Michael Lewis and what does it take to reform Goldman Sachs and its ilk

In writing a review of Greg Smith's book, Why I left Goldman Sachs, Michael Lewis raises the issue of what does it take to reform Goldman Sachs and the other Too Big to Fail banks.

Stop and think once more about what has just happened on Wall Street: its most admired firm conspired to flood the financial system with worthless securities, then set itself up to profit from betting against those very same securities, and in the bargain helped to precipitate a world historic financial crisis that cost millions of people their jobs and convulsed our political system. 

In other places, or at other times, the firm would be put out of business, and its leaders shamed and jailed and strung from lampposts. (I am not advocating the latter.) 

Instead Goldman Sachs, like the other too-big-to-fail firms, has been handed tens of billions in government subsidies, on the theory that we cannot live without them.

The theory that we cannot live without them is simply an extension of the policy of financial failure containment.  A policy effectively written by and for the banks during Robert Rubin and Tim Geithner's time at the US Treasury.

Under financial failure containment, global financial regulators stop engaging in activities like ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner that prevent a financial crisis.  Rather, after the financial crisis occurs, they turn to the taxpayers to pay to clean it up.

Naturally, taxpayers had to be called on to absorb the losses incurred by Goldman and the other Too Big to Fail banks.

They were then permitted to pay politicians to prevent laws being passed to change their business, and bribe public officials (with the implicit promise of future employment) to neuter the laws that were passed—so that they might continue to behave in more or less the same way that brought ruin on us all.

Mr. Lewis describes one of the ways that Jeff Connaughton says Wall Street always wins.

And after all this has been done, a Goldman Sachs employee steps forward to say that the people at the top of his former firm need to see the error of their ways, and become more decent, socially responsible human beings. Right. How exactly is that going to happen? 

If Goldman Sachs is going to change, it will be only if change is imposed upon it from the outside—either by the market's decision that it is no longer viable in its current form or by the government's decision that we can no longer afford it.

Mr. Connaughton would argue that because of the Blob (aka, a group comprised of politicians, economists/lobbyists and Wall Street) the government will never make the decision the we can no longer afford Goldman or any of the other Too Big to Fail banks.

That leaves it to the market to decide that Goldman and the other Too Big to Fail banks are no longer viable.

There is a bizarre but lingering aroma in the air that the government is now seeking to prevent the free market from working its magic in the financial sector-another reason that the Dodd-Frank legislation is still being watered down, and argued over, and failing to meet its self-imposed deadlines for implementation. 

Regular readers know that the Dodd-Frank legislation is simply the substitution of the bankers' preferred combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

Our current financial crisis shows that the combination of complex rules and regulatory oversight doesn't work.  Specifically, during the financial crisis the financial system continued to function where there was the combination of transparency and market discipline and collapsed where there was the combination of complex rules and regulatory oversight.

The areas of the financial system that had the combination of complex rules and regulatory oversight were all opaque.  Think banks and structured finance securities.

Why did Wall Street support Dodd-Frank (other than it was written by Wall Street's lobbyists for Wall Street's benefit)?

First, it protects Wall Street from the market.  So long as the Too Big to Fail remain 'black boxes', the market doesn't really know what is going on inside the banks.  This limits how effectively the market can impose discipline on Wall Street.

The only way the market can effectively discipline even the largest of the Too Big to Fail is if the banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, market participants could independently assess the risk of these institutions and impose discipline by properly linking the Too Big to Fail banks' cost of funds to the risk they are taking.

But the financial sector is already so gummed up by government subsidies that market forces no longer operate within it. Could Goldman Sachs fail, even if it tried?...

Currently, Goldman Sachs could not fail if it tried.  That is because it is on life support from the Fed.

So long as the Fed is willing to keep all the Too Big to Fail on life support (and every policy the Fed has adopted since the beginning of the financial crisis has been to clean up after the financial crisis while keeping the banks on life support), it is impossible for the market to exert any discipline on the Too Big to Fail.

However, it is the very fact that the Fed has all the Too Big to Fail on life support that makes it possible to require these banks to provide ultra transparency without worrying about the financial system collapsing.

Once ultra transparency is required and provided, investors can adjust their exposures and then the Fed can end its life support.

Along with the other too-big-to-fail firms, Goldman needs to be busted up into smaller pieces. 

Better to do this by the market exerting discipline rather than to rely on either legislation or the global financial regulators to do the job.

Under market discipline, bank managers will shed risk as quickly as possible without disrupting the financial system (its bad for the value they receive on the positions/businesses they shed if they cause too much disruption).

The ultimate goal should be to create institutions so dull and easy to understand that, when a young man who works for one of them walks into a publisher's office and offers to write up his experiences, the publisher looks at him blankly and asks, "Why would anyone want to read that?" 

The only way these banks are going to be easy to understand is if they provide ultra transparency.  Without this information, they will always be 'black boxes'.

Italian bank derivative scandal offers more evidence that financial regulators need help

Reuter's is out with another article on Monte Paschi, the Italian bank involved in the derivative scandal, that offers still more evidence of why financial regulators are not up to the task of policing the financial system.

They need help.

The way to provide the regulators with help is to strip them of their monopoly on all the useful, relevant information about each bank and require each bank to provide ultra transparency and disclose its current global asset, liability and off-balance sheet exposure details.

With this information, the market, with its ability to both analyze the financial institutions and discipline the institutions, can help the financial regulators.

Mario Draghi was informed of doubts raised by Bank of Italy inspectors about the Monte dei Paschi bank but had little control over what has been widely criticized as ineffective oversight of the scandal-hit lender, a senior BoI source told Reuters. 

The roots of the corruption and derivatives scandal at Monte dei Paschi all stem back to when Draghi, now president of the European Central Bank, was chief of Italy's central bank from 2006 to 2011. 

The Bank of Italy (BoI) says it did everything in its powers to oversee Monte Paschi, including forcing it to raise new capital and applying behind the scenes pressure to force out its executives, who left last year....

But the BoI, under Draghi's leadership, is under fire for not acting faster to sanction those managers and make its doubts public even though its inspectors had spotted the derivatives contracts at the centre of the scandal back in mid-2010....

As I have previously said, one of the problems with regulators having an information monopoly is that their disclosure to the markets seldom matches the reality of what is actually going on with a bank.

However, the senior BoI source stressed that the decision on launching a sanctions procedure, involving publicly blaming and fining bank officials, does not depend on the BoI governor and its five member executive board, but on the bank's inspectors and then a series of lower committees. 

"The inspectors are the only people responsible for initiating a sanctions procedure so if they don't find anything in the course of their inspection then it's not possible for the top management to start the process," said the source, who asked not to be named. 

"We instruct the staff to be absolutely free from any influence from us, to present exactly the case, so if a sanction is decided then they present a proposal to the board and the board decides on the actual implementation of the sanctions."

The highlighted text summarizes one of the reasons that the disclosure from financial regulators seldom matches reality.  By their very nature, financial regulators talk with one voice.

The text describes the bureaucratic process that the inspectors must go through to change what the financial regulator is saying knowing 100% of the time that the bank that is threatened with sanctions will lobby the board not to impose sanctions.  Please recall, Monte Paschi is one of Italy's most politically connected banks.

In the summer of 2010 BoI inspectors uncovered two opaque derivatives contracts that could cost Monte Paschi 720 million euros and are now at the center of fraud investigations, yet did not propose that sanctions be launched. 

That decision "had nothing to do with the board," the official said, though he added that Draghi was shown the inspectors report....

So Draghi shot down the inspectors' trial balloon.

That 2010 inspectors' report was leaked to the press and sparked much of the current criticism of the BoI because the sharp criticisms of Monte Paschi's accounts and operations made by the inspectors were not followed by pressing action....

A trial balloon that was a call for action.

"We may perhaps appear to be slow, but I think we are deliberate," the official said. He also stressed that although Monte Paschi failed to comply with the BoI's requests, the wrongdoing was already done at the time of the 2010 inspection. 

"What took place afterwards was to try to disguise the losses but it wasn't a recurrent or growing pattern of misbehaving," he said.

If banks were required to provide ultra transparency, the BoI could have taken all the time it wanted as the losses would not have been disguised to the financial markets.

For their part, market participants would have exerted discipline while the BoI was being deliberate.

The center-left has generally been more cautious, calling for more powers for the central bank rather than openly blaming it for laxity. 

The idea that the BoI lacks sufficient powers for effective oversight has become a common theme in the Italian press, with attention focusing on the fact that while it can replace the board of an offending bank, it cannot fire individual managers.

The BoI source made clear that giving the bank this power would be a welcome step, though he was careful not to acknowledge any blame for the Monte Paschi scandal. 

"If we get that power it will certainly be an additional tool but I don't subscribe to the idea that we don't have sufficient powers and that the exercise of our powers wasn't effective," he said.

Excuse me, the BoI exhibited an incredible degree of laxity by not disclosing what it knew to the market.  This failure to disclose meant that market participants did not have information they needed to properly assess the risk and solvency of Monte Paschi.  By definition, investors mis-priced any capital they invested in the bank since 2010.

In case anyone thinks that I am singling out the BoI for its failure to share with market participants information that these participants needed to properly assess the risk and solvency of each Italian bank, I have written numerous posts about financial regulators in other countries engaging in exactly the same behavior (the list includes, but is not limited to, Ireland, the UK and US).

The only way to prevent financial regulators from engaging in this behavior in the future is to strip them of their information monopoly and require the banks to provide ultra transparency.

Low rates force companies to pour cash into pensions

The Wall Street Journal reported that low interest rates are forcing companies to pour cash into their pensions rather than invest in their core business.

This report confirms the Retirement Plan Death Spiral that your humble blogger first discussed many months ago when I first looked at the headwinds created by the central banks' low interest rate policies.  

Under the Retirement Plan Death Spiral, the low interest rate policies being pursued by central banks trigger a self-reinforcing downward spiral in the economy.  

Companies offset the lack of earnings on pension fund assets by diverting funds needed for growth and reinvestment to their pension funds.  This depresses demand in the economy which results in further downward pressure on pension fund earnings.  

Downward pressure that companies then have to offset by diverting more capital needed for reinvestment and growth to their pension plans.

Of course, the Retirement Plan Death Spiral could be stopped, but this would require that the central banks acknowledge that their low interest rate policies aren't working and raising interest rates to at least the 2% level recommended as an absolute minimum by Walter Bagehot, the father of modern central banking.

Ford Motor Co. expects to spend $5 billion this year shoring up its pension funds, almost as much as the auto maker spent last year building plants, buying equipment and developing new cars. 

The nation's second-largest auto maker is one of a who's who of U.S. companies pouring cash into pension plans now being battered by record low interest rates. 

 Verizon Communications Inc.contributed $1.7 billion to its pension plan in the fourth quarter and—highlighting companies' sensitivity to this issue—Boeing Co. now reports "core earnings" to separate out pension expenses. 

"It is one of the top issues that companies are dealing with now," said Michael Moran, pension strategist at investment adviser Goldman Sachs Asset Management. 

The drain on corporate cash is a side effect of the U.S. monetary policy aimed at encouraging borrowing to stimulate the economy. Companies are required to calculate the present value of the future pension liabilities by using a so-called discount rate, based on corporate bond yields. As those rates fall, the liabilities rise.... 

Today, many of the companies contributing to the pensions are struggling with the costs but don't offer defined benefit plans to new workers....

Andrew Liveris, chief executive of Dow Chemical Co., which posted a loss of $716 million for the fourth quarter, said the company faces a "massive pension headwind" because of the change in the discount rate that added $2.2 billion to its pension liability. 

Pension expense this year is going to rise between $250 million and $300 million. 

"Other companies have got it, and so we're not alone, but clearly those are big numbers for us," Mr. Liveris said. 

More rhetoric: UK's George Osborne and electrifying the ring-fence

Since the beginning of the financial crisis, global policymakers have been long on rhetoric describing how they will save the taxpayers  from a future bank bailout through yet another example of the combination of complex rules and regulatory oversight.  The latest example is an electrified ring-fence.

Regular readers know this is hot air as the global policy is "financial failure containment" and not "financial failure prevention".

The basic idea behind ring-fencing is that it separates investment banking from retail banking and makes it possible to let the investment bank fail.

Why is this separation necessary?

So that the failure of the investment bank doesn't drag down the retail bank too.

This is nice in theory, but given the global financial regulators' concerns with financial contagion there is no reason to assume it will actually be used in practice.  Does anyone think the global financial regulators will not use taxpayer money to bailout an investment bank that is larger and potentially more interconnected than Lehman Brothers?

Please note, ring-fencing is focused on financial failure containment, what happens should an investment bank fail, and not on preventing the financial failure in the first place.

Apparently, global policymakers have never heard the expression:  an ounce of prevention is worth a pound of cure.

The focus has to be on preventing the investment or retail bank from failing in the first place.

There is only one way to prevent failure and contain the fallout should failure occur.  The only solution is to require that the financial institutions disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert discipline so that the financial institutions reduce their risk profile and therefore become less likely to fail.

Equally importantly, with this information, market participants can independently assess the risk of each financial institution and adjust their exposure to the financial institution based on the market participant's ability to absorb any losses on their exposure.  By limiting their exposure to what they can afford to lose, market participants contain the fallout from failure and eliminate the need for taxpayer funded bailouts.

George Osborne's rhetoric on ring-fencing as reported by the Guardian,

"My message to the banks is clear: if a bank flouts the rules, the regulator and the Treasury will have the power to break it up altogether - full separation, not just ring fence," ... 

"Any bunch of politicians can bash the banks, chase the headlines, court the populist streak. But what good would that do our country? The jobs, the investment, the banking system we all need would go with it. Let's take the anger we feel about the banks and turn it into change to build the banking system that works for us all," said Osborne.

The starting point is requiring the banks to provide ultra transparency.  Until this occurs, the bankers will continue to privatize the gains and let the financial regulators put the losses on the taxpayers.

Prudential CEO says QE "depressing growth"

Prudential's CEO, Tidjane Thiam, explains in a few brief comments why quantitative easing (QE) is a barrier to economic growth.

These comments should be familiar to regular readers as your humble blogger has been making this point for several years now.

As reported by the Telegraph,

“QE was a good short-term fix,” Mr Thiam said at a private breakfast last week. “In 2008, 2009 and 2010 it was the right answer. But now, it is different.  “We are just storing long term trouble by minimising short term pain.”

I would disagree with Mr. Thiam that QE was ever a good short-term fix as monetary policy is not a cure for a bank solvency led financial crisis.

The Prudential CEO ... said that the deepening market distortions created by quantitative easing had a negative effect on growth and damaged savers. 

Mr Thiam said that there was now a reliance on cheap money without a sensible exit plan. This, he warned, left the door open for inflation shocks that could throw the economic recovery off course. 

Mr. Thiam is absolutely right that QE damages savers and as a result has a negative effect on growth.  I refer to this effect as an economic headwind as savers cut back on current consumption to offset the loss in earnings on their savings.

Mr. Thiam's next point about the lack of a sensible exit plan is incredibly important.

Central bankers will say they have a sensible exit plan.  Unfortunately, these are the same central bankers who did not see the financial crisis coming and are frustrated that savers are not acting in the same way that the central bankers' models say they should act (with rates at 0%, they should be drawing down their savings rather than cutting back their current consumption).

“In the macro economy: savings equal investments. But QE is depressing savings and therefore depressing investment. This means, QE is depressing growth,” he said. 

While I agree with Mr. Thiam that QE is depressing growth, I don't agree with his causality.

QE and similar low interest rate monetary policies are depressing both return on savings and demand as savers offset the loss of income on their savings by cutting back on consumption.  By reducing consumer demand, QE is depressing the return on investment by companies.  Companies respond by reducing investments and this in turn further depresses growth.  Bottom line:  QE is depressing growth.

“It is a really strange economic strategy because everyone is looking for growth – but the monetary policy is completely anti-growth. There is no other exit to indebtedness than growth,” he said, referring to the UK’s £120bn or so deficit..... 

I agree with Mr. Thiam that it is a really strange to pursue anti-growth monetary policies like QE and similar low interest rate policies when the central bank is trying to stimulate growth.

I disagree with Mr. Thiam that the only way out of the indebtedness is growth.

There is a much quicker way.  Adopt the Swedish Model and have the banks recognize upfront the losses on the excess public and private debt in the financial system.

“I am very worried we are creating bubbles, everywhere. Interest rates will have to normalise. And it is not clear to me what the exit strategy is. I ask central bankers this all the time and I still have not heard a single sensible answer,” he said.... 

“QE creates a total distortion in the economy,” said Mr Thiam. “The risk free rate is possibly the single most important piece of economic information we have and we shouldn’t mess with it. That is a dangerous game, because, to manipulate the risk free rate is to introduce huge distortions.”

The role of central banks has always been to "distort" the risk free rate in an effort to smooth the business cycle (lower highs in economic expansion and lower lows during recessions).

What makes QE and similar low interest rate policies different this time is they have been shown to be ineffective at generating economic growth, but the central banks keep doubling down despite the lack of a sensible exit strategy and the huge distortions these policies are causing in the economy. 

The Question the UK's Commission on Banking Standards should ask bankers

The Guardian carried an article in which it suggested a number of questions that the Parliamentary Commission on Banking Standards should ask the senior banking executives from Barclays, HSBC and Lloyds at the hearing this week.

These questions include:

■ Has the go-for-broke bonus culture on the City's trading floors really changed? What are they doing to enforce different values?
■ How have they shifted incentives, from boardroom to branch, to prevent another major mis-selling scandal on the scale of PPI or interest-rate swaps?
■ Once the Vickers reforms are enacted, will it really be the case, as George Osborne hopes, that banks' investment arms can be allowed to go bust without inflicting huge collateral damage on the rest of the economy?
■ How can they justify the continued existence of a lavish bonus culture, despite the fact that tens of thousands of layoffs mean there should be bankers aplenty to snap up on the cheap?
■ Why was lending to small and medium-sized businesses still falling at the end of 2012, despite cut-price loans from the government's Funding for Lending Scheme?
■ Even if Osborne fixes the problem of banks being too big to fail, aren't they still simply too big to manage?

All of these are excellent questions, but they are follow-on questions to the real question:

What are you hiding that prevents you from adopting ultra transparency and disclosing on an ongoing basis your current global asset, liability and off-balance sheet exposure details?

Since at least the 1900s, ultra transparency has been the sign of a bank that can stand on its own two feet as it shows that the bank has nothing to fear because it has nothing to hide.  Clearly, the UK banks are hiding behind a veil of opacity that the Bank of England's Andrew Haldane says makes the banks 'black boxes'.

What are the banks hiding?

Since the 1930s, it has been well known that sunlight is the best disinfectant.  However, the bankers are not using sunlight but rather policy pronouncements to try to change their culture.  Policies that a Guardian poll showed that almost 3 out 4 people do not think will be effective at Barclays.

If the bankers are truly serious about changing their culture, why are they not deploying ultra transparency which is the best means for changing the culture and keeping future bankers from straying into bad behavior?

Please note that by asking about ultra transparency several of the Guardian's questions don't need to be asked.

The issue of whether a bank is too big to manage goes away as a result of subjecting the banks to the type of market discipline that ultra transparency makes possible.  For the first time since the 1930s, market participants will be able to assess the risk of each bank and adjust the amount and price of their exposure to reflect this risk assessment.  Linking risk and cost of funds will an incentive for banks to make themselves manageable (banks perceived to be too big to manage will pay a premium to obtain funds).

Can a bank's investment arm go bankrupt ceases to be a major issue when there is ultra transparency as the investment arm will no longer take proprietary bets.  It won't take proprietary bets because all of the market participants can see their position and can trade in such a way as to minimize the potential profit of the position and maximize the potential loss on the position (please see JP Morgan Whale trade for confirmation).

The existence of a lavish bonus culture doesn't need to be justified as providing ultra transparency allows the Board to link pay to risk adjusted performance.  The Board will do this as market participants will exert discipline on the bank to do so.

UK Chancellor wants RBS bankers to pay Libor-rigging fines and not taxpayers

In what could finally be the beginning of a change in how policymakers respond to bad banker behavior, George Osborne, the UK Chancellor, is arguing for RBS bankers paying the fine for rigging the Libor interest rate and not taxpayers.

Now that the principal that bankers should pay for their misdeeds is established, it makes sense to take the next step and have the bankers repay the taxpayers for all the taxpayer money spent cleaning up the financial crisis.

Yes, I realize that this will require the bankers to give up bonuses previously received and to forgo bonuses for the foreseeable future, but this is what they will have to do to repay the taxpayers.

As reported by the Guardian,

George Osborne has told bankers they must give up their bonuses to pay international fines imposed for the Libor rate-rigging scandal. 

The chancellor is understood to have "laid down the law" to state-backed Royal Bank of Scotland in recent days as it braces itself for a major penalty from US regulators. 

Senior RBS figures were warned that leaving taxpayers to cover the US penalty for the bank's role in fixing the lending rate, which governs the price of more than $500tn of loans and transactions around the world, would be "totally unacceptable". 

RBS is rumoured to be preparing to hold back some perks in preparation for the fines. The bank is thought to be close to reaching a deal with regulators in Britain, the US, Japan and Singapore and faces paying out an estimated £350m. 

A senior Treasury source said: "Fixing the Libor market is a symbol of all that went wrong with the banking system over the past 10 years. We are now putting those things right.

And one major step towards putting those things right is to have the bankers returning their bonuses from the last 10 years as part of their repaying taxpayers for the money that the taxpayers have had to spend dealing with the financial crisis.

From financial 'failure prevention' to 'failure containment': how regulators destroyed global financial system

In an interesting Guardian column, Leo Panitch looks at Tim Geithner's legacy through the prism of the shift in regulatory policy from financial 'failure prevention' to 'failure containment'.

This shift is best embodied in former Fed Chairman Alan Greenspan's policies that Professor Paul Krugman summarized as 'it was not the role of financial regulators to prevent or pop financial bubbles, but rather to clean up afterwards to limit the damage their popping causes.'

I would like readers to take a moment to think about the implications of shifting from a policy of preventing financial failure to trying to limit the damage by mopping up afterwards.

First, the financial system under the FDR Framework was designed so that regulators would perform certain tasks to prevent a financial crisis.  Specifically, financial regulators were given the task of ensuring that market participants had access to all the useful, relevant information in an appropriate, timely manner so they could independently assess this information and make fully informed decisions.

When regulators effectively stopped being in the business of preventing a financial failure, they let opacity reappear across wide swaths of the financial system including both banks and structured finance securities.

The result of this opacity was our current ongoing financial crisis.

Second, if the regulators were no longer going to prevent a financial crisis, then who was going to pay to clean up afterwards?

Under the FDR Framework, who "pays" when an investment goes down in value is well known.  It is the investor who pays as they are responsible for all losses on their exposures.

Under the mop up after a financial crisis, who "pays" is the taxpayer and, to the extent that policies like austerity are adopted, a country's citizens.  Who doesn't pay is the investors or the individuals responsible for the financial crisis.

Third, if the regulators are no longer going to prevent a financial crisis, then what is the financial system suppose to look like after they have cleaned up after the financial crisis?

Under the FDR Framework, regulators would clean up the financial system so that transparency, specifically valuation transparency, has been brought to all the opaque corners of the financial system.

Under the mop up after a financial crisis, the focus would be on adding more complex rules and regulatory oversight while providing additional meaningless price transparency.  In short, opacity would still exist across wide areas of the financial system and the financial system would still be prone to the next financial crisis.

The legacy of the policy of financial containment is that not only does it make the financial system more prone to a crisis, but it ensures that a crisis occurs more frequently.

Regular readers know that your humble blogger has been advocating a return to the policy of failure prevention and adherence to the FDR Framework.  It worked successfully for 7+ decades in preventing a financial crisis and has been shown to be successful at ending financial crises.

Perhaps the most important report on what the Treasury was up to in the 1990s – prepared in the teeth of some of most dangerous financial crises of the mid-1990s, and published as American Finance for the 21st Century in late 1998 in the wake of the Asian crisis – made a sharp distinction between the old practice of "failure prevention" and the new one of "failure containment". 

To persist in trying to make "the financial system safer by tying the hands of institutions will inevitably put a damper on innovation, at considerable cost to the economy as a whole and potentially to America's world leadership in financial services." 

Supervision and regulation needed to be of a kind that supported the financial sector's expansion – and insofar as its "mercurial growth" inevitably gave rise to financial crises, the main goal of financial policy should primarily be "failure containment".

Superintending global finance to this end was always a multilateral exercise, but one in which the Treasury was very much primus inter pares....

Please re-read the highlighted text as the policy of 'failure containment' was a necessary condition for the financial crisis which began on August 9, 2007.

This policy of financial containment is a policy effectively written by the banks for the banks.  It removes from them the downside from losses on dud assets or proprietary bets and places these losses on society.

In fact, Geithner's financial stability plan largely followed what had gone before. 

The main goal, as he told bankers from 27 countries at a 2011 American Bankers Association meeting, remained to find "better ways of managing the inevitable failures that will happen in competitive markets", which above all meant recognising that "the challenge of reducing the risk of contagion from a financial crisis requires much more global co-ordination internationally than has ever been the case".

As the FDR Framework based system is designed, the cost of those inevitable failures that will happen in competitive markets is borne by the investors, including banks.

With the policy of financial containment, these losses are now shifted to society.

Of course, what also made "failure containment" especially challenging was how to handle Congress at home.

A favourite phrase inside the Treasury, as Geithner rose through its ranks in the 1990s, was that of Congress "cutting off the water to the fire department when the city is burning down". 

Yet this Congressional opposition had in every instance been overcome. Indeed, Robert Rubin accurately described Congress's resistance to the Treasury's loan to Mexico to stop the 1995 peso crisis (the largest bailout of a sovereign in history to that point) as "meant to oppose us without actually stopping us".

To its credit, Congress sensed that putting the cost of the financial crisis on the taxpayers was not right. This is why it fought Treasury.

It probably never occurred to Congress that Treasury was at the vanguard of the fight to have financial regulators abandon their role in 'failure prevention'.  Had Congress seen Treasury's abandonment of failure prevention, Congress would have realized that someone needs to pay for cleaning up after the financial crisis and that someone should not be taxpayers.

Mathbabe: Bill Gates is naive, data is not objective

In a terrific post with direct application to the ability to bring transparency to all the opaque corners of the financial system like banks and structured finance securities, Mathbabe observes

rather than focusing on how individual models improve with more data, we need to worry more about which models and which data have been chosen in the first place, why that process is successful when it is, and – most importantly – who gets to decide what data is collected and what models are trained.... 

Bill Gates seems genuinely interested in tackling some big problems in the world, and I wish more people thought long and hard about how they could contribute like that. But the process he describes so lovingly is in fact highly fraught and dangerous. 

Don’t be fooled by the mathematical imprimatur: behind every model and every data set is a political process that chose that data and built that model and defined success for that model.

Please re-read the highlighted text again as Mathbabe has nicely summarized why letting the banks and the sell-side hijack the political process prevents transparency from ever being brought to the opaque 'black box' banks or the 'brown paper bag' structured finance securities.

In the case of structured finance securities, the sell-side through the industry trade lobbying organizations it controls set the agenda for bringing transparency to structured finance securities by trotting out the idea of 'data templates'.

By focusing attention on the data templates, the sell-side has been able to control the political process for bringing transparency to structured finance securities by taking many issues off the table.  These issues include 'when' data is disclosed and why not disclose all the data fields tracked by originators and servicers that are not protected by borrower privacy regulations.

The result as shown by a recent poll of investors conducted by Principia is that 59% of investors think that what is currently disclosed and what will be disclosed as a result of the efforts of the global regulatory community will not be sufficient to adequately perform due diligence.

Please re-read the previous paragraph in light of Mathbabe's observation: behind every model and every data set is a political process that chose that data and built that model and defined success for that model.

For the sell-side, success is defined as perpetuating opacity so that investors do not have the data they need to adequately perform due diligence.

The result is that anyone buying or selling structured finance securities is blindly gambling.

Of course, the exception to this is Wall Street which through its subsidiaries has access to all the data it needs on an observable event basis.

'London Whale' demonstrates why transparency ends banks taking proprietary bets

The Wall Street Journal carried an article on how the 'London Whale' sounded the alarm over concerns about the risk of his trading position.

In doing so, he demonstrated why transparency ends banks taking proprietary bets.  Specifically, transparency when banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The J.P. Morgan Chase & Co. trader known as the "London whale" tried to alert others at the bank to mounting risks months before his bets ballooned into more than $6 billion in losses, according to people familiar with emails reviewed by J.P. Morgan and a U.S. Senate panel..... 

In one instance, Mr. Iksil told another trader that the size of his bets was getting "scary," according to emails in a Jan. 16 report by J.P. Morgan and to the people familiar with the emails.... 

The panel, led by Sen. Carl Levin, D-Mich., also is looking into whether J.P. Morgan failed to disclose crucial information to its primary bank regulator, the Office of the Comptroller of the Currency, and whether the OCC failed to press the bank for details about how it managed its risks. The bank acknowledged previously that its information was wrong early in 2012. 

The OCC prepared an assessment of its performance and shared it with the subcommittee, said people familiar with the OCC report. ...

Like the Bank of Italy with the Monte Paschi derivative scandal, the OCC was in position, but failed to take action.

Your humble blogger is not surprised that the OCC did nothing.  Financial regulators do not see it as their role to question individual positions as this get them into allocating capital across the economy.  Instead, the regulators focus on whether the bank has the ability to absorb the 'expected' losses on the position.

Rather than change the regulatory focus to allocating capital across the economy, your humble blogger has argued that the regulators' information monopoly must be ended and the banks required to provide ultra transparency.  With this data, the markets can exert discipline on the banks by questioning individual positions.

Emails reviewed by the subcommittee and J.P. Morgan show Mr. Iksil was worried about the trades as early as January 2012, according to the people familiar with them. 

Mr. Iksil and another London trader, Javier Martin-Artajo, also suspected in early 2012 that other traders in a different part of J.P. Morgan leaked their positions to outside hedge funds and took opposing positions to those held by Mr. Iksil's group; both later communicated these suspicions to internal investigators, said people familiar with the case....

Please re-read the highlighted text again as it explains exactly why requiring the banks to provide ultra transparency will end the banks taking proprietary bets.

Simply put, if other traders know your positions, they will trade against you.

At a minimum, their involvement minimizes the amount that can be made on the position.  More likely, and this is what Mr. Iksil and his trade experience, their involvement maximizes the size of the loss on the proprietary bet.

I know I have repeated this point endlessly, but the Volcker Rule is simple to write and enforce.  The rule simply states that banks are not permitted to take proprietary bets and the banks are required to provide ultra transparency so that the market can enforce discipline so no proprietary bets are taken.

Messrs. Iksil and Martin-Artajo were key members of the London team that built a complicated, bearish position in an index that tracks the health of a group of investment-grade companies. Last year, the bets morphed into a not-easily-liquidated position on corporate credit. The wagers accumulated losses when the traders added to their positions instead of unwinding them and the market went the other way. 

On Jan. 30, 2012, according to emails in J.P. Morgan's report and the people familiar with the emails, Mr. Iksil said to Mr. Martin-Artajo that the size of the positions was becoming "scary" and suggested that the bank's chief investment office should take losses, or "full pain," immediately. Mr. Iksil then asked for a Feb. 3 meeting with his managers, including Chief Investment Officer Ina Drew. 

Mr. Iksil told Ms. Drew the portfolio could lose an additional $100 million and that it was possible J.P. Morgan didn't have the right positions in place. 

One of the advantages of requiring the banks to provide ultra transparency is that the banks are not going to take on a position that they cannot easily explain to market participants.

To Mr. Iksil, Ms. Drew didn't appear overly concerned by this potential $100 million loss....  

One week later, Mr. Iksil told those who attended the Feb. 3 meeting aside from Ms. Drew that he would need to expand his positions. He was told to proceed, while concentrating on managing profits and losses. He and the other traders added to their trades in February. Losses reached $169 million by the end of that month. 

At one point, Mr. Iksil told a trader to stop trading a certain credit index because he wanted to observe its behavior. He told Mr. Martin-Artajo about his plans, but Mr. Martin-Artajo, who was Mr. Iksil's direct superior, told him to keep trading. 

In March, traders overseeing the positions began to discuss whether they should place higher estimates for the values of certain trading positions of the CIO group, a step crucial in how they viewed the positions and reported them to investors and other outsiders.... 

Another advantage of ultra transparency is that this internal debate over how to value the trading positions goes away.  The market is going to value the positions so the bank has an incentive to make sure its values are always conservative (it is better to error on the side of undervaluing than overvaluing a position).

But on April 10, losses mounted again, and traders were at odds over how bad it could get. The estimates for that day ranged from $5 million to $700 million; the final number landed at roughly $400 million.... 

Then, on six trading days between April 23 and April 30, losses went up by nearly $800 million more. 

The losses caused Mr. Dimon and other top executives to question whether the traders "adequately" understood the trading portfolio "or had the ability to properly manage it," J.P. Morgan said in its Jan. 16 report.

Requiring the banks to provide ultra transparency removes the issue of whether the traders adequately understand or have the ability to properly manage a trading portfolio.

It is far better to eliminate proprietary bets upfront by having the market discipline of the market trading against a bank position than it is to have the banks lose money because their traders do not adequately understand or have the ability to properly manage a trading portfolio.