real economy from the damage caused by the excess debt and reduced the need for central bank intervention; and

• Market participants could actually trust Libor to reflect the cost of funding to the banking system because it would be based on the actual cost of funds by the individual banks.

Unfortunately, as I predicted at the start of the financial crisis, we are not going to achieve any of these until valuation transparency is focused on.

In defending Sir Mervyn King, the Telegraph's Liam Halligan underscores why financial stability must not be reliant on regulators

In his Telegraph column defending Sir Mervyn King's track record and agenda, Liam Halligan shines a very bright light on why the stability of the financial system must not be dependent on regulators.

Mr. Halligan shows two ways in which a regulator can be captured:  by politicians and by the firms it regulates.  Both forms of regulatory capture undermine the ability of the regulator to do its job and contribute directly to financial instability.

Readers will recall that when financial reforms were passed during the Great Depression regulators were suppose to complement and enhance market discipline.  Not replace it.

For example, in the 1930s providing ultra transparency and disclosing on an on-going basis its current asset, liability and off-balance sheet exposure details was a sign of a bank that could stand on its own two feet.  Bankers expressed concern that this practice would come to an end with the introduction of deposit insurance and regulatory oversight.


By 2012, not only has the practice come to an end, but the Bank of England's Andrew Haldane says that current disclosure practices to all market participants other than regulators leave banks looking like 'black boxes'.  This cements in both replacing market discipline with regulatory oversight and the market's reliance on the regulators to properly assess and communicate the risk of the banks.

It is this reliance that compounds the financial instability that occurs from regulatory capture.

Your humble blogger has been advocating for requiring ultra transparency to end this reliance and reduce the financial instability caused by regulatory capture.

Return to Mr. Halligan,

It needs to be clearly and widely understood, though, that the City is trying to destroy King's reputation for the simple reason that he is pretty much the only senior UK policy-maker still arguing for the kind of robust bank regulations, much tougher than those currently proposed, that are needed to prevent another serious financial meltdown. 

The negative-publicity campaign against King, years in the making but seriously escalated last week, is being staged by the same "vested interests" which he, almost alone among Western central bankers, has dared to face-down. As such, the investment banks drip their poison, the PR agencies punt it and knocking-copy sells papers – not least when times are tough. 

The Governor is determined to do everything he can, before his term expires in June 2013, to rein-in UK banks.

Hence the reason that Sir Mervyn King is a logical champion of ultra transparency.

The City doesn't want that, of course. So history is being re-written, with King being accused of all manner of things in order to undermine his authority. 

I don't remember, for instance, King "allowing the bubble to inflate" prior to the credit-crunch. On the contrary, he was often attacked by business lobby groups for being too hawkish. 

Example number one of regulatory capture:  firms being regulated.

In August 2005, lest we forget, King was out-voted when he tried, amid signs credit was over-heating, to prevent interest rates being cut. The casting votes against him came from external MPC members appointed by then Chancellor Gordon Brown.

Example number two of regulatory capture:  politicians.

Similarly in June 2007, again as credit was spiraling, King tried to raise rates. Again he was out-voted, with Brown placemen playing a crucial role. So let us not say King was soft on inflation or credit in the run-up to sub-prime. Let us stick to the facts. 

The reality is that King did see the credit crunch coming. Among several warnings he gave, the one that sticks in my mind was at the Lord Mayor's Banquet, also in June 2007. 

"Excessive leverage is the common theme of many previous financial crises – are we really so much cleverer than the financiers of the past?" King publicly observed, as the City boys pursed their lips. 

"It may say champagne – AAA – on the label," King boomed, criticizing sales of complex derivates approved be deeply-compromised ratings agencies. "But by the time investors get to what's left in the bottle, it could taste rather flat". 

King's words of June 2007 were truly extraordinary. What more could a Bank of England Governor have said, without being accused of spreading panic?

Here is an example of the problem that regulators have in communicating risk.  How exactly can risk be communicated so that it does not set off a panic?

This is one of the reason for ultra transparency.  With everyone having access to the data, then risk can be discussed:  as in, 'our analysis shows that risk is building up ... are other participants seeing what we are seeing?'

And when it comes to his "lack of market knowledge", King didn't have detailed break-downs of each banks' balance sheet because the bank supervision had been transferred to the (Treasury-controlled) Financial Services Authority back in 1997.

Requiring ultra transparency would eliminate this as a problem.

In fact, if the reason for putting regulation and supervision under the Bank is to eliminate this problem, ultra transparency does a better job.  With ultra transparency, the Bank is free to independently analyze the data and draw its own conclusions without worrying about bank supervision.

Please note, in the run up to the financial crisis, the Fed, which had both monetary policy and supervision authority, also failed to prevent the crisis.

Brown set up the FSA because he wanted to control the bank regulator. The then newly-minted Chancellor wanted to keep the UK's lending boom going, in the misguided hope that the resulting "feel good" factor would make him the UK's most popular politician. 

So King was right last week, when he said the FSA was "a reform that would return to haunt us". He was right to defend the Coalition's measures to bring bank regulation back to Threadneedle Street. 

I also believe he was correct, when the credit crunch first hit, to make the banks sweat, questioning unconditional root-and-branch bail-outs. "Moral hazard" isn't an academic parlour game. It's the reason why the Western banking system collapsed and why, unless drastic reforms happen, it will ultimately collapse again. 

As discussed elsewhere on this blog, adopting the Swedish model eliminates the issue of 'moral hazard' and bank bailouts.  The Swedish model allows banks in a modern financial system to perform their function of protecting the real economy by absorbing all the losses on the excesses in the financial system.

No-one is saying King is beyond reproach. The Bank's "quantitative easing" programme, which King has supported, has been grossly over-extended. Few have criticized it more than me. 

Yet King was presented with a fait accompli. Downing Street was, and remains, determined to print virtual money, taking the line of least resistance. I wouldn't be surprised if King finds such policies as distasteful as I do. He could have resigned, but what then? There would have been an almighty panic, with King anyway replaced with someone even more flexible in their understanding of basic economics. 

What really got the City's goat about King's latest speech is his on-going determination to separate "ordinary" retail banking from "risky" investment banking. 

It is vital, said King, that the Government brings the Vickers reforms into law "sooner rather than later". These changes, which "ring-fence" investment and retail banking in the same institution, aren't set to bite until 2019 – long enough for the banking lobby to water them down even more. 

King signalled, as he has before, that Vickers doesn't go far enough. "We don't build nuclear power stations in densely populated areas, nor should we allow essential banking services and risky investment banking activities to be carried out in the same 'too important to fail' bank". 

King then referred, albeit in coded language, to the massive off-balance sheet losses still smouldering, unaudited and undeclared, within the UK banking system. During the financial crisis, "it was difficult to know which banks were safe and which weren't", King boomed. 

And it still is.

In the aftermath of the Northern Rock collapse, "banks found it almost impossible to finance themselves because no-one knew which banks were safe and which weren't". That remains largely the case today....

I know I am repeating myself, but the only way to solve this problem is requiring ultra transparency.

Within the Square Mile, King's latest speech was a declaration of war on a banking sector that has wrecked our economy, been mollycoddled and remains astonishingly bloated.
Little wonder the money-men have buried the Governor's message under a pile of self-serving vitriol.

Hence the reason that it is important that Sir Mervyn King fight the right battle.  Ultra transparency will do far more to improve financial stability and reduce the risk of the banks then any regulation like ring-fencing.  Remember, Glass-Steagall was the ultimate ring-fence and it fell to the banks in under 60 years.