Negotiated banking standards vary in implementation

A Reuter's article demonstrates why current asset and liability-level disclosure required under the FDR Framework is the only standard that can be applied globally on a consistent basis.

Implementation of Basel III and liquidity rules is subject to interpretation by national bank regulators.  Disclosure is not subject to this interpretation as it applies equally everywhere.

Seven European Union finance ministers have written to the EU executive saying its plan for implementing Basel III capital and liquidity rules for banks were too soft, a German newspaper reported on Friday. 

Ministers, including those from Britain, Spain and Sweden, also said the European Commission's proposal for a binding, unified set of rules crimped an individual country's ability to demand higher capital quotas from banks, the Financial Times Deutschland reported, citing the letter. 

The proposal also curtailed national financial watchdogs' ability to take account of differences in banking systems. 

The plans as they now stand would "damage European financial stability and the EU's credibility in this area," the paper quoted the letter as saying. 

International financial regulators have hammered out the Basel III accord to tighten rules on banks to avoid a repeat of the financial crisis. The deal was endorsed by world leaders last November and will phase in tougher bank capital and liquidity requirements over six years from 2013. 

EU financial services chief Michel Barnier will publish a draft EU law in July based on the global agreement. 

The paper said Germany did not sign the letter and appeared to have been successful in its demand that joint-stock and non-joint-stock banks be treated the same under the new rules.

Reason the ECB is pushing for the creation of an ABS data warehouse revealed

As discussed previously on this blog, one of the reasons that the ECB has been pushing an ABS data warehouse in the hopes of restarting the structured finance market is that it has a significant amount of exposure to structured finance securities on its balance sheet.

The Dow Jones Newswire reports that according to Der Spiegel,

Skeleton risks amounting to several hundreds of billions of euros are on the balance sheet of the European Central Bank, magazine Der Spiegel writes in a preview of its edition to be published Monday. 

Those risks arise because banks, above all from Greece, Ireland, Portugal and Spain, have provided as collateral asset-backed securities that are unfit for central bank loans as their debt rating is low or non-existent, the magazine says. 

That way, the banks are able to receive more financing from the ECB, Der Spiegel says. 

We now find out that there are several hundred billion euros of asset-backed securities that are unfit for central bank loans regardless of the size of the haircut on the collateral.  Hence, the ECB has a very large incentive to get the market going so that these securities can be purchased by investors from the issuing banks and the ECB can stop funding the banks.

Given this incentive, the ECB should be doing everything in its power to make sure that the ABS data warehouse is successful.  Where success is not simply that a database is constructed, but rather that investors trust the data and are willing to end their buyers' strike.  If investors do no trust the data, they will not return to the structured finance market.

To date, your humble blogger is the only one in the world talking about a database that is likely to be trusted (no conflicts of interest with existing market participants and availability of all the useful, relevant data fields).

NovaStar Financial makes the case for embracing the FDR Framework

The NY Times ran an excerpt from Gretchen Morgenson and Joshua Rosner's new book, "Reckless Endangerment:  How Outsized Ambition, Greed and Corruption Led to Economic Armageddon".  The excerpt focused on NovaStar Financial and a short-seller's efforts to have the SEC look into the firm's business practices.

The excerpt presents a compelling case for why the FDR Framework needs to be embraced and fully implemented.

MARC COHODES had heard the stories.  Heard how these guys would give a mortgage to anyone — even to a corpse, the joke went. 

... So Mr. Cohodes, a money manager in Marin County, Calif., decided to bet against one of the big names of the subprime age: NovaStar Financial. 

NovaStar was part of a crop of new lenders that had sprung up in the 1990s.... 

Like others in the subprime industry, NovaStar used aggressive accounting that obscured its increasingly precarious finances. As far back as the 1990s, it had to underwrite loads of new loans to offset losses on older mortgages.

Under the FDR Framework, the damage to the financial system a NovaStar could cause would be minimized.  This is a direct result of NovaStar having to disclose to market participants all the useful, relevant information in an appropriate, timely manner.  In the case of NovaStar, this would have included its current loan-level performance data.

The disclosure of this data would allow market analysts to better understand the risk of NovaStar and its book of business.  With this better understanding of the risk, market participants could do a better job of setting both the price of and amount of their exposure to NovaStar.

Hiding behind the opacity of current disclosure practices, NovaStar was able to obscure the true risk of its business.  As a result, market participants under-estimated the risk and over-invested in the company and financial securities backed by loans originated by the company.

... Although NovaStar was not a household name in lending, in 2003 the company boasted 430 offices in 39 states. With headquarters on the third floor of an office building in Kansas City, Mo., it was fast becoming one of the top 20 home lenders in the country. 

NovaStar was also becoming a Wall Street darling,..., Thanks to aggressive management, unscrupulous brokers, inert regulators and a crowd of Wall Street stock promoters, NovaStar’s stock market value would soon reach $1.6 billion. 

... Mr. Cohodes knows every trick executives use to make their companies look better than they are. He prides himself on being able to spot trouble.... and he often shared his research with regulators at the Securities and Exchange Commission. 

... So in February 2003, Mr. Cohodes started corresponding with the S.E.C. about NovaStar. He began “throwing things over the wall,” as he put it, to Amy Miller, a lawyer in the division of enforcement.  

Among the questionable practices that are the easiest to find are those that appear in a company’s own financial statements.... “They made their numbers look however they wanted to,” he recalls. “Not even remotely realistic.”

One tactic gave the company lots of leeway in how it valued the loans held on its books. Another allowed it to record immediately all the income that a loan would generate over its life, even if that was decades. This accounting method ignored the possibility that some of the company’s loans might default. NovaStar assumed that losses on all of its loans would be nonexistent. 

Both of these tactics would be absurd in the face of having to disclose current loan-level performance data.

... NovaStar’s rosy assumption not only padded its profitability but also encouraged the company to make more mortgages, regardless of quality. The more loans it made, the more fees and income the company could record.

With disclosure of current loan-level performance data, the market would have seen the deterioration in credit quality.  The result would have been market discipline on management as investors charged more for the funds provided to NovaStar to be compensated for the risk.

... Mr. Cohodes and other NovaStar critics believed that they had found a company whose success was built on deceptive practices. What they did not recognize was that NovaStar was a microcosm of the nationwide home-lending assembly line that would lead directly to the credit crisis of 2008. 

IN Atlanta, Patricia and Ricardo Jordan learned the hard way how NovaStar’s freewheeling lending practices imperiled unsuspecting borrowers.

The Jordans sued NovaStar in 2007. As part of the lawsuit, their lawyer found that their loan had been placed in a mortgage securitization trust assembled by NovaStar and sold to investors in November 2004. More than half of the loans in the pool were provided with no documentation or limited documentation of borrowers’ financial standing. 

But the Jordans had given NovaStar bank statements and other documentation of their income. The lawsuit would show that NovaStar had inflated their monthly income by $500 to make the loan work. The lender had given the Jordans a loan that went against its own underwriting guidelines and that overrode federal lending standards. 

The Jordans’ was just one loan. There were literally thousands more like it. (NovaStar settled with the Jordans in 2010. The terms were undisclosed.)

Again, had there been current loan-level disclosure for the structured finance security, analysts could have seen what was occurring and the true riskiness of the underlying mortgages.  If NovaStar could not access funds through securitization at an attractive or any price, it would have cut back on its lending and the associated deceptive practices.

... Although some of the S.E.C. people he spoke with seemed to recognize the problems in NovaStar’s operations, their investigation did not appear to be gaining traction. 

The phone calls with the regulators went over the same material repeatedly, Mr. Cohodes recalls, leading him to conclude that Ms. Miller and her colleagues did not understand what was happening at NovaStar. 

“Whenever they seemed to get it, they would either call up or make contact frantically saying, ‘Can you please go over this again?’ ” Mr. Cohodes said. “It was almost like someone was presenting a case to the higher-ups and they would say, ‘Are you sure? Go back and make sure.’ ” 

This sort of behavior by regulators is not limited to the SEC.  In an earlier post, I discussed how bank examiners face the same issue.  They might uncover a problem, but they have present a case to convince the higher-ups.  In the meantime, the financial institution also got to present its case for why it was not a problem.

... But while NovaStar executives high-fived each other, a unit of Lehman Brothers, Wall Street’s largest packager of residential mortgage loans sold to investors, was discovering serious problems in a review of NovaStar mortgages. The findings were so troubling to the Lehman executives overseeing the firm’s purchases of NovaStar loans that they ended their relationship with NovaStar in 2004.

According to documents filed in a borrower lawsuit against NovaStar, Aurora Loan Services, a Lehman subsidiary, studied 16 NovaStar loans for quality-control purposes. What the analysis found: more than half of the loans — 56.25 percent, to be exact — raised red flags. “It is recommended that this broker be terminated,” the report concluded. 

Among the problems turned up by the Aurora audit were misrepresentations of employment by the borrower, inflated property values, transactions among parties that were related but not disclosed, and unexplained payoffs to individuals when loans closed. 

... S.E.C. rules require the disclosure by company management of information considered material to the company’s prospects or an investor’s analysis. In a 1999 S.E.C. bulletin, the commission defined materiality this way: “A matter is ‘material’ if there is a substantial likelihood that a reasonable person would consider it important.” Two Supreme Court cases use the same standard. 

Surely, Aurora’s findings that more than half of the sampled NovaStar loans were questionable would have been an important consideration for the S.E.C.’s “reasonable person.” 

Still, NovaStar failed to alert investors or the public at large to the Aurora analysis. Nor did NovaStar publicize the fact that Lehman Brothers had stopped buying its loans.

The analysis done by Aurora is the type of analysis that disclosing current loan-level performance data would allow all market analysts to do.  Without this type of disclosure, NovaStar was able to hide the Aurora analysis and resulting decision. 

... To keep its money machine running, NovaStar regularly issued new shares to the public. Between 2004 and 2007, for instance, the company raised more than $400 million from investors. To those critical of NovaStar’s practices, this was money the company should never have been allowed to raise from investors who were kept in the dark by the company’s disclosure failings. 

Mr. Cohodes reckons that over roughly four years, he conducted hundreds of phone calls with the S.E.C. about NovaStar. Each time, he would walk them through his points. Sometimes, a higher-up would get on the phone and contend that while NovaStar’s practices were indeed aggressive, the company did not appear to be breaking the law. 

NovaStar’s selective disclosures — it was quick to report good news but failed to own up to problems on many occasions — seemed to be infractions that the S.E.C. should have dealt with. But its investigation went nowhere.

Fundamental to the FDR Framework is the principle that market participants have access to all useful, relevant information in an appropriate, timely manner.  Had there been disclosure of current loan-level performance data, that would have been sufficient to limit the losses associated with NovaStar and the structured finance securities its mortgages were included in.

The story of NovaStar also highlights the role of regulators in ensuring access to all the useful, relevant information.  This is the regulators' responsibility.  A responsibility for which the regulators must error on the side of "too much" rather than "too little" disclosure.

Leading up to the credit crisis, decisions on disclosure were subject to a cost/benefit analysis.  If the cost of disclosure exceeded the regulator's estimate of benefit, useful, relevant information was not disclose.  With the hundreds of billions of dollars of losses taken by investors during the credit crisis as a result of inadequate disclosure, the cost/benefit analysis now permanently justifies providing disclosure.

Finally, the decision of what is useful, relevant information is driven by what market participants think is all the useful, relevant information and not what the disclosing party thinks is all the useful, relevant information.  As NovaStar showed, the disclosing party may have an incentive to hide useful, relevant information.

... As is its custom, the S.E.C. declined to comment on the NovaStar inquiry or the agency’s discussions with short-sellers. But documents supplied by the S.E.C. under the Freedom of Information Act show the extensive communications between Mr. Cohodes and the agency. Ms. Miller, still at the S.E.C., declined to comment. 

“It would be interesting to see who exactly dropped the ball, and why,” Mr. Cohodes said. 

“It would be interesting why nothing was ever brought. The S.E.C. should have sent a plane for us to come to D.C. and say: ‘How do we make sure this doesn’t happen again?’ ”

Fully implement the FDR Framework.

 ...At the end of 2009, NovaStar management concluded that the company’s financial reporting was “not effective.”

NovaStar had, in essence, confirmed what Mr. Cohodes had been telling the S.E.C. all along. The company’s financial reports just couldn’t be trusted.

UK's Prudential Regulation Authority Plans to Rely on Own or Market's Judgment

The Telegraph carried an article in which Hector Sants, the individual who will run the UK's Prudential Regulation Authority, laid out his vision for how the PRA would operate.

The Prudential Regulation Authority (PRA), which will take over the supervision of the banking sector from the Financial Services Authority within 18 months, will take a "judgment-based" approach to financial regulation that Hector Sants, the chief executive of the FSA who will run the new PRA, said could have lessened the impact of the financial crisis. 

"Central to this supervisory model is the presumption that regulators cannot rely on the judgment of the firms they supervise, and must take their own view formed from their own analysis about the significant issues which affect the safety and soundness of the firm. Furthermore, where that judgment differs from the firm's management, the regulator must act," said Mr Sants. 

This statement suggests that the pre-credit crisis method of supervisory regulation in the UK consisted of calling each bank, asking if everything was okay, being told it was and then going out to lunch.

Based on my experience with the bank examination model, which the FSA also was using, examiners were physically located in the largest banks every day looking for issues that wold affect the safety and soundness of the firm.  If they found any issues, they would report them both through the reporting channels at the regulator and to the firm's management.

It is at this step that supervisory regulation breaks down.  Management has the opportunity to correct or explain why it is not a problem.  If management does not think it is a problem, they document why it is not a problem.

Then the regulators have to decide if it is a problem worth pursuing based on what the examiner and management have to say.  Who should the regulators trust in making the decision that it is a problem worth pursuing?

In this decision process, the odds are stacked against the examiner and therefore it is unlikely that problems will be addressed.  As Mr. Sants says, regulators relied on the judgment of the firm's management.  This reliance means that the examiner would have to convince a significant number of people at the regulator why the examiner was right and management was wrong (the Nyberg Report on the Irish Crisis also makes this point).

Mr. Sants appears to be proposing that going forward the PRA will assume that the examiner/supervisor is right and it is up to the firm's management to convince the regulator otherwise.  This also does not work.

It cements in the concept of moral hazard. When the regulators have the final say in the management of risk at a financial firm, how can a financial firm be allowed to fail?

It also substitutes the judgment of the regulators for the judgment of the market.  No one believes that the regulators can do a better job of assessing risk than the market.  The common sense test of this is asking the question of who do you think would de a better job of assessing the risk of Citi - a competitor like JP Morgan or the regulators?

Outlining his plans for a PRA, which will be far smaller than the FSA with less than 1,000 staff, Mr Sants said he was hoping to attract "high-quality, experienced supervisors" to the regulator. 

Andrew Bailey, an executive director of the Bank of England who will be Mr Sants' deputy at the PRA, said hiring staff with the clout to deliver judgments on some of the country's largest banks would not mean paying large amounts of money. 

"To just say it is about money isn't right," said Mr Bailey, adding that the type of people who would want to work at the PRA would have to be interested in "policy issues".

Based on my initial read of the BoE's approach to bank supervision under the PRA, I observed that under principle 10, the PRA was adopting current asset and liability-level disclosure so the market could make judgments of risk and return.  These comments confirm that observation.

It makes sense not be be paying large amounts of money to hire the best analysts when financial firms have to disclose their current asset and liability-level data.  This disclosure allows the PRA to leverage off of all the best analysts regardless of where these analysts are employed.

Rather than pay for an in-house analysis that the PRA may or may not use, the best analysts will produce their analyzes but instead will make them available to market participants.  It is the market participants who have the clout and incentive to deliver judgments based on these analyzes on some of the country's largest banks.  This is the very definition of market discipline.

UK's Prudential Regulation Authority Adopts Current Asset-Level Disclosure

On May 19, 2011, the Bank of England published its approach to bank supervision under its Prudential Regulation Authority (the "PRA").

In discussing the Principles Underlying the PRA's Approach, the Bank of England and the Financial Services Authority observed under principle 10

That firms should be allowed to fail, so long as failure is orderly, reflects the view that financial firms should be subject to the disciplines of the market.  Consistent with its statutory objective, the PRA will not view the failure of an institution in an orderly manner as regulatory failure, but rather as a feature of a properly functioning market. This is an important change to the statutory basis of prudential supervision.  The PRA will seek to ensure that firms disclose sufficient information to enable the market to make judgements about risk and return.

As regular readers of this blog know, the only way for market participants to have sufficient information to make judgements about risk and return is if the market participants have all the useful, relevant information in an appropriate, timely manner.

When it comes to financial firms, the useful, relevant information is the firm's current asset and liability-level data.

• This is the data that market participants need to analyze to determine if a firm is solvent [that the market value of the firm's assets exceeds the book value of the firm's liabilities].  

• This is the data that market participants need to analyze to see if the risk profile of a financial firm is changing and to adjust both the price and amount of their exposure to the change in the financial firm's risk profile.  It is through the adjustment of price and amount of their exposure that market participants exert market discipline on financial firms.

• This is the data that market participants require if they are going to be willing to once again absorb losses in the case of the failure of a financial firm.  

• In the absence of this data and the presence of financial regulators issuing assurances about the solvency of a financial firm, investors are unwilling nor is it reasonable to expect them to absorb solvency losses.  

• In the presence of this data, it is no longer necessary for financial regulators to opine on the solvency of a financial firm.  Under the principle of caveat emptor [buyer beware], investors will use this data to determine the price and amount of their exposure knowing they could lose their investment to insolvency.

For those who would argue that there is a middle ground between what financial institutions disclose now and full disclosure of their current asset and liability-level data, the question is "Why should there be a middle ground?"

• How can investors exert market discipline without all the useful, relevant information? 

• Why would investors be willing to absorb solvency losses without the opportunity to analyze all the useful, relevant information prior to making an investment?  

• Why would investors not expect a bail-out from all solvency related losses when regulators are running stress tests and saying the financial institutions are adequately capitalized? 

• What benefit is there to the financial markets of not disclosing all the useful, relevant information?
• Financial institutions would prefer opacity because it limits the market's ability to properly judge and price risk and therefore makes them more profitable.  Why is this good for the financial market and the economy?

• Why would the financial system be more stable in the absence of disclosure of all the useful, relevant information?  
• Are regulators better at judging the risk and solvency of a financial institution than its competitors and the market's credit and equity market analysts?

The FDR Framework passed the test of time

Recently, this blog has spent a considerable amount of time discussing the ECB's ABS data warehouse.  This data warehouse has served as an excellent example of the problems, like opacity and conflict of interest, in our financial system that result from the failure to adhere to the FDR Framework.

As regular readers of this blog know, the FDR Framework, with its philosophy of disclosure combined with the principle of caveat emptor [buyer beware], has been with us for almost 80 years.

Your humble blogger never tires of pointing out that the financial markets did not stop functioning during the recent credit crisis in those areas that adhered to the FDR Framework.  In these areas, market participants had access to all the useful, relevant information in an appropriate, timely manner.  Market clearing prices may have declined, but there were investors standing willing to buy the securities being offered.

The financial markets failed in those areas, structured finance and unsecured debt securities of regulated financial institutions, that did not adhere to the FDR Framework.  In these areas, market participants did not have access to all the useful, relevant information in an appropriate, timely manner.  Market clearing prices in these areas disappeared as there were few investors standing willing to buy the securities being offered.

Your humble blogger out of necessity keeps reminding economists and regulators that the FDR Framework has an incredibly good predictive track record.  This track record applies to both predicting market failure before the credit crisis as well as predicting the failure of different regulatory responses to restore investor confidence (see posts on Irish banks and Spanish Cajas) subsequently.

Perhaps more importantly, the FDR Framework lays out a coherent explanation for why the financial crisis occurred (no need to ignore any inconvenient facts) and what has to be done to fix the financial system.

The FDR Framework is parsimonious.  It is the model of how the financial system works that requires the fewest assumptions and has the best predictive value.

A Simple Proposal that eliminates the need for tougher credit-rating rules

The WSJ carried an article on the SEC's 500+ page proposal to reform the credit rating system.

Your humble blogger would like to offer up a simple proposal from the FDR Framework that would probably be more effective than all of the SEC's proposed reforms.  The proposal is

Each rating agency should make available all of the data, including assumptions, that it used in developing its rating for a specific security.

Disclosure of this data would dramatically improve the transparency of credit ratings.  It would also let market participants compare their own analysis against the rating agencies.

Donald Kohn and the BoE's Financial Policy Committee could use a lesson in the FDR Framework

Testifying before British MPs at a confirmation hearing for the Bank of England's new Financial Policy Committee, Mr. Kohn demonstrated why he and other financial regulators could use a lesson in the FDR Framework.

According to a Financial Times article,

Speaking to British MPs at a confirmation hearing on Tuesday, Mr Kohn nevertheless said his experience would be valuable for the Bank of England, where he has been appointed to a new committee with powers to guide UK financial stability. 

“I believe I will not make the same mistake twice,” he said. 

This suggests an acknowledgement of what mistake he made is coming...

Mr Kohn has been appointed to the Bank’s new Financial Policy Committee, which will soon have powers to change system-wide UK financial regulations and even limit borrowing by households and companies if it thinks there are threats to financial stability. 

Having been a strong advocate of the Greenspan doctrine not to burst asset bubbles but to mop up any mess after a crash, Mr Kohn recanted much of his previous view in front of MPs.

Apparently the mistake was in not bursting the asset bubbles but instead waiting to mop up any mess after a crash.

However, the alternative of central bankers and financial regulators popping asset bubbles sooner is a non-starter.

As this blog has gone to great lengths to document (see discussion of the Nyberg Report on Ireland) and explain, there is an institutional reason that central bankers and other financial regulators do not burst asset bubbles sooner.

• First, the regulators have to come to a consensus that there is a bubble.  Some analysts in one part of the regulatory bureaucracy might think that there is, but it is a long way from their belief to convincing the entire regulatory body to share their view and take action. 

• Second, the regulators need evidence that the bubble is harmful.  Without this, politicians are likely to crackdown on the regulators as all that is visible to the politicians is the benefits of the asset bubble.

Returning to the FT article

He said he had “learnt quite a few lessons – unfortunately” from the financial crisis, including that people in markets can get excessively relaxed about risk, that risks are not distributed evenly throughout the financial system, that incentives matter even more than he thought and transparency is more important than he thought. 

And here is where the lesson in the FDR Framework comes in.  These are not separate, but issues that are all linked logically together under the FDR Framework.

As regular readers of this blog know, the FDR Framework makes the financial regulators responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is the transparency that he learned is important.

Under the FDR Framework, market participants, particularly investors, are responsible for analyzing this information to assess the risk of any investment knowing that it is buyer beware for any investment they make.

The requirement to ensure transparency is placed on financial regulators because there are market participants who benefit from opacity.  This is where incentives matter comes in.  The way these market participants benefit from opacity is that opacity makes it impossible for investors to properly analyze and price risk.

Similar to Mr Greenspan’s 2008 comment that the former Fed chairman had erred in presuming banks were able to act in their shareholders’ interests, Mr Kohn said: “I placed too much confidence in private market participants to police themselves”.

Actually, the financial crisis did not show that confidence in private market participants to police themselves was misplaced.

What the financial crisis showed was that since the financial regulators have an informational monopoly on all the useful, relevant information for each financial institution, other financial market participants are dependent on the regulators' assessment of the risk of the financial institutions.  When the financial regulators under-estimate the risk of the financial institutions, so do the other market participants. 

As predicted by the FDR Framework, without the useful, relevant information, the other market participants cannot exert any market discipline or police the financial institutions themselves should the risk profile of the financial institution change. 

The former Fed official was willing to offer an apology... 

“I deeply regret the pain that was caused to millions of people in the US and around the world by the financial crisis ... Most of the blame should be on the private sector: the people that bought and sold those securities, on the credit rating agencies that rated them. But I also agree that the cops weren’t on the beat,” he said 

“The regulators were not as alert to the risks as they could have been and, to the extent they saw the risks, were not as forceful in bringing them to the attention of management, or taking actions, as they could have been. All this with 20/20 hindsight obviously.”

Actually, it is a matter of public record that your humble blogger using the FDR Framework saw the problems in the financial system before the financial crisis and recommended steps that would have reduced the severity of the crisis.

Your humble blogger would be willing to sit on or consult with the BoE's Financial Policy Committee as it is clear that the committee could benefit from the insights of the FDR Framework.

The FDR Framework and Ending The Looting of Banks

The other day, Bloomberg ran an interesting column by William Black.  One of the main observations in the column was

Nobel laureate George Akerlof and Paul Romer wrote a classic article in 1993. The title captured their findings: “Looting: the Economic Underworld of Bankruptcy for Profit.” Akerlof and Romer explained how bank CEOs can use accounting fraud to create a “sure thing” in the form of record short- term income, generated by making low-quality loans at a premium yield while making only minimal reserve allowances for losses. While it lasts, this fictional income allows the chief executive officer to loot the bank, which then fails, and walk away wealthy.

The necessary conditions for this fraud to take place are the limited access to the asset-level data made possible by the financial regulators' information monopoly combined with the regulators' inability to effectively analyze the information.



Everyone knows that the first condition exists as financial institutions are not required to disclose their current asset-level data.  For confirmation that the second necessary condition exists, see the WSJ article in which

[A] top Bank of England official, Andy Haldane, said the new regulator will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... that ... rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.

As regular readers of this blog know, the FDR Framework would prevent this type of accounting fraud.  Under the FDR Framework, market participants have access to all the useful, relevant information in an appropriate, timely manner.  This is asset-level data for banks.

With access to the asset-level data, market participants, including competitors and credit/equity market analysts and investors, will do their own analysis of the risk of the assets.  It is this analysis that will show that the reserve allowance is not sufficient for the risk of the assets.

This type of accounting fraud is another way that the regulators' monopoly on all the useful, relevant information on financial institutions is harmful to the financial system.

EC Puts Up Stop Sign for the Market Group's Involvement in the ECB's ABS Data Warehouse [Update]

Bloomberg published an article on the European Commission's probe of financial market data vendors who control essential infrastructure.

As discussed previously on this blog (see here), the ECB is acting as a catalyst to spur the creation of a centralized ABS data warehouse.  The data warehouse will process, verify and ultimately distribute standardized loan-level information on all existing and future structured finance deals to all market participants.

In a recent International Asset-Backed Strategy report, an RBS analyst observed of this effort

[W]e would see an ECB-endorsed (even if “non-exclusive”) data provider as an effective market monopoly in the ABS data aggregation business.

Hence, it will be on the European Commission's radar as essential infrastructure.

The report continues

The ECB’s letter of intent states that “To the extent possible, market participants will have the opportunity to use and invest in the Data Warehouse subject to entering into appropriate legal arrangements” – while this statement appears to encourage a ‘market-owned’ data provider, we think the difficult practicalities of creating such a socialised venture will mean that the project likely ends up going to a private firm(s). 

This was in fact directly indicated by a press release issued on April 28th from a group of market participants (originators and investors) stating that they will oversee and manage the selection process for the construction and administration of the Data Warehouse, which according to the press release will allow ABS issuers to submit loan-level data electronically, which will then be verified and audited for compliance with the ECB’s criteria requirements for repo eligibility. 

Every member of this group of market participants, the Market Group, has a conflict of interest.  Another big, red flag for the European Commission.

European Union regulators, who are investigating 16 investment banks over the swaps market, will examine the “control and dissemination” of financial-market data for possible antitrust abuses. 

The European Commission will investigate whether data providers are engaging in abusive behavior by “attempting to leverage privileged access to information,” Joaquin Almunia, the EU’s competition commissioner, said in a London speech today. “I also intend to discuss the legitimate scope of intellectual property rights claims on such data,” Almunia said.

Almunia is increasing the EU regulator’s scrutiny of financial markets. Last month, he announced a probe into whether 16 banks ... colluded by giving data to Markit, a financial information provider.  

The commission is also checking whether nine of the banks struck deals with ICE Clear Europe, a clearinghouse for derivatives, that prevent other clearinghouses from entering the market. 

This should be a stop sign for the ECB and its involvement with and potential endorsement of the Market Group's version of the ABS data warehouse.

“The commission is ramping up antitrust enforcement in the financial services sector,” Suzanne Rab, a lawyer at King & Spalding in London, said in an e-mail “An underlying theme is the transparency of and access to data.” [emphasis added]

Almunia, who is set to examine Deutsche Boerse AG’s bid for NYSE Euronext, said he is opposed to “essential” market infrastructure being controlled by a small number of companies. 

“We should prevent that any one entity or group controls essential infrastructure -- be it a trading platform, a clearing platform or a pre-trading service -- to the benefit of a restricted few,” he said.

This problem is particularly acute if the companies all have conflicts of interest in the control and dissemination of the data.

This problem is mitigated if the firms that construct and operate the ABS Data Warehouse and therefore control the essential infrastructure are verifiably free of conflicts of interest with existing structured finance market participants.

This requires that any firm that is involved in either the day-to-day operation of the ABS Data Warehouse or the Coordinator role should be required to make a full disclosure of all competitive and financial interests in the design of the database, the presentation of the data, the analysis of the data, and the use of the data, including:

• Is the firm engaged in a related business that could gain a competitive advantage from its role? Examples of such related businesses include data distribution, pricing services, trustee services, monitoring, analytic solutions, loan servicing, collection services, consulting, ratings services, investment as a principal or agent or portfolio manager, and underwriting.

• Does the firm have investments that could benefit from its role, such as long or short positions in ABS transactions?

So long as these firms, like your humble blogger's, do not have conflicts of interest with existing market participants, they are motivated to do what is best for the structured finance market.  After all, they make money by seeing that the structured finance industry is successful.

The Bloomberg article highlighted another type of anti-trust concern.

... Standard & Poor’s offered to change its pricing policy in Europe to overcome antitrust concerns over licensing fees for securities identification numbers, the commission said earlier today.

This type of anti-trust concern will not be a problem for the ABS Data Warehouse your humble blogger would operate as the data warehouse will provide loan-level data for free to all market participants.

Update

The following are the highlights from a May 16, 2011 speech by Mr. Almunia, the Vice President of the European Commission responsible for Competition Policy to the Cass Business School in London.

The speech touches on many of the themes addressed on this blog under the FDR Framework.  This includes the need to replace opacity with transparency so that all market participants have access to the useful, relevant in an appropriate, timely manner.  This includes the need to eliminate conflicts of interest so that investors can trust this data.

Let me start by talking about the challenges we are facing. Promoting competition, cross-border integration, and transparency in the financial markets has been part of the European Union’s efforts to build and strengthen the Single Market for many years. The need for EU-wide oversight of the financial sector became apparent in the 1990s as the Union moved towards closer economic integration and the single currency. 

This recognition led to the adoption of the Financial Services Action Plan of 1999, which comprised 42 separate measures on securities, banking, insurance, mortgages and pensions. The plan resulted in major pieces of legislation, including the Capital Requirements Directive, the Markets in Financial Instruments Directive – or MiFID – and the Market Abuse Directive. As our first wave of legislation was being implemented, financial markets were changing fast.

• Technological innovation brought new organisations and practices such as broker crossing networks, systematic internalisers, and algorithmic and high frequency trading.

• Ever more complex financial products and derivative instruments were being introduced, and

• There was a massive rise of over-the-counter trading, which is now estimated at around 40% of all equity trades.

More importantly, the spectacular growth of trade in new financial products took place in a very opaque environment. In that environment, too much risk was being taken, also because risk was being mispriced. In addition, the crisis generated suspicions of market manipulation and abuse which contributed to damage investors’ trust in financial markets – and these suspicions have not dissipated yet. 

The EU has responded to these conditions by launching a comprehensive review of its existing legislation. The goals are to bring more transparency and stability to financial markets and to extend the scope of regulation to new financial instruments and infrastructure. 

Almost three years since the crisis erupted, financial markets are the scene of dramatic consolidation of trading platforms and infrastructure. This is due to a recovering environment for financial trading and to the imperatives of globalisation and technological change. 

... These are some of the current challenges in the financial services industry; now I would like to talk about what the joint action of competition policy and regulation at EU level can do to address them. 

... The regulatory measures taken by the European Commission will shed more light into the way financial markets operate and will prevent a dangerous accumulation of risk. But regulation alone is not enough. Whereas regulation tackles broad structural market failures, you need competition policy to tackle the harmful behaviour of individual market participants. 

Competition control should ensure that the actual evolution of the market does not lead to structures that harm users and legitimate market participants. In particular, we should prevent that any one entity or group controls essential infrastructure – be it a trading platform, a clearing platform or a pre-trading service – to the benefit of a restricted few. 

I am aware of the debate on inter-operability and the question of whether increased competition and the proliferation of market actors can undermine stability, but I cannot see a problem here. I believe that competition and stability are not at odds. If market participants comply with strict prudential requirements, I see no risk in having many of them supplying services to investors. In fact, I see potential gains. The level of concentration in the markets should reflect the search for optimal efficiency; it should not reflect the actions of powerful market players that have excluded potential competitors. 

So, in my view this is not a real danger. Let me tell you what I believe is one of the major problems in wholesale financial markets. Regulatory initiatives have gone a long way to increasing transparency of over-the-counter trade vis-à-vis regulators. But for a market to function well there must also be transparency vis-à-vis all market players. Market data that are necessary for a good appreciation of market conditions and for the efficient supply of information, trading and clearing services are not sufficiently available to market participants for many financial products. 

I think it is time we examined the control and dissemination of market data to establish whether there is abusive behaviour on the part of their owners attempting to leverage privileged access to information to foreclose rivals or distort the market. I also intend to discuss the legitimate scope of intellectual property rights claims on such data. 

... Now I would like to move to the third and final part of my presentation and give you a quick update of our current work in competition enforcement. The first two cases I will mention are those against Standard & Poor’s and Thomson Reuters. These two cases involve financial data or market infrastructure that may be important for the operation of markets. 

Our case against Standard & Poor’s regards the distribution of International Securities Identification Numbers developed by ISO, the International Organisation for Standardisation. S&P holds a monopoly position in the assignment of these ISO numbers to new securities issued in the US and in their distribution to the whole financial community. 

European investors have complained that S&P imposes license agreements and demands fees for the usage of the data even if they are downloaded from other vendors, something which is contrary to ISO rules. 

Our concern is that S&P may be abusing its dominant position by charging excessive prices.  

... The case involving Thomson Reuters is about the restrictions the company imposes on the use of Reuters Instrument Codes – or RICs. For example, customers of Thomson Reuters cannot cross reference them with identifiers of other vendors to retrieve data from them. That makes switching to an alternative data feed vendor costly and difficult. We are concerned that the practice could amount to an abuse of dominant position.

... Finally, I would like to talk about two new antitrust investigations into the markets for Credit Default Swaps; which are the first cases we have opened in the market for derivatives. 

The first case involves 16 investment banks and Markit, the leading provider of financial information in the CDS market. We want to find out if the banks are jointly coordinating the control of the information flow on CDS trade to prevent other providers and data vendors from developing competing services. Our preliminary investigations suggest that Markit may receive de facto exclusive information on the transactions and positions of many of these dealers. In addition, Markit’s licence agreements may be restricting the development of the market. 

The second case involves nine large banks – all of them also part of the first investigation – and the agreements they concluded when a company called The Clearing Corporation was sold to Intercontinental Exchange, or ICE. In this operation, the nine banks gave themselves preferential fees and a profit-sharing mechanism which gives them strong incentives to use ICE’s services with a de facto foreclosure effect on other clearing houses. Finally, we are investigating ICE’s fee structure, which may give an unfair advantage to the nine banks and discriminate against other dealers. If confirmed, this could be an abuse of dominant position to the detriment of potentially efficient competitors. 

... Over the past twenty years or so, the financial services sector has become increasingly larger and complex. No one knows this better than you, given that the wider industry accounts for around 14% of Britain’s GDP. Today, overseeing a few investment banks and specialised traders is simply not enough. We need to extend oversight beyond traders and banks to cover infrastructure owners, intermediaries, information services providers and possibly more. 

Competition enforcement and regulation must not saddle the industry with an unnecessary burden and must not stifle innovation. But we must make sure that the market develops in ways that are compatible with long term stability and efficient growth. We need deep and liquid financial markets. We need a system that gives participants all the information they need to fully understand the risks they are taking when they invest in a product and to fully appreciate the price they are paying. Participants need to know who their counterparties are and what their exposures are. Above all, we need to promote a system that participants can trust. 

I will continue to enforce EU competition law against collusion between firms and the undue influence of powerful players. I will also use every opportunity – such as our meeting today – to remind everyone to play by the rules. This is a responsibility that every player in these markets has towards their competitors, their customers, and towards society at large.