A mandate to tackle our banks' failures

In his Financial Times column, Andrew Tyrie, conservative MP and chairman of the Parliamentary Commission on Banking Standards, noted that trust in banks has plummeted and established the goal for the commission of suggesting a remedy that restores trust while also protecting taxpayers from future bailouts and eliminating bad behavior by banks.

Given these goals there is only one remedy.

It appears that Mr. Tyrie's commission will be recommending that UK banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Only ultra transparency restores trust, protects taxpayers from future bailouts and eliminates bad behavior.

Everyone knows that trust is restored when investors can independently assess the risk of each bank.  Investors trust their own analysis and this trust flows through to the banks.

By setting the global standard for disclosure by requiring the UK banks to provide ultra transparency, the UK will gain a competitive advantage for the City.

Ultra transparency protect taxpayers from future bailouts in two ways:

First, ultra transparency provides market participants with the information they need to exert discipline on the banks and restrain their future risk taking.

Second, should an individual bank's management ignore market discipline and cause the bank to fail, the government does not have to bail out the bank because investors/counterparties will have already reduced their exposure to the bank to what they can afford to lose.

Finally, it is only when everything the bank does today is visible and can be front page news tomorrow that standards in banking improve and bad behavior is eliminated.


It is only with this level of disclosure that sunlight can act as the best disinfectant and purge the banking system of its culture of embracing bad behavior.  For example, Libor was manipulated because it wasn't based on observable transactions.

Standards in banking have lapsed. Banks are not serving the real economy as they should and trust in them has plummeted. There has been a culture of recklessness, and often wrongdoing, which has done great damage. This is the well-understood backdrop against which the UK Parliamentary Commission on Banking Standards was created in July. All three main parties are agreed that restoring standards in banking is a priority.

The commission, which I chair, has been asked to conduct pre-legislative scrutiny on the Banking Reform bill by December 18 and we expect to make recommendations early next year – drawing on the lessons of recent financial scandals and on other reports on banking standards. However, our aim is forward-looking; not to launch a retrospective attack on banks or governments. 

This is a global industry with long-standing, global problems, many of which will be familiar to students of banking history. It is also one of the UK’s most important industries and if banks are to be at the heart of our economy, they must be allowed to remain internationally competitive....

It is only ultra transparency that improves the UK banks' international competitive position while also dealing with the long-standing problems in the banking industry.

The problems lie deep, some in the unique features of banking that give it a measure of protection from the full disciplines of the market. 

Specifically the substitution of complex rules and regulatory supervision for transparency.

The implicit government bailout guarantee, a de-facto subsidy of banks held to be too big to fail, protects incumbent banks from competition. Consumers’ reluctance to switch accounts, the lack of price transparency and barriers to new entrants have further compromised competition.... 

Information asymmetries – the gap in knowledge and understanding between banks and their customers – have allowed banks to sell inappropriate products, both in retail and in wholesale markets. Recent scandals have amply illustrated the consequences; a failure of banks, and the culture within banks, to meet acceptable standards.... 

The only solution to information asymmetries is to provide transparency so that the buyer has all the useful, relevant information in an appropriate, timely manner.

Gaps in the law that have allowed banking malpractice to occur require attention. The common perception is that the law has done little to deter practices that often seemed criminal, to victims and observers alike.

 In the case of the US, perception and fact go hand in hand.

Regulation has been shown to be equally defective. A box-ticking culture and pointless data collection are no substitute for effective oversight in both prudential and conduct of business regulation. The claim of the Bank of England’s Andrew Haldane, that more detailed and burdensome regulation has come in inverse proportion to its effectiveness, merits consideration.

Regular readers know that Mr. Haldane effectively argued for requiring banks to provide ultra transparency.  With ultra transparency, much of the detailed, burdensome regulation can be eliminated.  In addition, oversight becomes more effective as the regulator can now tap the market's analytical capabilities for answers.

It is widely held that shareholders have also been absent without leave and that corporate governance requires an overhaul. The formal structures of corporate governance have looked elegant enough in bank company reports but, in a number of cases, we now know that form was a substitute for substance....

The reason that shareholders have been absent without leave is that as a result of current bank disclosure banks resemble, in Andrew Haldane's words, 'black boxes'.  It is hard to exert discipline when you don't know what is happening.

The commission will not be able to address all of these deep-rooted problems in a few months.

Actually, the commission can when it looks at these deep-rooted problems through the prism of ultra transparency.

Looked at this way, it is easy to see the impact of Yves Smith's observation that no one on Wall Street was compensated for developing low margin transparent products.

But we can at least signal some remedies, suggesting ways to protect taxpayers better from the consequences of bank failure and to improve the experience of dealing with banks for customers of all types. If we can manage that, we will have made an important contribution to the task of restoring trust in our banks.

All you have to do is recommend banks provide ultra transparency.

Ireland is a case study in why not to accept money from the Troika to bailout your banks

Recently, finance ministers from Germany, the Netherlands and Finland took the position that the European Stability Mechanism could not be used for legacy assets and the cost of bank bailouts would be left to each country.

This was a very important statement as it cutoff Ireland from the possibility of having the ESM take over 20 billion euros of debt.  Debt that was incurred specifically to bailout the Irish banks so that they could repay unsecured debt owned by banks in countries like Germany, the Netherlands and Finland.

Given this example, Spain might want to ask itself why it would want to accept funds from the Troika to bailout its banks.

A bailout that helps banks from countries like Germany, the Netherlands and Finland avoid losses while saddling the Spanish taxpayer with more debt.

The Spanish banking system is designed so that banks do not need to be recapitalized even after the banks recognize all the losses on the excess debt in the financial system.

With deposit insurance and access to central bank funding, Spain's banks can continue to operate and support the real economy while they are rebuilding their book capital levels.

As discussed in the Irish Times,

The loot may be lost forever. All the media buzz last week surrounded the feisty Roisin's dramatic resignation in Dublin. Far more cataclysmic events in Helsinki were relegated to second place.

The three most powerful finance ministers in Europe had given the thumbs-down to Ireland's hopes of a Santa Claus-type bank rescue. 

The new European Stability Mechanism (ESM) funds would not, after all, be allowed to be used to sort out those sins of bankers committed prior to the establishment of a new European banking supervisor. 

Or, as they put it so delicately, no "legacy" assets would be taken on by the new body. Thus historic problems would be left in the hands of "national authorities". 

Enda and Ireland are left holding their own banking babies. Contrary to previous hopes, Europe was not now going to charge in, a white knight on a chariot, to buy shares in AIB and Bank of Ireland at inflated prices. 

Europe doesn't do white knights. As far as the three powerful finance ministers were concerned, Ireland was done and dusted. 

There was going to be no relief for past sins. 

Ireland is a sinner from the past, doing its penance dutifully -- an example to other errant nations. Future sinners will qualify for forgiveness. The ESM will step in with funding to break the link between bank and sovereign debt for them, but not for us. 

Ireland was out on a limb, abandoned by its colleagues. The Government was exposed. It had grossly oversold the benefits of the earlier agreement in June. 

Irish ministers were ashen -faced in the Dail on Wednesday morning. The premature cries of triumph after the summit in June had vanished. 

No wonder they looked shell-shocked. Enda admitted to the Dail that he had been given no warning about the three ministers' bombshell. He was kept in the dark. 

He was reminded that he had announced a "seismic shift" in June. Now, Ireland had been humiliated. 

Kenny was careful to repeat ad nauseam the bald words of the June communique: the vicious cycle of the link between bank debt and sovereign debt would be broken. 

Equally, he reminded TDs of the June promise that Europe would "examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme".

Gone was June's rhetoric of "seismic shifts" and "game changers". Stripped of the rhetoric, the June statement suddenly looked naked. 

The Taoiseach tried to claim that nothing had changed. He was in denial. 

So too was the Department of Finance who even told the Irish Times that it "welcomed the ideas put forward by [German finance minister] Schauble and his allies". The mandarins feebly mumbled that "these ideas will feed into our discussions over the coming months".
The Taoiseach was in denial. The mandarins of Merrion Street were in denial. And their own minister, Michael Noonan, was in denial....

Taoiseach Kenny spoke loftily of his own meetings with three PRIME MINISTERS, firmly putting the three upstart finance ministers in their place. Unfortunately the three prime ministers whom Enda had met came from Greece, Italy and Spain -- three basket-case countries. The three finance ministers issuing the statement came from the three strongest, triple-A rated nations in Europe: Germany, Holland and Finland. 

No contest. Enda's pals are the bearers of begging bowls. The three finance ministers hold the purse strings. His assertion that "all European finance ministers are equal when they sit around the table" is nonsense. 

The big powers in Europe are treating us shabbily. For a short while they even cruelly allowed us to indulge the fantasy that they would pay us €20bn for equity in our pillar banks when it was worth less than €8bn. 

We will hear no more of that. 

The Government needs someone with the bottle of Roisin Shortall to stand up to our European colleagues, someone who is neither captured, nor in denial.

Capital: a very strange way to assess bank safety

Anyway your look at it, bank capital levels or ratios are a very strange way to assess bank safety.

Regular readers know that bank capital, in particular shareholder equity, is an accounting construct with two main components:  capital paid in to buy stock and retained earnings.

Capital paid in cannot be manipulated.  It is simply a reflection of the number of shares sold and the price at which they were sold.

Unlike capital paid in which is based on historic facts, retained earnings are a derived number based on a series of assumptions. Assumptions that can be easily manipulated.

Earnings can be manipulated by the banks.

For example, earnings can be manipulated by simply moving an investment (think opaque, toxic structured finance securities) from the trading account where it is subject to mark to market accounting to the bank's investment portfolio where it is held at acquisition cost to avoid taking a loss.  The result of this manipulation is to a) overstate earnings, b) overstate book capital and c) overstate the value of the assets.

Earnings can be manipulated by the regulators.

For example, by practicing regulatory forbearance, regulators allow the banks to engage in 'extend and pretend' and turn their bad loans into 'zombie' loans rather than recognize the losses on the loans.  The result of this manipulation is to a) overstate earnings, b) overstate book capital and c) overstate the value of the assets.

Because of the ease with which regulators can manipulate capital, the regulators use capital, both the balance sheet level and the ratio, to mislead the public and the financial markets.

For example, Tim Geithner said that the stress tests were rigged in an effort to restore market confidence.  What the stress tests were suppose to show was that the banks had sufficient capital.

Because of the ease with which earnings can be manipulated, even a simple ratio like shareholder equity to assets is meaningless as a measure of the bank's risk.  Piling on complexity by risk-adjusting the assets simply gives banks and regulators more ways to game the capital ratio and render it even more meaningless as a measure of the bank's risk.

Based on these facts, the OECD concluded that bank book capital and capital ratios are meaningless.

Regular readers know that your humble blogger thinks that the only way to assess the risk of a bank is by looking at its current global asset, liability and off-balance sheet exposure details.

I am not alone in this.

For example, Goldman's Lloyd Blankfein said that the only way Goldman knows to manage its own risk is to monitor every position every day.

For example, banks with deposits to lend stopped lending in 2008 when they realized they could not assess the risk of the banks looking to borrow.  The interbank lending market remains frozen.

Despite being meaningless and useless as a measure of risk, bank capital does have its supporters.

In his Bloomberg column, Professor Simon Johnson tries to save bank capital as a measure of bank risk.

Global regulators have a peculiar way of assessing the soundness of big banks: Ask bankers how risky their investments are, then figure out if they have enough capital to absorb the potential losses....

The strategy of trying to make sure that expected losses are less than a bank's book capital level is not unreasonable given that the goal of the financial regulators is to protect the deposit insurance funds.

This method ... has failed repeatedly -- most spectacularly during the 2008 financial crisis....

Is the problem with this method the question of do banks have enough capital to absorb their potential losses or the regulators' ability to answer the question?

The Bank of England's Andrew Haldane observed that the problem lays with the regulators' ability to answer the question.

I don't think that the stability of the financial system should depend on whether the regulators can or cannot answer the question.  By requiring banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, we can use all the market participants to assess the soundness of the banks.

Like most firms, banks finance themselves with a combination of debt, which they get by taking deposits and issuing bonds, and equity, which they get from their shareholders. The latter, also known as capital, is crucial to the bank’s survival. 

If bad investments cause the value of a bank’s assets to fall, its equity decreases by an equivalent amount.

Not necessarily as shown by the examples above.

If equity is depleted, the bank is insolvent.

By definition a bank is insolvent if the market value of its assets is less than the book value of its liabilities.  Capital does not directly factor into this definition.

What is critically important to note is that a bank can be insolvent and still continue operating.

There will be either bankruptcy or some form of government bailout.

Actually, there is a frequent third choice made by regulators.

A modern banking system is designed so that banks can operate with low or even negative book capital levels.  The reason banks can do so is the combination of deposit guarantees and access to central bank funding.

With deposit guarantees, taxpayers effectively become the bank's silent equity partner when the bank has low or negative book capital levels.

While the taxpayer is the silent equity partner, if a bank can generate earnings, it can rebuild its book capital levels.

This choice has been made repeatedly.  Sometimes successfully.  Sometimes not.

An example of when the choice was unsuccessful was the US Savings and Loans.  To rebuild their book capital levels, they gambled on redemption.

One of the reasons for requiring the banks to provide ultra transparency is that it allows market discipline to restrain bank risk taking and prevents gambling on redemption.

Hence the need for capital requirements....

The facts simply do not support this conclusion.

One big problem is incentives. Bankers like to use as much borrowed money as possible, relative to their equity. This boosts the return to shareholders in good times, but also presents a threat to the financial system and the broader economy. 

If bankers are in charge of calculating their own risk weights, they will try to understate the risks. This happened with mortgage-backed securities and associated derivatives in the U.S., with real-estate-related loans and assets in countries such as Ireland and Spain, and with sovereign debt in much of the euro area.

This problem goes away if banks are required to provide ultra transparency.  Market participants can independently assess the risk of each bank and adjust both the amount and price of their exposure to reflect this risk.

As a result, simply increasing leverage or risk will result in a higher cost of funds and not necessarily a better ROE.

Second, regulators are no better than bankers at figuring out the right risk weights. For one, they are often heavily influenced by the bankers -- a reality I have experienced personally in my conversations with central bankers and other officials, who meet with banking staff continually and even now are convinced that top executives really know how to measure and handle risk. Beyond that, they are out of their depth. The system of risk weights has become too complex, unwieldy and far too easy to game.

This is what happens when complex rules and regulatory supervision are substituted for transparency.

Actually, no one can calculate proper risk weights. They are unknowable. Analysts at credit-rating companies, even if one sets aside all the conflicts of interest they face, are just as prone to group think, fads and misconceptions as the rest of us. Academics would do no better. And the “wisdom of crowds” -- as reflected in the market for credit-default swaps -- suggested that Citigroup Inc. was a low-risk investment until 2007.

The reason that Citigroup credit-defaul swaps were mis-priced was the combination of lack of transparency into Citigroup's actual exposure details and the Federal Reserve claiming that risk had been taken out of the banking system.

Professor Johnson actually makes the case for requiring ultra transparency.  The "wisdom of crowds" can only be realized if they have the exposure details necessary to assess risk.

The right approach, as articulated by Hoenig, is to choose capital rules that are “simple, understandable, and enforceable.”...

Of course, for any capital rule or risk reduction rule like the Volcker Rule, the enforcement mechanism is market discipline made possible by ultra transparency.

The bottom line:  talk about bank capital is simply a distraction so that we don't talk about what is really necessary for assessing bank safety ... ultra transparency.

Ben Bernanke cites Milton Friedman in justifying knowingly hurting savers

In defending his monetary policies and the fact that the Fed is aware these policies hurt savers, Ben Bernanke cited Milton Friedman.

According to a Business Insider article,

[Ben Bernanke] pointed out that Friedman advocated QE for Japan during its struggle against deflation and weak growth. He also recalled one of  Friedman's most important lessons, that low interest rates are not the same as loose policy.

Support for Friedman's advocacy of QE comes from a Q&A in 2000 between David Laidler and Mr. Friedman.

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue? 

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy. 

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. 

Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?” It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

Regular readers know that Japan's central bank subsequently engaged in massive amounts of purchases of long-term government securities (they have been pursuing QE for over a decade).

Has this ended the state of quasi recession in Japan?

No.

The question becomes, were Mr. Friedman still alive today, would he offer the same advice given a) Japan's experience with quantitative easing and zero interest rate policies and b) the global financial crisis?

While Mr. Friedman is not alive, prior to her death, his colleague Anna Schwartz in a Wall Street Journal interview weighed in:

Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again. 

To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it.  

We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs. 

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. 

"The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

A problem that your humble blogger has been saying since the start of the financial crisis can only be solved by bringing transparency to all the opaque corners of the financial system.

For banks, this means requiring them to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This allows investors to independently assess the risk of each bank.

For structured finance securities, this means requiring them to provide observable event based reporting so that all activities like payments or defaults on the underlying collateral are reported before the beginning of the next business day.  This allows investors to know what they own.

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

First, thank you Ms. Schwartz for defining what the real issue is, the lack of transparency that makes it impossible for lenders to know who can repay them or not.  A problem that still has not been fixed 5 years after the start of the financial crisis.

Second, based on Ms. Schwartz's analysis and her multi-decade collaboration with Mr. Friedman, the probabilities suggest that it is highly unlikely that Mr. Friedman would be supporting the policies pursued by Mr. Bernanke.

Update
The section in Mr. Bernanke's speech discussing the impact on savers.

How Does the Fed's Monetary Policy Affect Savers and Investors? 

The concern about possible inflation is a concern about the future. One concern in the here and now is about the effect of low interest rates on savers and investors. My colleagues and I know that people who rely on investments that pay a fixed interest rate, such as certificates of deposit, are receiving very low returns, a situation that has involved significant hardship for some.

Hardship that is the direct result of pursuing policies that Ms. Schwartz would say do not impact the underlying cause of the financial crisis or why the capital markets are not working today.

However, I would encourage you to remember that the current low levels of interest rates, while in the first instance a reflection of the Federal Reserve's monetary policy, are in a larger sense the result of the recent financial crisis, the worst shock to this nation's financial system since the 1930s. Interest rates are low throughout the developed world, except in countries experiencing fiscal crises, as central banks and other policymakers try to cope with continuing financial strains and weak economic conditions.

Actually, low interest rates are a reflection solely of central bank monetary policy.  Think Operation Twist to lower yields on long term treasuries.

Central banks around the world (EU, Japan, UK and US) are pursuing low interest rate and quantitative easing policies.  So it is no surprise that interest rates are low throughout the developed world.

To say that interest rates are low largely as a result of the financial crisis is simply being intellectually dishonest.

A second observation is that savers often wear many economic hats. Many savers are also homeowners; indeed, a family's home may be its most important financial asset. Many savers are working, or would like to be. Some savers own businesses, and - through pension funds and 401(k) accounts - they often own stocks and other assets. 

It has already been thoroughly documented in the UK that the value of these other assets for retirees has not increased enough to offset the decline caused by central bank zero interest rate policies.

The crisis and recession have led to very low interest rates, it is true, but these events have also destroyed jobs, hamstrung economic growth, and led to sharp declines in the values of many homes and businesses. 

What can be done to address all of these concerns simultaneously? 

The best and most comprehensive solution is to find ways to a stronger economy. Only a strong economy can create higher asset values and sustainably good returns for savers. And only a strong economy will allow people who need jobs to find them. Without a job, it is difficult to save for retirement or to buy a home or to pay for an education, irrespective of the current level of interest rates. 

The way for the Fed to support a return to a strong economy is by maintaining monetary accommodation, which requires low interest rates for a time. If, in contrast, the Fed were to raise rates now, before the economic recovery is fully entrenched, house prices might resume declines, the values of businesses large and small would drop, and, critically, unemployment would likely start to rise again. Such outcomes would ultimately not be good for savers or anyone else.

This blog has already documented that most of what Mr. Bernanke claims to be statements of fact in the last paragraph are in fact myths.

Based on what Walter Bagehot, the father of modern central banking, said in the 1870s, raising interest rates is likely to lead to an economic recovery.  Retirees and savers would have more money to spend.

House prices might not change at all given that the spread between what banks pay for funds and what borrowers pay for a mortgage is at an all time high.  Raising rates would simply squeeze this spread back to historic norms.

The value of businesses large and small is likely to increase as the value of a business reflects the demand for the goods or services provided by the business.  An increase in demand increases the value of the business.

When businesses see increased demand, they hire.  An increase in employment is positive because it further increases demand in the economy.

In short, raising rates would be great for savers and everyone else.

Please take the preceding comments with the appropriate grain of salt as your humble blogger does not have a PhD in Economics nor do I have an econometric model that shows zero interest rates are positive for the economy.

On the other hand, I managed to predict the financial crisis and that zero interest rates and quantitative easing would not arrest the downward spiral in the economy.

As predicted, analysts claim that Spain's stress test understated capital needs

As predicted by your humble blogger, in the absence of Spain's banks providing ultra transparency, analysts have concluded that Spain's banks need far more capital than the stress tests show.

The Telegraph reports that Moody's thinks Spanish banks might need over 100 billion euros (not exactly going out on a limb when some analysts were predicting 300+ billion euros several months ago).

The agency said banks would need between €70bn and €105bn “to maintain stability”.

What Moody's announcement did do is to undermine the credibility of the stress tests and open the floodgates for higher estimates of capital needs.

With these higher estimates in hand, Spain will do a loan by loan stress test and conclude that the average of these estimates is the amount of capital Spain's banks need (provided of course that Spain could find this capital; otherwise, the result will be lower).

Of course, this stress test will also not restore confidence in the Spanish banking system.  It won't restore confidence for the simple reason that there is still not ultra transparency and market participants cannot independently confirm the stress test results.

With no ability to confirm the results, analysts will assume that there is sometime to hide and predict even higher capital needs.  To date, this strategy has been successful in Ireland and Greece.  There is no reason to think that Spain will be different.

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

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

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

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

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

As discussed by the Guardian,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Europe blames UK for eurozone debt crisis

According to a Telegraph article, Europe blames the UK for its debt crisis arguing that without the UK led financial crisis that preceded it the eurozone debt crisis wouldn't have happened.

This line of reasoning is easy to support if one ignores a small fact.  It was the choice of pursuing the Japanese Model and its related policies for handling a bank solvency led financial crisis that triggered the eurozone debt crisis.

EU policy makers had and still have a choice in how to respond to the financial crisis.  They could choose between protecting bank book capital levels along with banker bonuses at all costs (the Japanese Model) or protecting society and making the banks absorb upfront the losses on the excess debt in the financial system (the Swedish Model).

Do you wonder why Brussels seems so dead set on crushing the City? Bull-dog Brits reckon Europeans are jealous, they don’t understand free-market capitalism, and are itching to spread stifling state regulation and avenge Agincourt all at once. 

Sharon Bowles, MEP and Britain’s most powerful financial politician in Brussels, says we’ve missed the point: Europe blames Britain for the debt crisis. 

“In their eyes, we are responsible for everything they are suffering,” she says. “The Greek debt levels were their own doing but the situation escalated into a crisis because of the additional sovereign debt and the financial crisis. So the rest of Europe thinks the contamination went into their countries, through the single market, from the UK. That’s the whole point.”...

It was the choice of the Japanese Model and its related policies like bailouts, zero interest rates and quantitative easing, that escalated a banking crisis into a sovereign crisis.

“Think about it,” she demands with trademark directness. “They wouldn’t have the eurozone crisis if we had not had the financial crisis. Who was culpable in the financial crisis? We were - we’ve said so. We’ve sent our regulators round the world saying “sorry”. So in Europe they say, you’ve admitted you got it wrong, you are wrong.” 

It was the UK that took the lead in selecting the Japanese Model and bailing out its banks.

As your humble blogger has pointed out since the beginning of the financial crisis, the Japanese Model is the wrong choice.  It essentially sacrifices democracy, the social contract and the real economy to pay banker bonuses.

So when we demand control - or more often a veto - over new financial regulation because the City is the biggest financial centre, there’s only one response. “They say forget it,” she says. “'We’re not going to take it from you - you’ve ruined our economy, you’re the reason we’ve got all this austerity and you think you can march around saying you know it best?’...

Clearly, Iceland made a better choice for how to handle the financial crisis.  It chose to implement the Swedish Model.  The result was strengthening its democracy, reinforcing its social contract with more benefit programs and preservation of its real economy.

You can see the point: on top of the implosion of 2008, London has been rocked by scandals from PPI mis-selling, to Libor rigging and money-laundering. 

Never mind Brussels, just listen to our own politicians. Last week the Business Secretary Vince Cable lamented the “greed and stupidity” of the banks - last year he called them “spivs and gamblers” - and we can expect more mud-slinging from Ed Balls, the shadow chancellor at Labour’s party conference which is under way in Manchester.

It does cause one to wonder when the opacity in the financial system that lets all of this mis-behavior by bankers to take place will be addressed.

As head of the European Parliament’s Economic and Monetary Affairs committee since 2009, Bowles is closer than anyone to the vast swathes of new financial regulation passing through Brussels. While Angela Merkel & Co fight the crisis, Bowles is involved with what she calls “the other half of the game of nudge”: pushing through structural changes that are needed to make the crisis-fighting measures politically acceptable.

Politically acceptable or acceptable to the Blob (aka, financial regulators, bankers and their lobbyists)?

Transparency and the Swedish Model are politically acceptable to society.  After all, we have a financial system based on the philosophy of transparency and the principle of caveat emptor (investors are responsible for their losses and don't expect bailouts).

Opacity and the Japanese Model are politically acceptable to only the Blob.  After all, they protect the Blob, enhance its members personal finances (see: bonuses) and allows the Blob to grow by substituting more complex rules and regulatory oversight for transparency.

UK government scheme fails to boost lending in first month

The Telegraph reports that the latest UK government scheme failed to boost lending in its first month.  In fact, lending contracted as borrowers repaid their existing debts.

Regular readers are not surprise that the UK government is having trouble boosting lending.  It is fighting against zero interest rate and quantitative easing policies.

One unintended consequence of zero interest rate and quantitative easing policies is that it changes the definition of the risk free rate.

Clearly, if the rates on government debt are being artificially lowered, these rates are not risk free.  As a result, there is a search for an interest rate that is risk free.

For anyone with a loan outstanding, the risk free rate becomes the rate they pay to borrow.  Any money they use to pay down the outstanding loan generates a return equal to the rate on the loan.

If you borrow at 5% and can only invest excess cash at 0.10%, it makes sense to 'invest' the excess cash in paying down the loan as it 'saves' the borrower 4.9% (the difference between the borrowing rate of 5% and the investment rate of 0.10%).

Attempts by the authorities to boost the supply of credit have failed in the first month of trying, economists said, after official data showed that borrowers repaid their debts last month and rates continued to rise. 

In the first full month that the Funding for Lending Scheme (FLS) was operating, households repaid £276m of mortgage debt and cleared another £134m of personal loans. Lending to businesses dropped by £2.2bn, the largest monthly decline since February. 

The figures, from the Bank of England, also showed that the average fixed mortgage rate rose by 0.03 percentage points in August and is now 0.52 percentage points higher than at the start of the year. 

Michael Saunders, UK economist at Citi, said: “The data suggest that the introduction of the FLS has not produced significant immediate results in improving the growth or price of credit to households and businesses.” 

The Bank and the Treasury launched FLS, which provides banks state-backed low-cost funding, on August 1 in an attempt reduce borrowing costs for households and businesses and increase lending. ... 

However, the Bank’s data suggest that there is little demand for credit currently, which would limit the impact the scheme would have on restoring economic growth....

“The Bank of England data indicate that consumers appetite for new taking on new borrowing is limited while there is also an ongoing strong desire of many consumers to reduce their debt,” Howard Archer, IHS Global Insight UK economist, said.

After a weekend to consider Wheatley's Libor recommendations, reviews point out harmful unintended consequences

After a weekend to consider Martin Wheatley's recommendations for fixing Libor, reviewers have concluded that not only will Libor not be fixed, but the result will be worse than where we currently are.

Regular readers are not surprised by this for the simple reason that the only way to fix Libor was to adopt your humble blogger's call for banks to provide ultra transparency.

It is only with banks disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details that the interbank lending market unfreezes and remains unfrozen.

It is only with this level of disclosure that market participants can see all of each bank's actual trades.  With all of the trades visible, it is possible for the market participants to analyze those trades used to calculate Libor to see if there is manipulation.

A Bloomberg article discusses the negative unintended consequences from implementing Wheatley's recommendations for fixing Libor.

Borrowing costs for consumers and companies will rise as efforts to revive confidence in Libor increase the number of banks involved in setting the rates, which determine more than $300 trillion of securities. 

A higher number of lenders will include smaller, weaker institutions that pay more to borrow, according to James Edsberg at Gulland Padfield, a London-based financial services consultancy....

“If you expand the panel by including banks beyond the largest ones, you will boost borrowing costs,” said Edsberg..... 

As part of the revamp the FSA will encourage more banks to submit quotes and will have powers to force the unwilling to take part in the process, Wheatley said in his report. The banks that will make up the pool will be selected by the new administrator, said Chris Hamilton, a spokesman for the FSA, who declined to comment further.

With the ability to force banks to submit quotes, the new administrator has the ability to redefine what Libor is suppose to represent.  Is it the rate that 'largest' banks borrow at?  Is it the rate that the 'most creditworthy' banks borrow at?

Originally, Libor reflected the rate the largest banks could borrow at regardless of their credit rating.

Rising borrowing costs risk deepening Europe’s debt crisis, making it harder for countries in the grips of austerity to foster economic growth....

A definite unintended consequence.

The panel setting Euribor includes National Bank of Greece (TELL) SA in Athens, which is awaiting recapitalization, and Bank of Ireland Plc, that country’s biggest lender. There are also four Italian lenders, including Intesa Sanpaolo SpA (ISP) and UniCredit SpA (UCG), the two largest, and four Spanish banks including Banco Bilbao Vizcaya Argentaria SA (BBVA) and Banco Santander SA (SAN), also the two biggest. 

The British Bankers Association panel for euro Libor includes Santander unit Abbey National Plc as the only lender connected to the peripheral countries. 

“On day one of the new rate being introduced it will jump higher if you increase the number of participating banks beyond the biggest ones that currently set it,” said Ian Gordon, a London-based analyst at Investec Plc. (INVP) “That obviously raises questions about the viability of the contracts that reference the old rate. It would seem to be a fundamental flaw in the new proposals.”...

Another unintended consequence.

“If you expand the panel to include a set of smaller banks, all else being equal that would tend to push up the average rate,” said Steve Hussey, a London-based financial- institutions analyst at AllianceBernstein Ltd., which oversees about $400 billion. “You could weight it by size or rating but that would be complex and may not be effective.”

As I previously pointed out, the Wheatley recommendations substitute complex rules and regulatory supervision for simple transparency.

Wheatley proposes allowing banks to wait three months before disclosing their Libor submissions, rather than publish them daily as at present. While immediate publication of individual submissions increases transparency, it makes manipulation easier because contributors are able to estimate the impact of the quote they put in.

Not if the banks are required to provide ultra transparency and disclose all their trades.  With this data, it is obvious who is submitting quotes that are not reflective of their borrowing experience.

Added to that, at times of stress, changes in submissions may be viewed as reflecting the contributor’s credit strength, offering an incentive to submit a lower rate than otherwise, according to the report. 

To rectify the “reduction in immediate transparency” the report recommends lenders publish a regular bulletin that includes trading volumes. 

“A three-month wait and then we find out that some of these institutions are more wobbly that we thought,” said James Ferguson, chief strategist at Westhouse Securities Ltd. in London. “That’s a horrible legacy for us to leave for the next crisis.”

Mr. Ferguson's observation summarizes why ultra transparency is needed to fix Libor and the Wheatley recommendations should be tossed in the recycle bin.

Test of Spain's latest bank stress test is whether investors willing to invest

In the aftermath of Spain's bank stress tests, are investors gullible enough to believe the numbers and invest in the banks that were represented as almost solvent?  Or will investors remember their experience with Bankia and stay far away?

Since Spanish banks do not provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, there is simply no transparency into the true condition of the banks so that market participants can independently assess their risk.

As a result, nobody can 'invest' in the banks today.  Rather, they can 'blindly bet' on the value of the contents of the black boxes the banks represent.

The last time investors were faced with this choice was Bankia.  Then, the institutional investors stayed away and the retail investors purchased the capital after being assured that it was as safe as their demand deposits.

Staying away turns out to have been the better decision as the value of the contents of the Bankia black box were worth significantly less than was represented.

So now we have our next example of the government trying to tell investors that it is 'safe' to buy the equity of a Spanish bank.  A Bloomberg article reports that Banco Popular Espanol SA is looking to raise 2.5 billion euros.

Why would anyone want to invest in this bank when even the government's stress test says the bank needs more capital than it is raising?

Banco Popular Espanol SA (POP) will seek to raise as much as 2.5 billion euros ($3.2 billion) from a stock sale and suspend its October dividend as the Spanish bank tries to cover a shortfall found in stress tests. The shares plunged. 

The bank expects to book a 2012 loss of 2.3 billion euros, compared with a previous estimate for a profit of 400 million euros, as it speeds up recognition of loan impairments and relies less than it previously planned on capital gains, Chief Financial Officer Jacobo Gonzalez-Robatto said on a webcast for analysts today....

While it is speeding up recognition of loan impairments, is there any reason to believe this covers all of its bad loans?

Unless Banco Popular is willing to provide ultra transparency to prove that all the bad loans are being addressed, it is highly likely that it has a considerable amount of bad loans that it is hiding.

The capital increase may be equivalent to 80 percent of the bank’s current market value. Popular, founded in 1926, is aiming to avoid taking state aid after a stress test on the Spanish banking system by consultant Oliver Wyman published on Sept. 28 showed the country’s sixth-biggest lender by assets had a capital shortfall of 3.22 billion euros in an adverse economic scenario. 

“Every man and his dog has known for a long time that Popular would need to raise capital, but it seems the only ones who didn’t were Popular’s management,” Simon Maughan, a financial industry strategist at Olivetree Securities in London, said by phone today....

“We are going to be generous in the rights issue, because that money is from our shareholders,” Gonzalez-Robatto said on today’s webcast. “We are going to invite our shareholders basically to join us in an extremely bright future for Banco Popular.”...

In the absence of ultra transparency, why would a shareholder want to double down and buy more shares in a bank where the bulk of its business is in a country where the economy is contracting, the government is implementing austerity and there is already 25% unemployment?

Popular will set up a so-called internal bad bank to manage soured real estate as it writes down 9.3 billion euros in 2012, an increase from the 7.7 billion euros in its business plan given in the second quarter of this year, Gonzalez-Robatto said....

They just discovered another 2.2 billion euros of bad real estate debt last quarter!

Investors must make clear their willingness to quickly relax financing terms for Spain’s stronger banks to show that the stress-test process is credible, Jose Manuel Campa, a former deputy finance minister, said in an interview. 

Actually, the stress test process was not credible.  That is why there is already another stress test process in the works that is based on a loan by loan 'review'.  That stress test will find at least twice as much capital is needed to restore solvency.

Of course, once that stress test is completed, the Spanish banks will still not be providing ultra transparency so there will be zero reason for investors to believe that the banks are not still hiding something and that their true condition is much worse.

“If we don’t see over the next month or six weeks a significant improvement in the ability to tap the markets by the banks that are considered solvent, regardless of the capital needs, I think that would be a major failure,” said Campa, who is now a professor at the University of Navarra’s IESE business school in Madrid.

 Based on the Bankia experience, there is no reason not to expect investors to stay away.