Monte Paschi scandal provides more evidence bank supervision by regulators inadequate

On two separate fronts, the Monte Paschi scandal provided evidence that supervision by bank regulators is inadequate as a substitute for the combination of transparency and market discipline.

First, Mario Draghi said that the Bank of Italy did what it was suppose to do and could only have done more it granted additional powers.  Second, the Bank of Italy made a previously undisclosed loan to Monte Paschi in late 2011.

As reported by Reuters,

European Central Bank President Mario Draghi denied suggestions on Thursday that he had been lax in his oversight of the scandal-hit Monte dei Paschi when he was governor of the Bank of Italy....

In his first public comments on the crisis, Draghi told the ECB's monthly news conference in Frankfurt that the Bank of Italy had "done everything it should and appropriately and on time." 

As governor of the Bank of Italy at the time, Draghi was ultimately responsible for bank oversight prior to his departure for Frankfurt to head the ECB in November 2011....

Let's assume that Mr. Draghi is correct in his statement about the performance of the Bank of Italy.

This simply confirms that supervision by bank regulators doesn't work as a substitute for transparency and market discipline.

If banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, the derivatives could not have been hidden as the counter-parties would have wanted them acknowledged so they could get the benefit of each deal.

While there are no legal restrictions that prevent banks from disclosing on a borrower privacy protected basis all of their current exposures, banks prefer not to do this.

Rather, banks prefer that the bank regulators, like the Bank of Italy, who have supervisory responsibility and the legal right to see all the useful, relevant information that is needed to assess the solvency and risk of the banks have a monopoly.

Why?

Because then the banks are not subjected to market discipline.  In fact, to the extent that the banking supervisors don't follow up aggressively on any problem, the banks are not subject to any discipline.

He said he had signed two reports into Monte Paschi by Bank of Italy inspectors, the first of which, from mid-2010, has been leaked to the press and raised several irregularities in Monte Paschi's operations and accounts....

Draghi said that as it does not have policing powers, the Bank of Italy was limited in its ability to counter fraud, one of the charges which prosecutors have leveled at Monte Paschi's former management.

Keep in mind that it was always an option for the Bank of Italy to disclose to the market that it had found these irregularities involving derivatives.

By not disclosing its findings to the market, the Bank of Italy allowed Monte Paschi to present a false picture of its financial condition.

Facing several different questions on the historic lender, Draghi suggested that the Bank of Italy could have benefitted by having more powers to supervise effectively....

More supervisory powers wasn't going to change the failure of the Bank of Italy to disclose information that the market needed to properly assess the risk and solvency of Monte Paschi.

In fact, it can be argued that due to safety and soundness concerns, the Bank of Italy had an incentive to not disclose the derivative irregularities.

As reported by the Wall Street Journal, the Bank of Italy extended a secret loan of almost 2 billion euros to Monte Paschi in late 2011 as it was experiencing liquidity problems due to the derivatives that the Bank of Italy had not disclosed to the market.

Again, had Monte Paschi been required to provide ultra transparency everyone would have known about the loan.

Instead, it looks like the Bank of Italy intended that the loan should be hidden and Monte Paschi make false representation about its financial condition to the market.

Monte dei Paschi di Siena SpA, the 541-year-old Italian bank at the center of a burgeoning financial scandal, was so strapped for cash in late 2011 that it negotiated a covert loan of nearly €2 billion ($2.7 billion) from the Bank of Italy even as executives were publicly describing the lender's funding position as comfortable, according to the Bank of Italy and people familiar with the deal.

The bottom line and the reason there is a scandal is that Bank of Italy failed to disclose material information about Monte Paschi that market participants needed to have if they were to accurately assess the risk and solvency of the bank.

The lesson from the scandal is that bank regulators need to be stripped of their information monopoly by requiring all banks to provide ultra transparency.

At a minimum, this subjects the banks to market discipline and eliminates the possibility that bank regulators will fail to disclose material information.

Surprise! Derivatives involved in Monte Paschi's ill-fated acquisition

In an attempt to escape blame for not taking prompt action on the Monte Paschi derivatives it knew about, the Bank of Italy is trying to change the topic by saying they were lied to about a derivative involved in Monte Paschi's ill-fated acquisition.

This latest disclosure reaffirms why all banks must be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Had this been the case, the counter-parties for the acquisition derivative would have noticed the Monte Paschi had not disclosed the derivative and would have alerted everyone to the omission.

Why?

Because the counter-parties want the derivative disclosed so they can get the benefit of the derivative.

As reported by Reuters,

Monte dei Paschi misled the Bank of Italy over a 1-billion euro hybrid instrument it used to partly fund its acquisition of rival bank Antonveneta, Siena prosecutors alleged in a document reviewed by Reuters on Wednesday. 

As part of their ongoing probe, prosecutors alleged in the document, dated February 1, that the Tuscan bank struck a deal which violated requirements set by the central bank over the hybrid financial instrument, known as FRESH 2008. 

Monte dei Paschi is being investigated for alleged wrongdoing relating to its 2008 acquisition of Antonveneta, a smaller rival. If proved correct, the allegations by prosecutors that Monte dei Paschi misled the Bank of Italy over the true nature of part of the financing it raised would undermine the basis on which the deal was approved....

Prosecutors alleged that the indemnity documents violated requirements set by the Bank of Italy by making the FRESH 2008 work like a bond rather than an hybrid equity instrument. Monte dei Paschi needed to show the Bank of Italy that it had sufficient equity capital in place to win approval for Antonveneta takeover. 

Based on the information officially received from the bank, the regulator allowed Monte dei Paschi to calculate those notes as core Tier 1 capital, a measure of a bank's financial strength which is closely monitored by regulators, boosting its financial base and allowing it to demonstrate it had sufficient capital to absorb the Antonveneta deal.

At best, this seems to confirm that Tier 1 capital is doesn't say much about a bank's financial strength.  At worse, this seems to confirm that Tier 1 capital is meaningless.

Japanese banks tried to do Libor manipulation one better

The Financial Times reports that the Japanese banks manipulated Tibor (the Tokyo interbank lending rate) so they could improve the margins on their loans.

Just like Libor, Tibor was not set based on actual transactions, but rather on submissions by the banks.  Submissions that consistently overstated Tibor.

Regular readers know that the only way to restore trust in Libor, Tibor, Euribor and other benchmark interest rates is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, banks with deposits to lend can assess the risk and solvency of the banks looking to borrow.  This keeps the interbank lending market open.

With this information, all of the benchmark interest rates can be based on actual transactions.

A former star trader in Tokyo has accused Japanese banks of operating a “cartel” in loan pricing, forcing higher rates on millions of borrowers and hampering central bank efforts to spark lending in the world’s third-largest economy. 

Hideto “Eddy” Takata, a former derivatives trader who worked for several investment banks until 2008, claims in a self-published book coming out this month that Japan’s banks have collectively kept the Tokyo interbank lending rate [Tibor] benchmark “artificially high” since the global financial crisis to boost profits on domestic products such as mortgages, almost all of which are linked to Tibor.

Since early 2009, Tibor rates have been much higher than yen Libor rates, which are generally used outside Japan. In theory, the two rates should be very similar because they are both used as a reference for borrowing in the same currency. 

The current premium for three-month Tibor is about 13 basis points over yen Libor. Since early 2011, the spread has held steady, ranging from 13 to 15 basis points. 

Mr Takata says the premium that existed between 1997 and 1999 when the Japanese banking system was rocked by bankruptcies may have been justified. But he argues there should be no discrepancy now because Japan’s financial system has been stable for several years. 

Credit-market specialists agree that Tibor and yen Libor rates should be similar – as they were for seven years until 2007 when fears over US and European banks began to emerge. 

Explaining how Japanese banks have profited from the spread between Tibor and yen Libor, Mr Takata says: “If Japanese banks need to borrow, they use Libor. If lending, they use Tibor. No other country has a double standard like this.” 

The collusion allegations, which Mr Takata admits are based on “circumstantial evidence”, could open a new front in the sprawling regulatory probe into allegations that big US and European banks manipulated the rate setting process for Libor and other key benchmark lending rates.

So far, regulators have focused on allegations that the banks sought to move the rates around to make money on derivatives and make themselves appear stronger during the financial crisis, rather than to affect the prices of ordinary loans.....

Tibor rates are gathered and published by the Japanese Bankers’ Association, while the mostly non-Japanese banks who quote yen Libor rates provide their submissions to the British Bankers’ Association. 

Under the JBA’s self-policed system, banks are asked to quote what they think are the prevailing market rates. However, according to the Association of Call Loan and Discount Companies – an industry body that records actual transactions – the average rate for a couple of three-month transactions in December was 0.17 per cent, while three-month Tibor averaged 0.32 per cent. 

“It is rigged,” said a credit strategist, giving his opinion on condition of anonymity. “If banks cut Tibor, they’d lower their margins. But with interest rates so low [in Japan] by global standards, they need to make a living.” ....

“Yes, the manipulation for trading profit was wrong,” Mr Takata said. “But the organised manipulation of rates by Japan’s banks is much worse.”

HSBC chief admits that complexity exposed bank to problems

Over shadowed by RBS reaching a settlement  for its role in manipulating Libor was that admission by HSBC's chief that complexity exposed the bank to problems.

As reported by the Telegraph,

Stuart Gulliver said HSBC's structure "was not fit for purpose for a modern world"....

Please reread the highlighted text as Mr. Gulliver has nicely made the case for why banks must be 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, it is easy for market participants to see just how complex the banks are and, as a result, exert discipline on bank management to make their organizations much less complex.

"To be honest, our geographic footprint became very attractive to trans-national criminal organisations, whether they are terrorist in origin or criminal in origin," he added, responding to questions from the parliamentary commission on banking standards on Tuesday....

As shown by the ongoing Libor benchmark interest rate manipulation scandal and the mis-selling of insurance and interest rate derivatives scandals, criminal activity also existed inside the bank.

What allowed this type of activity to flourish is opacity.

HSBC and the other banks are currently, as the Bank of England's Andrew Haldane says, a 'black box'.   It is this opacity that hid the complexity the Mr. Gulliver says was a major factor in money laundering.

HSBC Chairman Douglas Flint said the bank was too slow to improve its systems and controls. 

"There were things we were not aware of, and standards we believed were being applied that were not," Mr Flint said. 

While admitting past fault, the pair insisted the bank is no longer out of their control. 

"I do not believe this bank is too big to manage or too big to control [any more]," said Mr Gulliver. 

"We have re-organised HSBC. We have implemented the highest standards, which are the US standards, everywhere in the world."

With ultra transparency, it is not a question of whether Mr. Gulliver thinks HSBC is too big to manage or too big to control, it is a question of what the market thinks.  

Banking sector needs to adopt ultra transparency after Libor-rigging

Perhaps the best line to emerge as RBS settles and pays the equivalent of a parking ticket for its role in manipulating Libor was (from a Telegraph article):

Senior Yen Trader: its just amazing how libor fixing can make you that much money

Senior Yen Trader: its a cartel now in london[.]

Please re-read the highlighted text as it provides an insight into the culture of all of the global banks.  I say culture because it isn't 21 individuals at RBS or 100+ individuals at UBS.

The culture that permitted manipulating Libor at all these banks also permitted money laundering at Standard Chartered and HSBC, mis-selling payment protection insurance by all the UK banks and mis-selling interest rate hedging products by all the banks.  And this list of scandals doesn't even include the banks' involvement with toxic structured finance securities or lying about the value of their derivative exposures (see Monte Paschi).

To date, the regulatory response to changing this global culture in banking has been inadequate.

Like Barclays and UBS before it, RBS paid a fine that was equivalent to a parking ticket.  It was simply a cost of doing business.

The lesson from these fines is not that manipulating a benchmark interest rate is bad, but rather, next time don't say it in an email so you don't get caught.

If the policymakers and financial regulators are ever going to get serious about reforming the banks and their cultures, it will start with requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

It is only with this level of disclosure that sunlight can begin to act as the best disinfectant.

In the absence of ultra transparency, the bank executives can spew forth all the rhetoric they want about how bankers have to behave better, but everyone knows that the rhetoric will not change the culture of the banks.

David Rowe: Regulators' high-wire act

In a terrific column, David Rowe explains the high-wire act regulators perform when it comes to regulating the banking industry and why this act is prone to failure.

Mr. Rowe does this by looking at the complex rules for determining a bank's liquidity coverage ratio.  Rules that only the regulators can determine if a bank is in compliance with due to the lack of transparency into the bank's exposure details.

Regular readers know that the combination of complex rules and regulatory oversight have been substituted for the combination of transparency and market discipline.  This substitution makes the financial system dramatically more unstable.  A point that Mr. Rowe makes.

The recent easing of the Basel III liquidity coverage ratio ... highlights the difficult – perhaps impossible – regulatory challenge of striking the right balance in a world of too-big-to-fail banks..... 

When Basel III appeared in December 2010, it included proposals that would sharply increase holdings of liquid assets to cover stress-level net outflows from banks – the liquidity coverage ratio (LCR). ... 

The basic idea behind the LCR is to ensure banks hold enough high-quality liquid assets to meet potential net cash outflows over a 30-day period even in a crisis. The original proposal allowed little more than central bank reserves and government bonds to be counted as liquid assets. 

The new rule expands the range of eligible assets while, not surprisingly, introducing yet another layer of complexity. It defines three categories of assets: level 1, level 2A and level 2B. 

Level 1 assets are essentially cash and official obligations assigned a zero risk weight in the Basel II standardised approach. 

Level 2A and 2B assets may include lower-grade official obligations, corporate bonds rated as low as BBB– subject to different haircuts depending on their credit ratings, simple residential mortgage-backed securities rated AA or better (excluding structured products) and even certain equities subject to a 50% haircut. 

Other provisions deal with the added risk of exchange rate fluctuations for liquid assets that are not denominated in the bank’s home currency. 

The terms for calculating the potential net cash outflow were also eased. For so-called stable deposits, specific jurisdictions can lower the 30-day run-off assumption from 5% to 3%, provided that the national deposit insurance programme meets certain requirements and historical evidence can demonstrate a 30-day run-off of less than 3% under past periods consistent with the conditions specified in the LCR. Less stable deposits are subject to 30-day run-off assumptions of 10% or higher as determined by national supervisors. 

Finally, implementation is to be phased in, starting with 60% of the full requirement in 2015, rising to 100% in 2019. 

Basel III and the Liquidity Coverage Ratio are a prime example of the complex rules that do not make the financial system safer.

Needless to say, all these provisions will be subject to endless wrangling between banks and their national supervisors. 

How does an instrument qualify as being “traded in large, deep and active repo or cash markets”? What makes a deposit stable or less stable? 

More to the point, how can we be sure that supervisors will consistently strike the right balance between bank safety versus the socially essential functions of intermediation and maturity transformation? 

The simple answer is we cannot be certain of this. 

In fact, the very complexity of the regulations within which this balance must be struck virtually ensures that institutional momentum – both in the banks and the supervisory authorities – will be the dominant force. 

Please re-read the highlighted text as Mr. Rowe nicely lays out why the combination of complex rules and regulatory oversight fails.  This combination requires the regulators to do the impossible:  design rules that produce exactly the right outcome in the face of overwhelming political pressure from the banks.

It simply is not going to happen.

This is why your humble blogger has been saying that the regulation that is needed is to require banks to disclose on an on-going basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert discipline on the banks so that they are adequately capitalized, retain enough liquidity for any temporary funding interruptions and also provide the credit that the economy needs.

As long as we continue to act as if bank failure is not an option, we cannot rely on the fear of failure as a disciplining force. 

Furthermore, the attempt to eliminate the risk of failure by uniform and highly complex regulatory requirements actually promotes a degree of institutional homogeneity that is conducive to systemic crises.... 

I remain completely unconvinced, however, that this continuing exercise in financial casuistry will do much, if anything, to prevent a future systemic crisis.

All of the complex rules will not prevent a future systemic crisis.  The only way to prevent a future systemic crisis is by requiring the banks to provide ultra transparency and bringing transparency to all the other opaque corners of the financial system.

UK banking standards commission sees through Barclay's rhetoric and call for real change

As reported by the Guardian, the UK's commission on banking standards saw through the rhetoric about change offered by Barclays new CEO and asked for real proof of change.

To drive home this point, the head of the commission, Andrew Tyrie, waived around a report that Barclays had heavily redacted by blacking out paragraphs.

This was a none to subtle suggestion that Barclays adopt ultra transparency as the cornerstone of its efforts to change its culture and become a 'socially useful' bank.

Antony Jenkins told MPs that he would resign if another scandal on the scale of the Libor rate scam erupted during his tenure, vowing to transform a bank that he described as an aggressive and self-serving institution under its former chief executive. 

In an appearance at the banking standards commission, he said: "We are shredding that legacy and in the value of stewardship, whoever is sitting in front of a committee in a decade's time – I want them to have inherited a fundamentally different culture." 

He added: "We should shred those behaviours of the past, we should shred situations where we're short-termist, too aggressive and too self-centred. It's those things I want to eliminate from our culture."

Ultra transparency is the key for Mr. Jenkins to reach his goal.

With ultra transparency, Barclays will be disclosing on an ongoing basis its current global asset, liability and off-balance sheet exposure details.  This will usher in sunlight which is the best disinfectant for bad banker behavior like manipulating a bench mark interest rate.

However, MPs and Lords on the inquiry remained unconvinced and said the company must do more to show it is changing its ways. 

The Committee chairman, Andrew Tyrie MP, said: "It doesn't really matter what the scandal is – Barclays seems to have a finger in every one of those pies."

He was also critical of Barclays' initial refusal to provide unedited information. 

Waving a redacted document covered in blacked-out paragraphs, he said: "We asked for full papers and frankly it has been very hard getting them... Even the page numbers have been redacted."...

Please re-read the highlighted text as it is obvious from Mr. Tyrie's comments that he and the commission know that the only way real change will occur at Barclays is if Barclays starts to provide ultra transparency.

When a bank is committed to providing ultra transparency, it is saying that it can stand on its own two feet.

A bank that can stand on its own two feet has nothing to hide from market participants or a parliamentary commission (a bank providing ultra transparency would never send over a heavily redacted document).

But Tyrie expressed doubts that the cultural change sought by Jenkins can be achieved by the current board. He said: "Doesn't it seem that the time has come to set your remuneration strategy in a new framework led by a new [remuneration committee] chairman?"...

One of the great things about providing ultra transparency is that it naturally leads to the bank linking remuneration to the risk being taken.

Full turnaround plans for the bank under Jenkins will be unveiled next week, including a new five-point plan for determining bonuses, which must take into accountupholding values as well as financial performance. 

However, Tyrie said the commission would reserve judgement on whether Barclays has changed....

After all, what Mr. Jenkins is proposing is long on rhetoric and short on real substance.

In fact, anything less than adopting ultra transparency is short on real substance when it comes to changing the culture and making Barclays a social useful bank.

Tyrie said yesterday: "We don't seem to be getting very far in thinking through how we can have confidence that the non-executives in Barclays are going to be carrying the right culture. What we want is some more concrete evidence that the board is being put in a shape that can help give you a chance of succeeding."

The only way to have confidence that the non-executives in Barclays are going to be carrying the right culture is if Barclays adopts ultra transparency.  This exposes their activities to sunlight and discourages unacceptable behavior.

Mapping Toxicity: bringing transparency to risk assessment

Regular readers know that this blog has been the leading advocate for bringing transparency to all the opaque corners of the financial system.

It is transparency that allows market participants to assess risk and adjust the amount and pricing of their exposures so they are compensated for the risk they are taking.

It is the principle of caveat emptor and the knowledge that the they are responsible for all losses on their exposures which gives market participants the incentive to use the disclosed information and limit their exposures to what they can afford to lose based on the risk of the exposure.

By limiting their losses to what they can afford to lose, market participants end concerns about financial contagion.

With that as background, I would like to share with you an article that shows how close the academic community is to understanding the FDR Framework and what your humble blogger has been saying about the role of and need for transparency.

The fiscal crisis of 2007–2009 caught people—including expert economists—off guard.

Not yours truly who is on record for having predict it.

And even as the crisis unfolded, useful insight was hard to come by. 

No they weren't.  I offered a transparency based solution before the financial crisis heated up that would have moderated the impact of the financial crisis.

"At the end of the day, most policymakers and economists had some idea as to what was going on, but not as much as one would hope," says Arvind Krishnamurthy, a professor of finance at the Kellogg School of Management. 

Based on the policies that have been implemented since the beginning of the financial crisis, there is zero evidence to back up this observation.

Why should this be? 

Why were the over-leveraged, so-called "toxic" real estate assets that contaminated the rest of the economy invisible even in plain sight? 

Great question.

Why were opaque securities that hid their toxicity allowed to be created in a financial system that is based on transparency?

According to Krishnamurthy, the problem is that financial reporting practices are too outdated to capture the information necessary to accurately assess modern macroeconomic health.

"In trying to document the crisis [after the fact], you start to look for the data you need and you find it's not exactly there," Krishnamurthy says.

Professor krishnamurthy's comment is true whether you are looking for the data you need to assess structured finance securities or banks.

"Our measurement of financial activities might have been good in the 1940s or '50s, but it's very poor currently given how much the financial sector has changed."

Current financial reporting focuses on assets and liabilities on a cash balance sheet. "If you look at an industrial firm like GM, their assets are the various manufacturing plants. These are all tangible things, and when you look at the financial statements, you can see it all fairly clearly," Krishnamurthy explains. 

Transparency exists for non-financial firms.  That is why the stock market continued to function throughout the financial crisis without government intervention.

The trouble is that firms like Goldman Sachs and Morgan Stanley assume contingent economic exposures, through financial instruments like derivatives, that do not show up clearly on their balance sheets.

"A simple derivative security might be one in which, when real estate prices go up by 10%, this company will make an extra $5; and if they go down, they'll lose $5, so the risk is commensurate to the $5," Krishnamurthy continues. 

"But you can’t really see the $5 of risk on financial statements.  You see that the firm has a derivative, perhaps tied to real estate, but you can’t see if the firm is exposed to real estate risk of order $5, $50, or $500. Right away this obfuscates things." 

Risk, rather than cash instruments, says Krishnamurthy, is the attribute of our financial sector that defines its overall health. And this risk goes largely unreported in financial statements to the government or the public.

Please re-read the highlighted text again as Professor Krishnamurthy makes a very important point about how current disclosure practices for financial institutions do not provide the information necessary to evaluate the risk these institutions are taking.

Where I disagree with the Professor is that the government is not restricted to financial statements, but in fact has a monopoly on all the useful, relevant information for assessing a bank's risk.  This is a fact as the bank regulators have examiners full-time at each of the major banks. These examiners see all of the exposure details needed to assess the risk of each bank.

"If you work at Goldman Sachs, the way you measure your own risks is entirely different than these types of [public] accounting statements," he says. "You'd measure things like, 'How much money do I make or lose if real estate prices go up or down by 10%?' That's the principal number you're interested in."....

The basis for assessing risk at Goldman Sachs or any other financial institution is the exposure level detail.  It is only by knowing what the exposure is that the question of how much will they make or lose if prices go up or down by 10% can be answered.

This is why I have repeatedly called for banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The irony is that while few financial firms report this data, "most companies collect it for internal purposes in fairly sophisticated ways," Krishnamurthy says. 

Unlike assets and liabilities on a balance sheet, risk is fundamentally dynamic, so assessing it requires a different approach from classical financial reporting.... 

It takes requiring the banks to provide ultra transparency.  With the exposure details, market participants can independently assess the risk of the bank and its various positions for themselves.

Few firms are motivated to [provide this information], since it is expensive and the letter of the law does not require it....

Actually, it is not very expensive to provide ultra transparency from an IT perspective.

It is expensive to provide ultra transparency from the perspective that it will eliminate certain types of activities that banks currently engage in like betting through proprietary trading and manipulating benchmark interest rates like Libor.

Professor Krishnamurthy is right that the letter of the law does not require that banks disclose their exposure details.  Until the 1930s, ultra transparency was the sign of a bank that could stand on its own two feet.  So it was provided voluntarily.

In the last 30 years, bankers have preferred to hide behind opacity as it hides what they are doing and allows the banks to privatize the gains from misbehavior and socialize any losses.

"The truth is that it's easier to not invest in standardizing data reporting and remain relatively opaque. But this is where a government can step in for the common good," Krishnamurthy says. "One way to do this is expand regulatory filings that require banks to use a common language. It seems possible that if everyone communicates risk in the same way, eventually they will disclose it on, say, SEC filings." 

It is in fact the government's responsibility in our financial system to step in for the common good and require banks to provide ultra transparency.

What this kind of new financial reporting could enable, argues Krishnamurthy, is a "50,000-foot view of the economy's 'risk map,'" which would illuminate pockets of toxic risk and illiquidity in the overall landscape, like those that caused the recent financial crisis.

Much more importantly, what ultra transparency will do is to subject banks to market discipline and let market participants do their own independent assessment of risk.

The result will be a stable financial system that is free of financial contagion and the need for taxpayers to bailout the banks.

Transparency > bank capital/liquidity rules > role split

Reuters reports that the general manager of the Bank for International Settlements, Jamie Caruana, observed that bank capital and liquidity rules are more important for achieving financial stability that separating retail and investment banking.

I agree with this observation and would make one minor addition.

The addition is that transparency is more important than bank capital and liquidity rules for achieving financial stability.  Specifically for banks, this would be ultra transparency under which banks are required to disclose their current global asset, liability and off-balance sheet exposure details.

Lesson 1A from the financial crisis is that the areas of the financial system that are opaque fail.  This is true whether the area has complex rules and regulatory oversight (banking) or not (structured finance).

Lesson 1B from the financial crisis is that the areas of the financial system that have transparency continue to function (stock markets).

Separating banks' riskier trading activity from their retail business would make the banking system more complex and is less important that building bigger capital buffers to prevent future crises, a top central banking official was quoted saying. 

"From my point of view, higher capital and liquidity requirements are more important for stabilising banks than the separation of proprietary trading and deposit-taking business," Jaime Caruana, general manager of the Bank for International Settlements, was quoted saying in Handelsblatt newspaper. 

However, it was up to finance ministers if they want to make changes to the universal banking model, whereby retail and investment banking are under the same roof, he told the paper. 

France and Germany are planning a reform of the banking system that will leave big lenders largely intact, despite a welter of rules aimed at making sure taxpayers are not forced to bail them out in the next crisis....

Please note that the welter of rules is focused on containing the next financial crisis with the hope that taxpayers will not have to bail the banks out.

Your humble blogger has repeatedly made the point that the focus should not be on containment, but should be on prevention.  That is why transparency is more important than bank capital/liquidity rules or separating investment and retail banking.

With ultra transparency, market participants can assess the risk of each bank and exert discipline on each bank so that it has adequate capital and liquidity and a lower risk profile.

The BIS has led efforts by international banking supervisors to force banks to bolster their loss-absorbing capital to help prevent the spread of financial crises.

Without ultra transparency, more capital does not help prevent the spread of financial crises.

What we are talking about is financial contagion.  The idea that if one bank fails it will take other banks with it.

And why would other banks also fail?

Because they have too much exposure to the bank that fails (call this interconnectedness)?

And why would the other banks have too much exposure?

Because opacity makes it impossible for the banks to independently assess the risk and solvency of any other bank and adjust the amount of their exposure to reflect this risk.

Leading up to the financial crisis, bankers listened to assurances from the bank regulators that the other banks were low risk and solvent.  This was shown to be untrue on August 9, 2007 when BNP Paribas announced it could not value structured finance securities.  At that moment, banks discovered they had more exposure to insolvent banks than they could afford to lose.

Ending contagion is simple.  Provide ultra transparency.

Banks will use this information to independently assess each other's risk and reduce their exposures to what they can afford to lose.  In doing so, they will assert market discipline on each other to lower their risk profiles and increase their capital and liquidity.

UK looks into how meaningless bank capital is

The Wall Street Journal reports that UK regulators are looking into just how meaningless bank capital ratios are.  Specifically, the regulators are looking at how banks assign risk weights to their assets.

This exercise is exactly as useful as rearranging the deck chairs on the Titanic.

Why?

Because since the beginning of the financial crisis, bank capital has been meaningless.  The suspension of mark-to-market accounting combined with regulatory forbearance has effectively divorced what is reported in bank financial statements from reality.

The OECD made the point that the suspension of mark-to-market accounting combined with regulatory forbearance distorts both the asset and equity accounts.  This renders any bank capital ratio meaningless.

The UK regulator's examination of how banks apply a risk adjustment to their overstated assets doesn't address the underlying problem that the assets are mis-stated.

As part of a review that began in November, U.K. bank supervisors are assessing the "risk weights" banks assign to their assets—a notoriously subjective process that many analysts and investors are convinced banks have used to understate the riskiness of their balance sheets. 

Please re-read the highlighted text as it explains the simple fact that even if the financial statement accounts were accurate, Basel capital regulations are subject to being gamed by the banks.

Because banks' capital cushions are generally calculated as a percentage of their risk-weighted assets, banks can make their capital buffers look fatter by understating the riskiness of their assets. 

Not all assets are created equal. Banks can hold smaller amounts of capital against less risky assets, such as residential mortgages or government bonds. The riskier the loan, the more a bank must put aside. 

British banks are locked in tense discussions with the Financial Services Authority to determine how and whether they need to shore up their balance sheets, according to regulators and bank executives. 

The results of these negotiations, which could see banks sell chunks of their businesses or issue debt, will be presented by the Bank of England in March.

Given the stakes, naturally the banks have an incentive to game the calculation of their risk-weighted capital ratios.

A Europe-wide rule change in 2008 gave banks more freedom over calculating their risks and resulting capital needs. In combination with pressure from investors to boost their capital levels, that led to British banks systematically cutting their risk weights over recent years. 

The Bank of England recently published data showing that average risk weights for U.K. banks are at their lowest levels since 1987. Further analysis shows British banks could be overestimating their capital levels by between £5 billion ($7.9 billion) and £35 billion by applying aggressive risk weights, according to the BoE.... 

Surprise! Given the incentive and the freedom to game their capital ratios the banks did just that.

The U.K.'s biggest banks use complex in-house models to predict how likely borrowers are to default and how much capital they should hold to cover potential losses. Although these models are ratified by the U.K. regulator, investors and analysts are worried that banks' methodologies are too opaque or simply don't add up. ... 

For instance, according to its most recent disclosure, Lloyds assigns a 2.2% risk weighting to £143.5 billion in mortgages—more than half of its total portfolio. That means it only needs to keep back £250 million to cover potential losses. Using a pre-2008 model, where mortgages had a 35% weighting, Lloyds would have to hold £4 billion in reserves.... 

Of course the bank methodologies are opaque.  If they told the market how they were modeling their assets to minimize their capital ratios, market participants would realize that the banks are far riskier than they are presenting themselves to be.

The benefits to banks of adjusting their internal models can be enormous.  

Deutsche Bank Thursday said it shaved around €55 billion from risk-weighted assets in the fourth quarter through changes to its models and other adjustments, a move that boosted its capital ratios but drew concern from some analysts on what would happen if regulators took a tougher stance.

Deutsche Bank's ability to dramatically change its capital ratios by changing its models reveals the fundamental flaw in relying on capital ratios that can be gamed by the banks.

Concern around risk weights is shared by regulators globally. 

The Basel Committee in charge of setting new international rules for banks said Thursday it found material differences on risk weightings from bank to bank in a recent study, in large part because of the choices banks made on what to include in their models and how regulators policed them. 

"Model-based approaches haven't given as accurate results as regulators had anticipated they would. Everyone is on a learning curve, so what constituted a good model back in 2006 may not constitute a good model today," said Vishal Vedi, a partner in Deloitte's financial services advisory practice. 

It is currently unclear what steps regulators will take to reappraise risk weights. 

One idea would see minimum risk weights for certain types of assets, such as home loans. Swedish regulators made such a move in November, with a plan to set a 15% floor on mortgage risk weights. 

Another approach is to go back to fully-standardized risk weights. For example last year, U.K. banks were ordered to change the way they treat commercial-property loans, a move that collectively added around £45 billion to risk-weighted assets at RBS, Lloyds and Barclays BARC.

A better idea is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, the market would value each bank's exposures and exert discipline on the banks to ensure they are adequately capitalized.