Iceland takes on Too Big to Fail

Bloomberg reports that Iceland is in the process of taking on the Too Big to Fail banks.

Regular readers will recall that Iceland put its society ahead of banker bonuses and adopted the Swedish model for handling a bank solvency led financial crisis at the beginning of the crisis.

Having saved society and recovered its investment grade bond rating, Iceland is now taking the next step in banking reform by forcing its banks to separate their investment banking and commercial banking businesses.

The last step in insuring that the bankers don't take excessive risk again is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off balance sheet exposure details.

With this data, market participants, including regulators, can exert discipline on the banks and restrain their risk taking and proprietary betting.

Iceland was brought to the brink of bankruptcy when its biggest banks failed four years ago. Now, the site of the world’s most spectacular financial collapse is becoming a pioneer in banking reform. 

“We’ve been burned by this and that’s why we have to look very closely at what we need to do to prevent it happening again,” Economy MinisterSteingrimur J. Sigfusson said in an interview. “Icelanders are more interested in taking greater steps than small steps when it comes to regulating banking.” 

His party, the junior member in Prime Minister Johanna Sigurdardottir’s coalition, has submitted a motion to parliament to stop banks using state-backed deposits to finance risky investments. ... 

The Icelandic lawmaker who presented the motion, Alfheidur Ingadottir, says the best way to stop banks creating asset bubbles is to pass laws akin to the 1933 Glass-Steagall Act, which separated commercial and investment banking in the U.S. for more than six decades.

The law would force Arion Bank hf, Landsbankinn hf and Islandsbanki hf -- state-engineered successors to the banks that failed -- to break up their operations. Investment banking now makes up less than 5 percent of business at the banks, whose deposits are backed by the Icelandic state. Before the crisis, the ratio was as high as 33 percent at Iceland’s biggest lender, said David Stefansson, an economist at Arion. 

Sigfusson, whose ministry oversees the financial industry, wants a “partial, or even complete, separation of commercial and investment banking,” he said. “It’s a way to prevent the riskier parts of banking being mixed with regular day-to-day banking and shouldered by regular customers or taxpayers,” he said. 

The government has found support inside Iceland’s banking industry. The head of the island’s biggest investment bank says breaking up financial conglomerates is the most effective crisis prevention tool and one that would have prevented the nation’s meltdown.

“Giving banks too much of a free ride with deposits -- money they don’t need to repay if something goes wrong -- isn’t such a great idea,”Straumur Investment Bank hf Chief Executive Officer Petur Einarsson said in an interview. 

Einarsson says Europe should look to Iceland to get a sense of how much damage an overgrown banking system can wreak. 

“Europe is today feeling the pain of the same disease Iceland caught in 2008,” he said. 

“The changes that need to be made should benefit the depositors and businesses served by these financial institutions, rather than the institutions themselves.”...

Unfortunately, the EU, UK and US chose the Japanese model for handling a bank solvency led financial crisis.  Under this model, policies are designed to benefit the banks rather than society.

The financial regulator also missed the red flags. Iceland’s three biggest banks all had capital adequacy ratios of more than 10 percent of their risk-weighted assets as of the end of June 2008, the Financial Supervisory Authority said in August the same year. All three lenders passed FSA stress tests in a report published two months before they failed....

Your humble blogger continues to say that ultra transparency is needed so that market participants do not have to depend on the financial regulators to spot problems.  With ultra transparency, market participants can independently assess the banks for themselves.

Now, the government wants to ensure that the new banks are never again allowed to grow big enough to wreak such havoc. Preventing financial conglomerates from dwarfing the economy is key, according to Ingadottir. 

“Running a commercial bank isn’t really compatible with running an investment bank, especially in regards to financial risk management,” she said in an interview. 

Iceland’s economic reforms since the end of 2008 have so far proven successful. The economy will outgrow the euro area this year and next, the International Monetary Fund estimates. Iceland’s krona has appreciated 14 percent against the euro since the end of March, making it the best-performing emerging- market currency in the period. The krona was little changed today at 147.67 per euro....

Confirming the success of adopting the Swedish model for handling a bank solvency led financial crisis.

Corners of Iceland’s bank industry remain apprehensive about a split. 

The nation’s Financial Services Association and the bank regulator say any overhaul should only take place after an analysis of the benefits and drawbacks....

The worst outcome of the global financial crisis would be if policy makers and regulators fail to fix the mistakes of the past, according to Einarsson. 

“If commercial and investment banking aren’t separated now, we might have to wait a long while before such an opportunity presents itself again,” he said. “This is going to be one of the defining issues of the coming years.”

Even in Iceland, the Financial-Academic-Regulatory Complex fights banking reform.

Bloomberg LP proposes alternative to 'fix' Libor

In his Wall Street Journal column, Daniel Doctoroff, CEO and president of Bloomberg, LP offers his alternative for fixing Libor given the fact that the interbank lending market is frozen.  He suggests a complicated one-off solution.

One potential solution to this problem is to combine two types of inputs to compensate for the diminished volume in loans available for bank reference. The first input would follow the current Libor approach. The interbank borrowing rate—the numbers they submit—will be transparent. That is, if bank X says it borrowed at rate Y, that submission to Bloomberg would be public. 

The second, supplemental inputs would consist of market-based quotes for credit default swap transactions, corporate bonds, commercial paper and other sources of credit information. Analysis of these sources of information would yield an "indicative" Blibor index.

Why go for the complex when there is a simple solution for increasing the volume of interbank loans:  ultra transparency?

With ultra transparency, banks disclose on an ongoing basis their current global asset, liability and off balance sheet exposure details.

With this information, banks with funds to lends can independently assess the risk of the banks looking to borrow and transactions that are priced to reflect the true risk of each bank can take place.  [Imagine the impact of ultra transparency on all the other sources of credit information.]

As a result, Libor can be based on what it truly costs banks to borrow on an unsecured basis (what Libor was intended to represent from Day 1).

Central banks can't save the world; but they can cause unlimited damage

It is only fitting that in a week where the Bank of England's Andy Haldane admitted that economists share blame for the financial crisis and the ongoing recession:

• Pimco's Mohamed El-Arian should point out that central banks, which are led by economists, can't save the world; and

• Ros Altmann should point out that the pursuit of zero interest rate policies and quantitative easing has set off a 'death spiral' for pension funds and the real economy by diverting funds needed for growth to paying for pension obligations.

Regular readers know that Walter Bagehot, the man who literally wrote the book, Lombard Street, on central banking, observed in the 1870s that the lower limit for interest rates that was consistent with functioning financial markets and by extension the real economy was 2%.

Regular readers also know that Japan has confirmed the accuracy of this observation by pursuing zero interest rate policies and quantitative easing with a result of over 2 'lost' decades when it comes to meaningful economic growth.

However, the current generation of economists, particularly those in academia and that run the central banks in the EU, Japan, UK and US, are true believers in what Mr. Haldane refers to as a "theological doctrine".  

They justify and pursue policies based on their belief that the assumptions underlying their economic models are facts.  In reality, these assumptions are not facts.  Something that Walter Bagehot pointed out in the 1870s.

The result of pursuing policies based on flawed assumptions has been an unmitigated disaster.

Your humble blogger is an optimist and believes that it is still not too late to save the global economy.  However, doing so will require more than economists admitting they are wrong.

Doing so will require that economists, particularly central bankers, stop pursuing policies that are crushing the real economy.  This shouldn't be too difficult to do.  

They can start by following Walter Bagehot's advice and raising interest rates back to 2%.

At the same time, the Bank of England, ECB and the Fed can require banks to provide ultra transparency and disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.  

The central banks have the power to do this by simply making it a requirement for any bank to have access to central bank funding.  This is a reasonable requirement because the market will value all of the assets on and off a bank's balance sheet and the central banks only want to lend against assets where the value is well known.

Pensions (and real economy) face "death spiral"

Pensions face a 'death spiral' as a result of quantitative easing and zero interest rate policies says Ros Altmann in a Telegraph article.

Regular readers are not surprised by this conclusion as your humble blogger has been talking about the unintended consequences of central bank policies that create headwinds that undo any benefit that can be achieved from extraordinarily low interest rates.

The Bank of England's policy of quantitative easing has done "irreparable damage" to Britain's final salary pension schemes, a leading economist has said.... 

its policy of forcing down long-term interest rates has caused huge problems for the pension schemes of many firms, according to Ros Altmann of Saga, the over-50s' group. 

Pension deficits at FTSE 100 firms have more than doubled in the last year alone, despite companies pumping millions into their schemes to repair their pension shortfalls, Ms Altmann said. 

"This is turning into a 'death spiral'," she added. "The lower gilt yields fall, the worse pension deficits become. The worse pension deficits become, the more trustees will feel they need to 'de-risk'. This often means buying more gilts which itself means worse deficits because trustees are competing with the Bank of England, which is also trying to buy gilts due to QE."... 

"Firms are left trying to find more money to plug pension deficits, causing funds to be diverted from creating jobs and expanding operations. 

Worryingly too, companies trying to borrow money to expand, or to meet a pension recovery plan, are finding the banks increasingly unwilling to lend because of the pension deficit." 

This vicious circle must not be allowed to continue. Artificially inflating pension deficits is hampering economic recovery.

Please re-read the highlighted text as she describes a death spiral in which funds that could be used to grow the economy are instead fed into the pension funds and from there into government debt securities.

Bottom line:  central banks are making the problem of excess debt in the financial system worse by contributing to the diversion of funds that are needed for growth in the real economy.

Will Sweden adopt ultra transparency as part of overhaul of Swedish Libor?

Reuters reports that Swedish banks and regulators are looking at overhauling the Stockholm Interbank Offered Rate (Stibor, the Swedish Libor) by basing it off of actual transactions.  However, they are not limiting themselves to just disclosure of actual transactions, but are looking at what else they can do to ensure that the interbank lending market is remains unfrozen.

Unfreezing and keeping unfrozen the interbank lending market requires that banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this detail information, lending banks can independently assess the current risk of borrowing banks.  This ability to independently assess risk unfreezes the interbank lending market and keeps it unfrozen.

Sweden is scurrying for ways to boost the credibility of its interbank lending rate, a benchmark linked to some $6 trillion in financial contracts, following a storm over potential rate rigging around the globe. 

The five contributing banks are to meet at the end of August to hammer out ways to improve the way the daily Stockholm Interbank Offered Rate (Stibor) is set in the wake of the scandal over Libor, the London equivalent. 

Sweden's central bank is working on its own review, due in the fall. 

"The most important thing for our industry is that Stibor has transparency and is 100 percent trustworthy," said Rikard Josefson, chief executive at Lansforsakringar Bank, part of a pensions and insurance firm which uses the rates in many of its contracts but is not on the rate-setting panel.

The only way to achieve this is if the banks provide ultra transparency. That way the market can verify the trades included in the calculation of the interest rate.

Unlike Libor, .... banks set the rate by saying what they are willing to lend at, not the level at which they think they could borrow, meaning there is less incentive to cheat. 

However, critics say the way it is set also lacks transparency and can be improved....

One idea touted by banks is to ensure the rates are backed by actual interbank deals, something not required today. 

British authorities are also looking into the feasibility of using actual trades for Libor rather than offered rates. 

"It would be good to show there are real transactions behind the reference rate," Peter Hagberg, head of treasury at SEB , told Reuters. 

"The credibility would come if you could just find from time to time, documented transactions taking place among banks."

This is an argument for transparency.

Jan-Peter Larsson, Global Head of Trading at Danske Markets , agreed that basing the rate on real underlying transactions would help increase confidence. 

The problem, however, is that since the 2008 financial crisis, interbank lending has been thin not just in Sweden but around the world, meaning credibility might improve only marginally....

Ultra transparency is needed to address the problem that the interbank lending market is thin to frozen.

So the question is, will Sweden lead the way with requiring ultra transparency?

One in twelve UK companies are 'stuck in debt trap'

The Telegraph reports that according to R3, the insolvency trade body, one in twelve UK companies are 'zombie businesses' that are servicing their debt, but cannot grow.

There is no reason to believe that similar figures do not exist in both the EU and US.

R3, the insolvency trade body, warned that 8pc of businesses are stuck in corporate limbo, only able to pay the interest on their debts, but not reduce the debt itself. 

The group, which based the figure on its latest “business distress index” survey, said this could equate to as many as 146,000 zombie companies in the UK. 

Its quarterly research also found that 8pc of businesses said they would be unable to service their debts if interest rates rose. 

Lee Manning, R3’s president, said: “The implication here is that these businesses have been 'running on empty’ for quite some time now and with no reserves left in the tank, they may not be able to carry on for much longer. 

Please re-read the highlighted text.

As regular readers know, policymakers and financial regulators have been pursuing the Japanese model for handling a bank solvency crisis.  Under the Japanese model, bank book capital is protected at all costs.

This means that policies like regulatory forbearance are adopted and rather than recognize their losses, banks engage in extend and pretend on loans to 'zombie borrowers'.

Here is the evidence of how extensive this extend and pretend practice is.

“The danger for businesses that are teetering on the edge is that any change of circumstances, such as a rise in interest rates, the loss of a major customer, or suppliers upping their prices, will mean that they will not be able to hang on any longer.” 

The real problem is that these companies currently exist solely to pay interest.  As a result, they engage in different behavior than would a company that is trying to generate earnings for its equity holders.

In addition, since they are kept alive in interest paying mode, the assets that they control cannot be redistributed so that they can be used to support economic growth.

The retail and construction sectors were most likely to have zombie businesses, the research found.

US Treasury may let investors pay it for holding their money

As reported by Reuters, the US Treasury is working out the mechanics for how investors can pay it for holding their money (also known as selling US Treasury securities with negative yields).

Regular readers know that as long as the EU, UK and US pursue the Japanese model for handling a bank solvency led financial crisis, investors will be more concerned with the return of rather than the return on their money.

One way investors demonstrate this is by paying off their debts (deleveraging).

With central banks pursuing zero interest rate and quantitative easing policies that artificially depress the yield curve, investors look to their own debt as a source of risk free return.  The way to capture this risk free return is by paying off their debt.

Unfortunately, with investors paying off their debts, there is less capital available to be invested in growing the economy.

Another way investors demonstrate they are more concerned with the return of their money is by buying government securities with a negative yield.  Investors are willing to pay a little money so as to avoid any risk that their money will not be returned.

The Treasury is working on allowing investors to bid on securities that offer negative interest rates, another sign that officials expect borrowing costs to stay very low for a long time.... 

While no decisions has yet been made on negative-rate bids, the Treasury is encouraging market participants to report any operational concerns they might have with Treasury bill auctions that settle at negative rates. 

Negative rates effectively mean investors are paying the government to lend it money, presumably due to concerns about potential losses in riskier assets....

Germany and France have experienced negative yields recently as panic about southern European states drove investors into the relative safety of the continent's two largest economies. 

The Treasury's move could bolster concerns that the United States and Europe may be heading for a Japan-style period of sputtering economic growth and very low if not negative inflation rates.

The Federal Reserve has already indicated it expects to leave official rates near zero until at least late 2014, and some analysts think it could push that date further into the future at a two-day meeting that ends this afternoon.

Regular readers are not concerned that we are headed into a Japanese 'lost decade' economy.  They know we are.  Your humble blogger has been saying that this is a direct consequence of adopting the Japanese model for handling a bank solvency led financial crisis.

Our policy makers and central bankers made an explicit choice to have no economic growth versus to have an expanding economy.

Why Ben Bernanke and the rest of the economists at the Fed think that having no economic growth and saving banker bonuses is more important than having a growing economy that protects society remains a mystery to me?

ECB demonstrates that central banks don't have the tools to solve bank solvency problem

A week after promising to deliver a solution that would solve the Eurozone financial crisis, the Wall Street Journal reports that ECB President Mario Draghi announced that maybe the ECB would resume buying sovereign debt in the secondary market.

This has been tried before without success and there is no reason to believe that it will be successful now.

Typically, when you make a promise and then break the promise your credibility goes down.  There is no reason to expect that will not happen with the ECB and Mr. Draghi.

What you humble blogger has not understood since the beginning of the financial crisis is why we continue to use monetary policy tools that are designed to fight a liquidity crisis to fight a bank solvency led financial crisis?

The tool you fight a bank solvency crisis with in a modern banking system that has deposit guarantees and access to central bank funding is transparency.

By requiring the banks to disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details, banks step up and recognize all of their on and off balance sheet losses.

This in turn takes the burden of the excess debt in the financial system off of both the state and the real economy.  As a result, rather than direct funds to debt repayment, the funds are instead directed towards economic growth.

This economic growth in turns creates new loan demand that helps the banks generate the earnings necessary to rebuild their book capital levels.

JOBS Act: 'scandal waiting to happen'

Reuters reports that investor advocates are meeting with the US Treasury to try to minimize the damage to the financial system that will occur as a result of the JOBS Act and its explicit elimination of disclosure requirements.

Regular readers will recall that the JOBS Act turns back disclosure requirements to the 1920s when there were none.  The Act is yet another effort by the Obama Administration at destabilizing the financial system and giving Wall Street anything it asks for.

Advocates for investors will meet with U.S. Treasury Department officials and others on Wednesday to express concerns about a new law that makes it easier for smaller companies to raise capital, people familiar with the matter said. 

The Jumpstart Our Business Startups law, or JOBS Act, won overwhelming bipartisan support from Congress in March. 

But critics of the legislation have said it goes too far in scaling back important protections for investors....

Investor protections that are necessary if we are to have deep, liquid, vibrant capital markets.

The new law reduces certain regulatory requirements for companies with less than $1 billion in revenue seeking to go public, raises the number of shareholders that trigger public financial reporting and lifts a long-time ban on advertising for private offerings.

Basically, the new law repeals the Securities Acts of the 1930s for companies with less than $1 billion in revenue.

Before the bill's passage, SEC Chairman Mary Schapiro and SEC Commissioner Luis Aguilar both called for major changes to the legislation, most of which were not adopted before President Obama signed the measure into law. 

A majority of bankers also agreed in a recent survey that the law could open the floodgates for accounting problems. 

Earlier this week, as the Sarbanes-Oxley law celebrated its 10-year anniversary, former Senator Paul Sarbanes said the JOBS Act's lax regulatory scheme for IPOs below $1 billion in revenue is a "scandal waiting to happen."

A scandal waiting to happen?  No wonder it passed with overwhelming support in Congress and was signed by President Obama.

Recapitalizing banks without first determining precise losses is waste of money

Reuters reports that 'recapitalizing the Spanish banks without first determining precise losses' could be a waste of money.

Regular readers know that a modern banking system is designed so that it does not need governments to bailout the banks.

With deposit guarantees and access to central bank funding, banks can operate and support the real economy for years while they have negative book capital levels.  As a result, bailouts are unnecessary as banks can rebuild book capital levels through retention of 100% of future pre-banker bonus earnings.

However, the idea that the losses the banks are currently holding should be precisely determined and realized today is important.

Regular readers know that precisely determining and recognizing the losses hidden on and off the banks' balance sheet is the first step in implementing the Swedish model for handling a bank solvency led financial crisis.

The Advisory Scientific Committee said in a report to the European Systemic Risk Board (ESRB), that if losses at the Spanish banks were not determined and balance sheets not cleaned up then EU funds may well be insufficient for recapitalisation. 

"Adding capital without knowing what the assets are actually worth and how much capital is really needed entails a serious risk that the funds may simply be lost as the necessary resolution of the banks is delayed further," the committee said in a report to the ESRB published on Tuesday. 

The first loans are not expected to be handed out until October and Spain will have to restructure its banks in return for the money. 

The committee also backed the controversial principle that all debtholders of a bank, including unsecured senior bondholders, should be forced to take a hit to shore up an ailing bank. 

So far in the financial crisis, senior bondholders have been largely shielded, with shareholders and junior bondholders bearing the brunt of a bank failure. 

"The examples of Ireland and Spain suggest, already at the national level, that the full protection of all senior creditors may exceed the government's fiscal capacity," the committee said. 

"The buyers of such debt should know what they are letting themselves in for, and should have the strongest possible incentives to assess the creditworthiness of, and exercise discipline over, their debtors," the report said.

In theory, buyers of senior debt should have the strongest possible incentives to assess the creditworthiness of and exercise discipline over the banks.

In practice, this is impossible as the financial regulators have a monopoly on all the useful, relevant information that investors need to independently assess the risk of the banks.  Remember, banks are in the words of the BoE's Andy Haldane "black boxes".

Furthermore, the stress tests create a moral obligation on the part of the government not to inflict losses on the senior debt holders.  If the financial regulator says the stress tests show that a bank is solvent, it is reasonable for investors to rely on this representation.

In equally blunt terms, it criticised the "vagueness" of plans by EU leaders to turn the ECB into the supervisor for euro zone lenders, saying they fell short of giving Frankfurt the power to close down ailing lenders.

"Unless the power to close a bank is effectively transferred from national to supranational institutions, the 'single supervisory mechanism in the euro area' will not be effective," the committee of academics and finance industry officials said. 

In such a case, the use of the bloc's bailout funds could very expensive without actually solving the problems, the committee added.

The only banks that need to be closed are those that do not have a franchise that allows them to generate earnings with which to rebuild their book capital levels.