Bank of England: crackdown on bankers' bonuses

The Telegraph reports that the Bank of England is preparing a regulatory crackdown on the out of control bonus culture that exists in finance.

Regular readers know that rather than try to stop excessive bonuses through a regulatory crackdown, I prefer to reduce them by requiring ultra transparency.

Ultra transparency is a trader's worst nightmare.  Ultra transparency requires disclosing on an on-going basis current asset, liability and off-balance sheet exposure details.

Traders hate it because it lets market participants trade against them.  This includes piling into and out of trades before the trader has a chance to take a meaningful position or can exit their position.

In case there is any doubt about this, Warren Buffett negotiated with the SEC to keep his trades confidential.

Ultra transparency is also a bank CEO's worst nightmare.  Ultra transparency shines a very bright light on a bank's efforts to increase its earnings (the return in Return on Equity or Return on Assets) by increasing its risk.

With ultra transparency, market participants can assess the risk of the bank and adjust both the amount and price of their exposure to reflect this risk assessment.  As risk goes up, so does the cost of funds to the bank.

Finally, with ultra transparency, there is no need for specific regulations on payments to bankers.  If they can deliver high earnings with verifiably low risk, they should be rewarded with high pay.

The Bank has warned lenders it is considering changes to the way bonuses are measured to make it far harder for big-hitting investment bankers to justify their multi-million pound awards. 

The threat follows the central bank's decision last week to force British lenders to "limit" bonuses this year in order to shore up their balance sheets against the looming eurozone crisis....

The threat of a bonus crackdown was made in the Bank's Financial Stability Report. It said the Financial Policy Committee (FPC), which has the power to set new rules, had "noted that performance metrics, such as return on equity targets, that take little account of the risks taken to achieve them could be distorting incentives". 

It added: "Given the importance the committee attaches to this issue, it agreed to consider it in greater depth at a future meeting. It would consider, among other things, the extent to which such performance metrics influence …remuneration." 

The disclosure appears to be an early warning that reform is coming. 

At least two leading members of the FPC have been campaigning for change for some time, endorsed by the Bank. 

Robert Jenkins, an external member, said earlier this month: "Return on equity is the wrong target. Over the last 10 to 15 years it has helped to make many bankers rich and loyal shareholders poor." 

Although technical, the reform would have far-reaching implications. Return on equity, or RoE, rewards bankers for taking risk that in the recent crisis was ultimately borne by taxpayers. 

Instead, both Andy Haldane, the Bank's executive director of financial stability and a member of the FPC, and Mr Jenkins believe that bonuses should be measured against return on assets, or RoA, which adjusts for risk. 

"While the risks have typically been borne by wider society, the returns have been harvested by bank shareholders and managers," Mr Haldane has said. 

According to his analysis, the effect on bonuses from switching targets would potentially be huge. Between 1989 and 2007, in which time there was "increasing focus on RoE as a performance target", the average pay of the top seven US investment bank bosses rose from $2.8m to $26m. If their performance had been linked to RoA, it would have increased to just $3.4m. 

"Rather than rising [from 100 times] to 500 times median US household income, it would have fallen to around 68 times," Mr Haldane said.... 

According to Mr Haldane: "In effect, RoE is skill multiplied by luck."

Can today's meaningless, easily manipulated bank capital ratios be saved?

With its Financial Stability Report, the Bank of England followed in the footsteps of the Organization for Economic Co-operation and Development (OECD) and showed why today's bank capital ratios are highly manipulated and meaningless.

First, there is the problem with book capital, the numerator in a bank capital ratio.  The amount of reported bank capital is distorted by regulatory forbearance and suspension of mark to market accounting.

In both the Financial Stability Report and a Guardian article, the UK's FSA estimates that bank book capital is overstated by 5 billion pounds based on extend and pretend policies applied to 50 billion pounds of commercial real estate exposures.  This is before we get to similar policies on mortgage loans to individuals.

Suspension of mark to market on sovereign debt and structured finance securities further distorts reported bank book capital.

The bottom line is that today regulatory policy easily manipulates bank book capital and deprives it of any meaning.

Second, there is the problem with how banks calculate their risk-weighted assets, the denominator in the bank capital ratio.  Banks calculated the risk-weights on their assets differently.  The Financial Stability Report suggests that it would not be unusual for a large bank to use over 100 models in calculating its total risk adjusted assets.

In fact, as this blog has previously documented, banks "optimize" their risk-weights to minimize their risk adjusted assets in order to produce the highest capital ratios.

The bottom line is that today banks easily manipulate risk adjusted assets and deprive it of any meaning.

The question is how to restore meaning to bank capital ratios and end the various ways that they can be manipulated?

Regular readers know that the solution is implementing ultra transparency.  By requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, meaning is restored to bank capital ratios.

Ultra transparency directly addresses over-stating bank capital.  Market participants will use the disclosed data to calculate the current market value of the bank's exposures.  They will use the difference between current market value of the bank's exposures and the book value of these exposures to adjust bank book equity.

This adjusted bank book equity is a meaningful number to use in calculating a bank's capital ratio.

Ultra transparency directly addresses under-stating risk adjusted assets.  Market participants will use the disclosed data to independently calculate risk adjusted assets.  Thereby rendering meaningless the bank's efforts to game the risk adjusted asset calculation.

The independently calculated risk adjusted assets is a meaningful number to use in calculating a bank's capital ratio.

Ultra transparency brings meaning back to both the numerator and denominator of the bank's capital ratio and thereby restores meaning to a bank's capital ratio.

Eliot Spitzer on regulatory discretion and Fed's secret loan program

Slate ran a column by Eliot Spitzer, the former NY attorney general and governor, in which he discussed how the government and big banks deceived the public with their $7 trillion loan program.

In a previous post on the secret loan program, I discussed the idea of and role played by regulatory discretion.  I noted that ultra transparency is necessary as it would end the possibility of a secret loan program in the future as well as provide the information the market needs to assess the banks in the aftermath of the distortions to the bank balance sheets caused by regulatory discretion (think extend and pretend).

Mr. Spitzer focuses on the issue of disclosure.  He leaves no doubt that even if the secret loan program did not violate the law (and there is plenty of reason to think that statements made to the public misrepresented what was going on) they violate the spirit of the law.

During the deepest, darkest period of the financial cataclysm, the CEOs of major banks maintained in statements to the public, to the market at large, and to their own shareholders that the banks were in good financial shape, didn’t want to take TARP funds, and that the regulatory framework governing our banking system should not be altered. Trust us, they said. 

Yet, unknown to the public and the Congress, these same banks had been borrowing massive amounts from the government to remain afloat. 

The total numbers are staggering: $7.7 trillion of credit—one-half of the GDP of the entire nation. $460 billion was lent to J.P. Morgan, Bank of America, Citibank, Wells Fargo, Goldman Sachs, and Morgan Stanley alone—without anybody other than a few select officials at the Fed and the Treasury knowing. 

This was perhaps the single most massive allocation of capital from public to private hands in our history, and nobody was told. This was not TARP: This was secret Fed lending. And although it has since been repaid, it is clear why the banks didn’t want us to know about it: They didn’t want to admit the magnitude of their financial distress. 

The banks’ claims of financial stability and solvency appear at a minimum to have been misleading—and may have been worse. Misleading statements and deception of this sort would ordinarily put a small-market player or borrower on the wrong end of a criminal investigation. 

So where are the inquiries into the false statements made by the bank CEOs? And where are the inquiries about the Fed and Treasury officials who stood by silently as bank representatives made claims that were false, misleading, or worse?

All of the representations were also being made by the regulators.  Just look at the borrowing being done at the same time the stress tests were conducted.

Only now, because of superb analysis done by Bloomberg reporters—who litigated against the Fed and the banks for years to get the information—are we getting a full picture of the Fed and Treasury lending. 

The reporters also calculated that recipient banks and other borrowers benefited by approximately $13 billion simply by taking advantage of the “spread” between their cost of capital in these almost interest-free loans and their ability to lend the capital. 

In addition to the secrecy, what is appalling is that these loans were made with no strings attached, no conditions, and no negotiation to achieve any broader public purpose. 

Even if one accepts the notion that the stability of the financial system could not be sacrificed, those who dispensed trillions of dollars to private parties made no apparent effort to impose even minimal obligations to condition the loans on the structural reforms needed to prevent another crisis, made no effort to require that those responsible for creating the crisis be relieved of their jobs, took zero steps towards the genuine mortgage-reform that is so necessary to begin a process of economic renewal. 

The dollars lent were simply a free bridge loan so the banks could push onto others the responsibility for the banks’ own risk-taking. 

If ever there was an event to justify the darkest, most conspiratorial view held by many that the alliance of big money on Wall Street and big government produces nothing but secret deals that profit insiders—this is it. 

So what to do?

Mr. Spitzer, at a minimum banks should be required to provide ultra transparency.  They should be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

With this disclosure, market participants, particularly taxpayers and policymakers, could see if and to what extent the Fed was propping up the financial system.

Regulators as source of financial instability: how Citi sank itself on the Fed's watch

Reuter's carried an interesting column by Nicholas Dunbar on how Citi sank itself on the Fed's watch.

Regular readers know that the regulators' monopoly on all the useful, relevant information on financial institutions is a source of financial instability that needs to be fixed by requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Mr. Dunbar recounts in very vivid fashion what happens when only regulators have access to all the useful, relevant information and the regulators manage not to use this data.

The Federal Reserve may have been at the top of the U.S. regulatory pecking order, but within the Fed itself, the New York branch was top dog when it came to regulating banks. This was hardly surprising given the dual importance of Wall Street as the engine room of the bond markets and as the base for the largest multinational U.S. banks... 

Ever since the regulatory blessing of VAR in the mid-1990s, the New York–based multinational banks had been growing rapidly. By 2003, when William McDonough retired as New York Fed president and was replaced by Timothy Geithner, an ambitious former Treasury and International Monetary Fund bureaucrat, bank supervision was equally important to markets. 

If any U.S. commercial bank needed to be challenged, it was Citigroup. 

In 1999, when then-chief executive Sandy Weill had needed an act of Congress in order to fuse the SEC-regulated Salomon Brothers with Fed- and OCC-regulated blue-chip lender Citibank, he had taken care to reassure his new shareholders and supervisors about the importance of governance. A veteran ex-AIG and Chemical Bank executive, Petros Sabatacakis, was appointed chief risk officer of the new conglomerate and ordered to rein in the freewheeling Salomon traders. Sabatacakis was so tough in applying position limits that on the trading floor he was known as “Dr. No.”... 

The incoming CEO, former general counsel Chuck Prince, may have seemed like a steady pair of hands on the wheel, but it was Prince who undermined the risk governance mechanism that Weill had put in place. Prince allowed Tom Maheras, the head of fixed income, to appoint his own risk managers. Feeling that his independence had been compromised, Sabatacakis quit in 2004 and was replaced by a Maheras crony, David Bushnell, whose first move was to abolish Sabatacakis’s trading book position limits. 

Hidden from public view, this weakening of internal risk governance made it ever more essential that Citi, the largest bank in the United States, was supervised properly. It was essential that the bank’s day-to-day supervisors were not intimidated by the conglomerate and Weill, its charismatic chairman. 

A former senior New York Fed staffer recalls that the OCC seemed particularly cozy with Citigroup: “I remember being in a meeting in Citigroup, and Sandy Weill stopped by. He gave a big hug and a kiss to this lady examiner from the OCC . . . That didn’t give me the feeling of tough supervision.” 

The names of two of the New York Fed’s key bank supervisors— head of bank supervision William Rutledge and head of risk management Brian Peters—appeared on the “written agreement” censuring Citigroup over Enron. Another key figure was Sarah Dahlgren, who from around 2003 onwards was the New York Fed’s chief relationship manager dealing with the conglomerate. Rutledge was widely respected but was also a graying career bureaucrat (he retired at the end of 2010) who defended the status quo of balkanized U.S. bank regulation because he believed it was conducive to financial innovation. In conversations, he was careful and precise about defining what was not his responsibility....  

The Federal Reserve System has a governance mechanism intended to reinforce regulatory best practice. The Federal Reserve Board in Washington, D.C., provides centralized resources and sets standards for bank examiners based at the thirteen regional Federal Reserve Banks. In order to apply this governance, the Board has the authority to obtain information about the banks that were supervised within each region.

The Fed's monopoly on all the useful, relevant information.

Setting the Fed’s centralized standards for market and liquidity risk supervision was the responsibility of a small D.C.-based team of former regional reserve bank examiners.... 

Around 2003, the market and liquidity risk team began trying to collect the trading P&L and VAR data feeds that some of them had seen at regional Fed offices such as Richmond. “We thought that we would pull things together, look for trends, get ahead of systemic risks, and see where crowded trades are,” a member of the team recalls. The most important data would come out of New York: the daily P&L and VAR data for the biggest trading banks, J.P. Morgan and Citigroup.... 

For whatever reason, Peters appeared too busy to talk to the market and liquidity risk team members when they approached him asking for daily trading data feeds from the giant New York banks. They returned to Washington, D.C., empty-handed. 

Although the sources close to the New York Fed insist that the Board had the right to access whatever information it wanted, the market and liquidity risk team remembers things differently. To them, it was as if the New York Fed was on a different planet from its siblings. 

“It wasn’t that they wouldn’t provide information because we hadn’t asked for it,” a member of the team says. “They wouldn’t provide information because they weren’t forced to.” 

Partial access eventually came from a committee on Large Financial Institutions (LFIs) set up in March 2005 in response to complaints from Fed governors that the Board was not getting enough information about regional Fed banking supervision. As a result, the market and liquidity risk team learned that the New York Fed did not receive electronic daily P&L, VAR, or other relevant trading book information from Citigroup. Instead it received three-month-old reports photocopied from originals provided to the OCC.

Even from the untimely trading reports that the New York Fed did receive, the staffers at the Federal Reserve Board became concerned that the New York Fed seemed to lack the expertise—and, just as crucially, the skepticism—to even ask the large banks the right questions. 

The team obtained information indicating that one major New York Fed–supervised bank had lost between $60 and $80 million trading in the nascent market for carbon emission credits. Up to the moment of the loss, the VAR loss estimate for this trading book had been approximately $1 million, on the basis that the bank’s long position in emission credits had been rising steadily by small increments for the previous year. 

Although it was not a substantial or dangerous loss for the bank, this was the type of model methodology weakness that could be indicative of broader problems. Such a weakness could have been picked up by a fulsome trading book or regulatory capital inspection; however, such inspections did not appear to have been undertaken by the New York Fed, despite recommendations from the market and liquidity risk team. 

Questioned about the need for such inspections, New York Fed bank supervisors complained to their Washington, D.C., counterparts about a lack of resources. One person on the market and liquidity risk team vividly remembers a New York Fed bank examiner shrugging off the emission trading losses, arguing, “Don’t worry about that. We just have to respond to these things when they happen. We can’t get ahead of these problems. We don’t have enough people, and the bankers have a lot of smart people.” ...

Meanwhile, the market and liquidity risk team and others in the Federal Reserve Board supervision division had grown concerned that as large banks built up their trading businesses and accounting rules gravitated to fair value measurement, bank balance sheets were increasingly subject to short-term market moves that could lead to rapid falls in regulatory capital. 

A memo produced by the team pointed out the issues and risks involved in increased use of fair value and warned that a sudden freeze in certain markets might imperil bank solvency. But when the market and liquidity risk team tried to interest Dahlgren in their findings, she retorted, “I think our banks know how to manage to fair value,” ending the discussion....

In the five years that the market and liquidity risk team struggled to improve the New York Fed’s supervision of Citigroup, the conglomerate added almost a trillion dollars to its balance sheet—visibly and “invisibly.” 

While sources close to the New York Fed might dispute the words and actions that the market and liquidity risk team attributes to its staff, they are curiously silent about its failings as a supervisor— failings that ultimately would hit U.S. taxpayers. 

One of the sad ironies is that even the twenty priorities for Citigroup that Peters cut to the bone did not include the biggest problem of all: the way Citi was building up a $43 billion super-senior CDO exposure on its trading book. Both the New York Fed and its watchdogs in Washington, D.C., failed to spot a fundamental breach of the thin blue line they created: recording the super-senior CDOs as trading exposure and interrogating the bank’s VAR model. 

A senior Federal Reserve Board official who is still angry about that screwup says, “They didn’t put them in their VAR. And that is a complete violation of all the rules. I mean this is just basic. You do not need to be a quant to catch this. They were supposed to be mark to market. But the attitude seemed to be, ‘Why bother? They don’t change in value. They’re AAA.’ They didn’t put them in the VAR. You can stress-test your heart out. If it’s not in the VAR, you’re not going to get anything on it.”

EU bank write-down plan said to exclude forcing losses on pre-2013 debt

There are a number of issues that must be addressed to transition from the current model of governments' guarantee all investments in banks from solvency risk to a model where investors are responsible for bank solvency risk.

A Bloomberg article looked at a proposal by the European Union for how this might be accomplished.

Regular readers know that so long as financial regulators continue to perform and publish the results of stress tests, governments have a moral obligation to bailout investors for any solvency related losses.

The most recent example of this was Dexia Bank passing the European stress tests earlier this year and now having to be nationalized by the French and Belgium governments.

This blog has long said that the only way to make investors take on the responsibility for bank solvency risk is by requiring the banks to provide ultra transparency.  By disclosing each bank's current asset, liability and off-balance sheet exposure details, market participants can assess the risk of each bank.

With the ability to assess the risk of an investment in a bank comes the responsibility for accepting all gains and losses on that investment.

This blog has said that the way to manage the transition is for governments to continue to guarantee all investors from solvency risk until a bank has been providing market participants with ultra transparency for 6 months.

After this time, market participants will have been able to assess the risk of the bank and should be held responsible for all gains or losses.  This will apply to all new securities issued by the bank after the 6 month mark.

The European Union may exempt bank debt issued before 2013 from proposals forcing investors to take losses at failing lenders, said a person familiar with the plan.... Michel Barnier, the EU’s financial services chief, has promised to propose draft rules to end the need for taxpayer bailouts of failing banks. ... 

“From a funding point of view it brings two words to mind -- cliff effect,” Bob Penn, financial regulation partner at Allen & Overy LLP, said in a telephone interview in London today. 

“There’ll be swathes of bank-funding issuance and then it will fall off a cliff” when the so-called bail-in rules are implemented. 

Under draft proposals obtained by Bloomberg News, holders of long-term unsecured senior debt in a collapsing bank would be first in line to take losses once a lender’s capital and other subordinated debt is exhausted. Long-term bonds would be those with a maturity of more than one year....

Short-term debt, with a less than one-year maturity, and derivatives should only be written down by regulators as a last resort if losses from longer-term debt aren’t “sufficient to restore the capital of the institution and enable it to operate as a going concern,” according to the draft. 

“Exempting short-term debt and derivatives may be justifiable, but this would increase the use of systemically risky derivatives and excessive levels of short-term debt that contributed to the ongoing crisis,” said Sony Kapoor, managing director of policy advisory firm Re-Define. 

Taxing them “may help alleviate some of these distortions.” 

Regulators would also have the power to forcibly convert a bank’s bonds into ordinary shares, according to the draft. 

Authorities could intervene to impose losses if a bank was “likely, in the near future,” to breach its minimum required capital levels, or be unable to meet its obligations to creditors, according to the EU document. 

There is a “growing acceptance on the part of regulators” that the wind-down plans “have to be implemented in a way which does not overly conflict with the ability of financial institutions to refinance themselves in the near-term,” Richard Reid, research director for the International Centre for Financial Regulation, said in an e-mail.... 

Efforts amid the debt crisis to force investors to share in bailout costs have roiled markets and sparked disputes among policy makers. 

Last week, German Finance Minister Wolfgang Schaeuble suggested European governments may ease provisions in a planned permanent rescue fund requiring bondholders to share losses in sovereign bailouts. 

Other parts of the commission plans include giving regulators the power to force healthy banks to sell off parts of their business so that they could be wound up in a crisis. This process is known as bank “resolution.” 

“We need to put resolution regimes in place for every type of institution,” Paul Tucker, deputy governor of the Bank of England, told reporters at a Financial Policy Committee press conference in London today.... 

EU leaders last month agreed to offer their banks temporary guarantees on their debt issuance as part of a package of measures to restore confidence in lenders. 

Finance ministers agreed yesterday to coordinate the national guarantee programs, while rejecting proposals to pool them.

Germany remains oblivious to apocalyptic warnings

In his Telegraph column on Germany's apparent obliviousness to what is going on, Jeremy Warner touches on a number of issues that have been discussed on this blog.

The intent of this post is to use his column to provide readers with an overview of how these issues are interconnected.

Regrettably, [the Bank of England's Mervyn King is] only telling it as it is. We stand on the brink, apparently incapable of pulling back. 

Events on the Continent have come to feel much like the drift into war. There is a feeling of powerless inevitability about it ....

Europe is already back in the midst of a credit crunch, with its banks largely frozen out of wholesale funding; eurozone banks have become so risk averse that they prefer to lodge their excess liquidity with the European Central Bank than lend to each other. Across the Continent, banks are shrinking their credit. 

The wholesale funding freeze results from the fact that no bank can determine if the borrower is solvent or not.  This point was driven home when Dexia passed the European bank stress tests and then had to be nationalized a couple of months later.

The credit crunch was triggered by the financial regulators insisting that the banks meet a 9% Tier I capital ratio.

How close are UK banks to being similarly engulfed? Sir Mervyn trod a fine line at his press conference on Thursday between warning banks to prepare for the worst on the one hand, and on the other trying to play down fears of a renewed funding crisis. 

For now, the UK banking system is mercifully not quite as stressed as its European counterparts. Thanks to earlier Government bailouts and other sources of new equity, UK banks remain relatively well capitalised. They have also already financed themselves with term lending through to the end of this year, so they don't face the same immediate threat from the funding drought. 

Yet they surely cannot remain immune for much longer. Thursday's Financial Stability Report from the Bank of England warns that issuance of term funding has been very weak since May. 

Worryingly, UK banks have £140bn of it due to mature in 2012, with most of that concentrated in the first half of the year. If the Bank of England fails to provide alternative liquidity, UK banks will soon be struggling.

A condition that could be easily avoided if the banks provided ultra transparency.  By disclosing on an on-going basis their current assets, liability and off-balance sheet exposure details, UK banks would be providing market participants with the data they need to independently assess the solvency of the UK banks.

When market participants are comfortable with a bank's solvency, it is easier to raise funds.

In addition, the UK banks would be expanding the pool of collateral they have to pledge.  With market participants valuing their loan portfolios, UK banks could, in theory, pledge whole loan portfolios as collateral to the Bank of England.  The use of whole loan portfolios would take the pressure off of using government securities as central bank collateral.  This would ease funding in the repo markets.

According to Sir Mervyn, the antidote is more capital. The greater the bank's capital reserves, the more confident markets can be that their money is safe and the easier it therefore is for banks to fund themselves. 

Regrettably, it is quite difficult to see where this capital is gong to come from. 

Private investors? Forget it. As things stand, virtually all European banks are regarded as essentially "uninvestible". 

This would change if there was ultra transparency as investors would be able to independently assess the risk of an investment in the bank.

Governments then? Again, forget it. They are all out of money.

Governments should never have invested in banks in the first place.

Banker bonuses? That's the source that Sir Mervyn seems to have set his heart on. Yet despite the obvious political appeal, it is also unrealistic. The bonus pool is too small to make much of an immediate impact on capital....

So long as a bank has less than the Admati-Miles Capital Ratio (the value of book equity to risk weighted assets equals 20%), bonuses should be paid in stock.  A little capital issuance being better than none.

In any event, the Governor's call for increased capital buffers is somewhat at odds with the Government's parallel aim of increased lending. 

Where the capital buffer cannot be improved by raising more capital, it tends to get done instead by shrinking the lending book....

As previously stated, calling for increased capital buffers triggered the credit crunch in the Eurozone.

One of the benefits of ultra transparency is that it can also be applied to structured finance securities.  In the same way that ultra transparency allows banks to be valued, it also allows structured finance securities to be valued by secondary market participants.

With demand for securities in the secondary market, the structured finance market will reopen and banks can both continue to originate loans which they subsequently distribute and increase their capital buffers.

It's obviously right that financial regulators urge banks to prepare for the worst; it would indeed be somewhat surprising if they needed to be prompted....

Ultra transparency allows all market participants, including the banks, to prepare for the worst.

With ultra transparency, each market participant is responsible for all gains and losses on its investment exposures.  As a result, market participants will adjust the amount and pricing of their exposures to reflect the risk of the investment.  Particularly the risk that they might lose 100% of their investment.

When someone borrows far more than they can ever repay, ultimately the creditor always takes a haircut. Essentially, that's what the eurozone crisis is about. The debtors are already insolvent, and the creditors find their own solvency threatened by the insolvency of their debtors. 

With ultra transparency, market discipline forces the creditors to take a haircut.  After all, market participants know what exposures the creditors have and the market participants are capable of valuing these exposures.

Ultra transparency forces banks to act as a safety valve between the excesses of the financial market place and the real economy.  It is the bank capital account that absorbs the losses on the excesses rather than the real economy.


Market participants know that a bank with negative book equity can operate indefinitely so long as depositors think the deposit guarantee is good and that central banks will lend against good collateral.

Should a bank have negative book equity, ultra transparency is needed so that market discipline can prevent the bank from trying to gamble on redemption as it rebuilds its book equity.

Where is extra capital going to come from for UK or European banks?

The Bank of England's financial policy committee thinks that now would be a good time for banks to raise additional capital.

Setting aside my reservations about bank capital, where exactly is this capital going to come from?

As the Bank of England's Andy Haldane has said, banks are 'black boxes'.

Who is going to invest in a black box where they cannot assess the risk of the investment?

Since the beginning of the solvency crisis on August 9, 2007, I have been saying that in order to restore confidence, opacity must be eliminated throughout the financial system.

One place where there is considerable opacity is the black box that represents a bank.  To shine light into this box requires that the bank discloses its current asset, liability and off-balance sheet exposure details.

Without this data, it is simply impossible to assess the risk of a bank as the bank's exposures can and do change rapidly in today's financial markets.

Regulators confirm this fact every day by having bank examiners on-site at the largest financial institutions.

Nils Pratley has an interesting article in the Guardian focused on the question of where the capital is going to come from.

Alarm bells are ringing at full blast in Threadneedle Street. The current environment is "exceptionally threatening," says Sir Mervyn King. The spiral of decline - falling confidence, lower asset prices, tighter credit conditions, damage to the economy - is "characteristic of a systemic crisis." 

But what should banks do? On this score, the governor of the Bank of England offered only a broad description. The gist was: whatever it takes. 

The banks actually know that ultra transparency is required.  Notice how SocGen, BNP Paribas and Jefferies turned to it briefly when faced with bank runs.

So banks should raise their capital levels to preserve confidence and maintain lending capacity.

But how much capital is required? "There is no simple answer," said Sir Mervyn. In other words: just keeping jumping and don't stop to ask 'how high?'  

This advice comes with the usual qualification about the dangers of deleveraging: don't make matters worse by stopping lending to the economy. That implies cuts to bonuses and, possibly, straightforward capital-raisings since the Financial Policy Committee thinks bank boards should "give serious consideration to raising external capital in coming months." 

But how is the latter going to work? Take Royal Bank of Scotland, already 83% owned by the state. If wholesale funding markets become fully frozen (and ice has been forming since the spring), where should the bank turn? Are taxpayers meant to subscribe for a rights issue? Are we meant to nationalise RBS all over again? Is that where we are? 

It's not the governor's job to delve into specific mechanics of capital raisings - and, in theory at least, there are many sources of new capital before the buck lands on shareholders' laps. But the problem looks acute since, for three out of four UK banks, capital levels (as opposed to capital ratios, which can be improved by deleveraging) have been going down or sideways over the past year. 

And it gets worse. Hope is fading that a strong recovery in profits could raise capital levels. 

 "The outlook for UK banks' profits has deteriorated since the previous report [in June], particularly since the start of October, which would limit banks' ability to build capital without taking other actions," says the report. ... 

Two other points flow from the above. More capital implies lower returns on capital if other factors remain the same. So bank shareholders should probably prepare to kiss goodbye to the sunny thought that double-digit returns can be earned within a year or two. Most investors had already worked this out for themselves; it's only the bank managements that are clinging to the idea that 13% is in sight. 

But, since the banks may wish to cling to the hope that capital-raisings can be avoided, the Bank and Financial Services Authority may face a big battle to get their way on capital levels. 

Second, remember that the UK is not at the heart of this "exceptionally threatening" environment. The eye of the storm is the eurozone. And if UK banks need more capital, imagine the demands on eurozone lenders.

Shortage of collateral in Europe

One way to solve the shortage of collateral in Europe is by requiring the banks to provide ultra transparency.

By disclosing on an on-going basis their current asset, liability and off-balance sheet exposures, banks allow market participants to price their loans and investments.

Central banks can then lend against the bank's whole loan portfolio since the central bank can now look to an independent market value for the portfolio.

This frees the banks up to lend other assets into the repurchase funding markets.

Bank of England's Mervyn King on solvency crisis

This post contains excerpts from Sir Mervyn King's discussion of the current state of the global financial markets.

From a Guardian live blog of the discussion,

Even by his usual standards, Sir Mervyn King is in gloomy mood. On the issue of yesterday's liquidity push by the Bank and five other central banks, the governor explained that it would only bring temporary relief. 

King addresses the key issue about this crisis: "It is not a liquidity crisis, it is a solvency crisis."...

 "Funding follows the absence of concerns about solvency".

This is a point that your humble blogger has been focused on since the beginning of the solvency crisis on August 9, 2007.

There is only one way to end a solvency crisis:  require every bank to provide ultra transparency on an on-going basis.  Ultra transparency involves each bank disclosing its current asset, liability and off-balance sheet exposure details.

It is only with this data that market participants, including competitors, can independently assess the solvency of each bank.  It is only with this independent assessment that market participants can adjust both the amount and price of their exposure to reflect the risk of each bank.

Until this independent assessment can be done, the solvency crisis will persist throughout the global financial system as no market participant can be sure they have properly adjusted their exposure to any bank.

For those regulators who disagree with Sir Mervyn King and your humble blogger and see this as a liquidity crisis and not a solvency crisis, the market has spoken as shown by the fact that banks are refusing to lend in the interbank market due to solvency concerns.

From a Guardian article,

Sir Mervyn King, governor of the Bank of England, insisted that UK banks were well-capitalised but - with the storm in the eurozone escalating - it was "sensible" to improve their resilience.

As Dexia showed, high capital ratios are not synonymous with solvency.

King warned that "an erosion of confidence" was damaging economic activity, creating "a spiral characteristic of a systemic crisis."

The solvency crisis has always been systemic.  The opacity in the financial system has steadily eroded confidence.

After all, why would regulators not require ultra transparency?  Do they have something to hide?

This blog has noted repeatedly that insolvent banks can operate for years so long as their depositors believe that the guarantee on their deposits will hold and central banks will continue to lend against good collateral.  Given these facts, the regulators' failure to require ultra transparency is a clear indication of something to hide and a driver in the loss of confidence.

Central bankers buy time, but will it be used to implement a simple solution to the global solvency crisis

Gee, we appear to have turned back to 2008 when the question was:  which banks are solvent and which are not?  

Now, as then, the answer is to provide ultra transparency so the market can figure it out.  Ultra transparency for banks is to require them to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Then divide the insolvent banks into two categories:  those with a franchise where they can eventually earn their way back to solvency and those who cannot.

It actually is a simple solution because it recognizes that insolvent banks can operate for years so long as their deposits are guaranteed and the central bank is willing to lend against good collateral.

One of the benefits of ultra transparency is that it naturally expands the pool of good collateral that can be pledged to a central bank to include everything on a bank's balance sheet.  By definition, the market prices all the assets (including loans and securities) on the balance sheet and the central bank can lend against these market values.

In Europe, there is the sovereign debt issue that raises doubts about the deposit guarantees.  This can be solved by having the European Financial Stability Fund (EFSF) act as a backstop to the sovereigns.

Ultra transparency on an on-going basis is needed so that insolvent banks do not gamble on redemption (a lesson we learned from the US Savings and Loan crisis).

Ultra transparency also forces the issue of dealing with the troubled assets.  Market participants know and have applied a discount to the trouble assets.  As a result, banks can write them down to levels where the borrower can afford to service the debt obligation.

Finally, writing down the troubled assets to levels the borrower can afford also ends the Eurozone sovereign crisis.  By definition, the sovereigns will be able to afford the written down debt level.

The issue the sovereign will face moving forward is trying to access the capital markets for increased funding (as opposed to rolling over their existing debt).  To the extent that the sovereign wants to raise additional debt, it will have to adopt policies that show it is capable of repaying the new debt.

This simple solution has many advantages including:  

• It relies on market discipline.  No one is going to force an investor to buy the new sovereign debt, so the sovereign really is going to have to adopt policies that show it can service any increases in its debt level;

• It does not require other countries to backstop the sovereign or oversee the sovereign to be sure it is adhering to budgetary restraints.  The market does this instead.