Barclays to close tax unit in bid to say that its culture has changed

The Guardian reports that Barclays is going to close its tax unit which engaged in industrial strength tax deferral in a bid to say that it is reforming its culture and can be counted on to focus on socially useful activities in the future.

This is a promise much like the idea of the global financial institutions saying they were ending proprietary trading.

Yes, the tax unit will go away.  However, that doesn't mean that the its human resources will not be allocated to other departments where they will continue to engage in similar activities.

Regular readers know that the large global financial institutions have literally thousands of subsidiaries which exist for the sole purpose of regulatory and tax arbitrage.

There is no reason to believe that Barclays has truly exited the tax deferral business until such time as it provides ultra transparency and discloses on an ongoing basis its current global asset, liability and off-balance sheet exposure details.  This includes the details of each of these thousand of subsidiaries.

It is only with this information that market participants can confirm that Barclays has exited the tax deferral business.

In the absence of ultra transparency, Mr. Jenkins announcement is just rhetoric.

The new chief executive of Barclays is to close the bank's controversial tax avoidance unit in a bid to repair its battered reputation, although he still risks inflaming the row over City pay by paying out up to £2bn in bonuses. 

Antony Jenkins ... will announce on Tuesday that the tax planning part of the structured capital markets (SCM) division – which has been accused of orchestrating tax avoidance on an "industrial scale" and has generated vast profits for the bank – is to be axed. 

The tax planning operation is one of several areas that have put been under review by Jenkins to assess if the bank's businesses are ethical and not just profitable. 

While Barclays will continue to offer straightforward tax planning to customers, it will pledge to no longer devise schemes purely intended for this purpose....

 Rhetoric.

The existence of SCM has long been controversial, including rumoured £40m pay deals for former bosses, and reports from insiders about tough management styles and odd rituals. 

Lord Lawson, the former Tory chancellor, and Labour peer Lord McFall have repeatedly raised the existence of the division when Barclays witnesses have appeared before the Banking Standards Commission, set up after the Libor scandal in June. 

McFall has cited reports from insiders – disputed by the bank – that the division had generated 110% of the bank's profits. 

When Jenkins appeared before the commission last week, Lawson accused the bank of engaging in "industrial scale" tax avoidance that while legal was unethical....

Which suggests that closing the tax unit is good PR.

Jenkins will admit that some parts of the business were engaging solely in devising tax schemes. 

"There are some areas that relied on sophisticated and complex structures, where transactions were carried out with the primary objective of accessing the tax benefits," he will say.

"We will not engage in it again," he will say, because it is "incompatible" with a new commitment to pay tax.  

But he will insist that some areas are "not controversial" because they delivered "value as part of real client transactions".

The loophole through which Barclays gets to carry on as before and confirms that closing the tax unit is all about PR/rhetoric and has no real economic substance.

"Unpunished and unreformed, the bankers have got away with it"

In his Guardian column, Phillip Inman notes that little has changed in the banking industry that brought on the financial crisis.

Of course, this was the explicit goal of the policy of financial failure containment and its corollary, the Geithner Doctrine (nothing must be done that will hurt the profit or reputation of any bank that is big and/or well-connected).

Unfortunately, much has changed outside the banking industry.  And all of this change has been for the worse.

The list of changes includes, but is not limited to:

• governments that are pursuing austerity policies and re-writing the social contract so that they can repay the debt taken on as a result of the financial crisis;

• savers that are having to cut back on current consumption so as to offset the loss of earnings on their savings caused by central banks pursuing zero interest rate and quantitative easing policies; and

• companies that are seeing their profitability hurt as competitors who should have gone out of business because they have too much debt are allowed to continue as a result of regulatory forbearance that lets banks turn these bad debts in to 'zombie loans'.

Regular readers know that your humble blogger has been saying since the beginning of the financial crisis that there is an alternative that ends the financial crisis and brings change to the banking industry without the negative changes to society and the real economy.

This alternative is the policy of financial failure prevention.  This policy is the foundation of the global financial system and is summarized by the FDR Framework.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Under the FDR Framework, investors have an incentive to use the information that is disclosed to independently assess the risk of any investment to make a fully informed investment decision as the investors are responsible for all losses on their investments.

The one exception where investors are not responsible for losses on their investment is bank deposits.

The FDR Administration recognized that it was necessary to have a banking system that functioned at all times to support the real economy.  The solution for achieving this was the combination of deposit insurance and access to central bank funding.

As I have repeatedly said, the combination of deposit insurance and access to central bank funding allows a bank to continue operating even when it has low or negative book capital levels.  A bank can do so because a) the taxpayers effectively become the bank's silent equity partners and b) anyone looking to withdraw their deposits can do so as the central bank provides the necessary liquidity.

Please note that even though depositors are protected this does not mean that investors in bank stock or unsecured debt are suppose to be protected.

In our current financial crisis, an argument could be made that these investors had to be protected as a result of the performance of the financial regulators.

First, the financial regulators did not fulfill their responsibility under the FDR Framework of ensuring that market participants had access to all the useful, relevant information about each bank in an appropriate, timely manner.  As the Bank of England's Andrew Haldane said, banks are 'black boxes'.

As a result, market participants could not independently assess the risk.

Second, the financial regulators made public announcements about both the risk and solvency of the banks both before and during the financial crisis (who can forget Tim Geithner's stress tests).

As a result of the regulators' public announcements, the financial regulators created a moral obligation to bailout the investors who relied on the regulators' risk assessment to make an investment (by the way,  FDR made the point very clearly that the government should not be in the business of offering an investment opinion because it would create this moral obligation to bailout the investors).

Finally by designing both the financial system and the banking system the way the FDR Administration did, a safety valve was created should the global financial system ever encounter a bank solvency led financial crisis.

The banks are the safety valve between the excess debt in the financial system and the real economy.  Because of their unique ability to operate with low or negative book capital levels, banks can absorb all the losses on the excess debt in the financial system and protect the real economy.

Of course, many changes occur in a bank that has low or negative book capital levels.  These changes include that cash compensation is dramatically lower until such time as the bank has retained sufficient earnings to rebuild its book capital levels.

Bottom line:  by pursuing a policy of financial failure containment and its corollary, the Geithner Doctrine, global policy makers didn't use the financial system as it was designed and instead of having the banks protect the real economy from the excess debt in the financial system, the policy makers but the burden of the excess debt in the financial system on the real economy.

Fortunately, policy makers could abandon the policy of financial failure containment and its corollary, the Geithner Doctrine, and use the financial system as it was designed.  This would lift the burden of the excess debt from the real economy and put the burden of the excess debt on the banks and banker bonuses.

BoE's Robert Jenkins: "banks should defer bonuses for 10 years"

Bloomberg reported that the Bank of England's Financial Policy Committee member Robert Jenkins suggested that banks should defer bonuses for 10 years so that executives were not compensated prematurely for the risks taken to earn the bonuses.

Your humble blogger does not quibble with the need for a careful rethink of how bankers are compensated.  However, I don't think that regulators should be leading the charge in this area.

Regulators should be focused on making sure that transparency is being brought to all the opaque areas of the financial system so that market participants can properly assess risk.

For example, banks should 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 information, market participants could assess the risk of each bank and adjust their required return on their investment in each bank to its level of risk.

Linking a bank's cost of funds to its risk would result in a substantial change in each bank's risk profile. Specifically, it would provide an incentive for each bank to lower its risk profile.

Key point:  the regulators should focus on subjecting banks to market discipline so the banks reduce their risk profiles.

Regulators should leave it up to the shareholders how they want to split the bank's earnings with its employees. 

The shareholders know that with the banks providing ultra transparency they are responsible for losses on their investment should a bank need to be resolved.  This gives the shareholders plenty of incentive to restructure the way a bank's earnings are shared between the bank's employees and shareholders so that the shareholders get compensated for the risk they are taking on as investors.

Bottom line:  The FDR Framework gives investors the incentive to exert market discipline on banks to reduce their risk profiles and to rethink banker compensation because the investors are responsible for all losses on their investments.

Bankers’ bonuses should be deferred for as long as 10 years to hold executives accountable for risks, said Robert Jenkins, a member of a Bank of England committee charged with ensuring financial stability. 

“Five years might or might not be appropriate for some categories of risk, but if we are going to rely on remuneration as a key driver of financial stability then it should probably be between five or ten years,” Jenkins said in an interview yesterday in Washington. 

“Ten years would capture the majority of risk cycles and therefore the gains and losses that came from any risk that was taken today.”

We should definitely not rely on renumeration as a key driver of financial stability.

The key driver of financial stability in the global financial system is and has been for the last 7+ decades transparency.

If you look at all the parts of the financial system that stopped functioning at the beginning of the financial crisis, each of them is opaque (think structured finance securities and banks).

Jenkins’ comments echo those of Andrew Haldane, another member of the BOE’s Financial Policy Committee, and signal U.K. regulators may continue to push banks to reduce risks. 

The central bank, which is adding regulatory powers to its monetary- policy remit, said in November banks may need to raise more capital to cover loan losses and that they may have overstated their capital strength.

If the BoE really wants to push banks to reduce risks, it must champion requiring banks to provide ultra transparency.

Banks can currently provide ultra transparency on a borrower privacy protected basis, but bank management prefers not to.  Why?

The problem “is that very large sums of money can be given to risk takers as a reward for the apparent profitability on the risks that they take before the risks have matured and before anyone knows for sure that it was profitable,” said Jenkins...

The big problem is not that bankers are rewarded before it is known if the risks taken are profitable.

The big problem is that bankers can take risks without being subject to market discipline and having their cost of funds change to reflect the degree of risk they are taking.

Jenkins, who previously worked at Credit Suisse Group AG and F&C Asset Management Plc, also called for higher capital requirements and said “too-big-to-fail, too-big-to-bail and too-big-to-jail” institutions remain a challenge for regulation.

The too-big-to-fail-bail-or-jail banks would not be a challenge for regulation if global financial regulators focused on requiring the banks to provide ultra transparency.

Subjecting each of these banks to market discipline would bring about substantial changes.

For example, the market would punish the complexity of these banks.  All of their subsidiaries involved in regulatory and tax arbitrage would be seen as adding risk.  It doesn't take much of a boost in a bank's cost of funds before they would jettison these subsidiaries.

For example, market discipline would end the banks taking proprietary bets.  Every trader knows that if their bets are disclosed other market participants will engage in trades that minimize the profit potential of their bets while maximizing the loss potential (see JP Morgan's Whale Trade for example).

Bottom line:  banks have been shielded from market discipline by the regulators for the last 3+ decades and the result is global financial institutions that are effectively too big for the regulators to deal with.

Fortunately, there is an entity that is still bigger than these institutions that carries the necessary clout to truly reform these institutions: the market.  What the market needs to exert discipline and shrink these institutions to a manageable size is transparency. 

Ultra transparency solves problem of enough banks on Libor-Euribor panels

With their ability to profit from manipulating benchmark interest rates like Libor and Euribor temporarily gone, Bloomberg reports that banks are dropping off the rate setting panels.

Naturally, the reaction of the regulators is to think about forcing some of the banks to stay on or rejoin so that the panel is a representative sample of banks.

Of course, by requiring the banks to provide ultra transparency, both the problem of having enough banks for the panel as well as the banks manipulating Libor/Euribor/Tibor goes away.

When all banks have to disclose all their transactions in the unsecured interbank lending market, then market participants can choose any combination of banks, from some to all, to include in the calculation of the benchmark interest rate.

Europe’s top financial regulator said he’s considering forcing banks to participate in setting Libor and Euribor rates after lenders including Citigroup Inc. and HSBC Holdings Plc pulled out of some panels amid the rigging scandal. 

Regulators will draw up a list of lenders that should be forced to participate in the setting of interbank rates “in view of their involvement” in those markets, Michel Barnier, the EU’s financial services chief, said in an e-mailed statement today. 

“Any banks considering withdrawing from the contributing panels should therefore take into account that they may be required to rejoin,” Barnier said. 

The plans to force banks to submit data for rate setting will be included in draft legislation on benchmark setting that the European Commission will present in the first half of this year.... 

“The Eurosystem strongly encourages banks to remain in, or join, the Euribor panel to prevent potential disruptions to the functioning of the financial markets while the regulatory framework is being refined,” the ECB said in a statement on its website.
U.K. Regulator 

“For such rates to remain representative, it is essential that there is an appropriate level of bank participation in the respective panels,” the Frankfurt-based ECB said. 

Martin Wheatley, the managing director of the U.K. Financial Services Authority, called last year for oversight of Libor to be handed to the U.K.’s financial regulator, and dozens of the currencies and maturities that make up the benchmark axed, under proposals designed to revive confidence in the rate....

Wheatley's recommendation are a classic example of substituting the combination of complex rules and regulatory oversight for the combination of transparency and market discipline and making the financial system worse off.

Since July, as many as ten banks have dropped out of the setting of the Eurepo Index, which is also managed by Euribor- EBF. These lenders include Societe Generale SA, UBS AG and HSBC. Euribor is derived from a daily survey of interbank lending rates conducted for Euribor-EBF by Thomson Reuters Corp.

Libor scandal finally heads to executive suite

As reported by the Telegraph, one of the central figures in the global Libor interest rate manipulation scandal is saying that senior bank executives were involved.

The involvement of senior bank executives should come as no surprise.  Does anyone think for a moment that a trader can earn a bonus in the tens of millions of dollars and senior management would not know about it?

In a text message to the Wall Street Journal, Tom Hayes, the former senior trader charged by the US Department of Justice in connection with interest rate-rigging said: “This goes much, much higher than me.”... 

Jennifer Arcuri, described by the Wall Street Journal as a close friend of Mr Hayes, defended him saying he believed he was “innocent” and intended to implicate his seniors in the scandal. 

“He had no idea this was going to come back at him,” she told the newspaper. 

She added that Libor-rigging “was a common industry practice”....

Of course it was a common industry practice because banks were not required to do two things which would have prevented it:  provide ultra transparency and base Libor off of actual trades.

Without banks providing their current global asset, liability and off-balance sheet exposure details, market participants could not see that the bankers were manipulating not only Libor, but all the global benchmark interest rates (including Tibor and Euribor).

Without banks providing ultra transparency, these benchmark interest rates could not be based off of actual trades in deep liquid markets.

As well as the large fines, City analysts expect banks to face billions of pounds in potential payouts as a result of legal cases brought by customers that were financially hurt by the manipulation. 

Most analysts expect this to cost the industry just over $20bn (£13bn), however some say the eventual cost will be measured in hundreds of billions of dollars and could force another round of taxpayer bailouts.

Please note that there are literally hundreds of trillions of dollars of financial transactions based off Libor and related benchmark interest rates.  For everyone of these transactions, there is the potential for one side of the deal to have lost as a result of the interest rate manipulation.  The banks' potential liability is very large.

Italian bank derivative scandal shows that transparency and discretion in bank supervision cannot co-exist

As reported by the Wall Street Journal, the lesson from the Monte Paschi derivative scandal is that transparency and discretion in bank supervision cannot co-exist and therefore, discretion must be ended.

This is an incredibly important point.

The choice we have is between a stable financial system based on transparency and market discipline or an unstable financial system based on opacity, complex rules and regulatory oversight.

In the stable financial system, investors are responsible for the losses on their investments and hence they have an incentive to use the information disclosed to independently assess the risk of each bank.  Specifically, investors link the amount of their exposure and the return they require on this exposure to each bank's risk.

This results in market discipline as banks with higher risk have to pay more to attract funds.  This also results in ending financial contagion as investors limit their risk to what they can afford to lose.

In an unstable financial system, investors are not responsible for the losses on their bank investments as they have to rely on bank supervision for the assessment and disclosure of risk at each bank.  Bank supervision that is concerned with the safety and soundness of the banking system and therefore exercises discretion in its disclosures about the riskiness of the banks.

This results in banks not being subject to market discipline as the price they are able to access funds at is substantially less than what it would be if investors had transparency and could assess the risk for themselves.

This also results in financial contagion as investors, including other banks, have far greater exposure to each other than they can afford to lose.

Finally, this results in moral hazard and the need to bailout the investors who relied on the bank supervisors' disclosure of the risk of each bank.

Your humble blogger thinks that a stable financial system is preferable.  Achieving this requires having the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

I recognize that this will end the bank supervisors' information monopoly and will limit their ability to exercise discretion.  This is a feature and not a bug in a stable financial system.

There is no reason that bank supervisors should be able to exercise wide discretion.

As I have previously said, bank supervisors don't approve or disapprove of any exposure that a bank takes on.  Bank supervisors don't do this because they do not see it as their job to allocate capital across the economy.

Bank supervisors attempt to focus on one question:  does the bank have enough book capital to absorb the expected losses on its exposures.  Bank supervisors focus on this question because they are attempting to protect the taxpayers by limiting losses that the taxpayers might have to cover because of the deposit guarantee.

The irony here of course is that if banks are required to provide ultra transparency, the bank supervisors could harness the market's analytical power to assess the banks and market discipline to restrain the banks' risk taking.  Both of these would lower the risk to taxpayers of losses on deposit insurance.

Ultimately, the real issue bank supervisors would like discretion on is when to resolve a bank.

Bank supervisors would like this discretion because a bank can be insolvent (the market value of its assets is less than the book value of its liabilities) at one moment in time and can subsequently earn its way back to solvency (the market value of its assets exceeds the book value of its liabilities).

However, this discretion over when to resolve a bank is not needed in a stable financial system.

Requiring banks to provide ultra transparency is not incompatible with letting a bank continue operating and earn its way back to solvency.  In fact, ultra transparency helps in this situation by eliminating the possibility that bank management will 'gamble on redemption'.  An insolvent bank that takes on more risk would see its cost of funding rise substantially.

In a financial system with deposit guarantees and banks providing ultra transparency, the only banks that need to be resolved are the banks that cannot generate pre-banker bonus earnings.  All the rest of the banks should they be temporarily insolvent have the ability to earn their way back to solvency.

The recent trouble at Banca Monte dei Paschi di Siena ... highlights potential vulnerabilities in plans for a new single European bank supervisor. 

The Tuscan lender, which bills itself as the world's oldest bank, used complex derivatives to tweak its balance sheet that have now triggered massive losses contributing to a €3.9 billion ($5.23 billion) black hole to be filled by taxpayers. Many of these derivative schemes are now the subject of judicial probes.

It wasn't the use of derivatives to tweak its balance sheet that was the problem, but rather that it hid the derivatives so that market participants did not know about them.  As a result, the bank's financial statements did not present a true picture of the bank's condition.

The Bank of Italy admitted its supervisors were aware of the schemes, fueling demands for a wider investigation. 

The Bank of Italy is under pressure because it exercised its discretion and it too did not disclose the existence of these derivatives.

So here is a bank supervisor with concerns about safety and soundness of the banking system supporting the mis-representation of the true level of risk at the bank.

In reality, the BOI's freedom for maneuver was limited. One problem was that the derivative deals did not violate accounting rules. 

While international accounting standards require that a seller of credit default swaps mark their position to market, that's not the case for "structured repos"—an innovative transaction that achieves the same effect—for which historical costs can be used. 

Monte dei Paschi took advantage of this loophole to issue structured repos, thereby spreading out accrued losses over a longer period even though the bank remained fully exposed to fluctuating liquidity risks. 

Thanks to this ruse, the bank posted a profit in 2009, enabling it to pay a dividend—which it had secretly promised to creditors that had subscribed to preferred shares used to bolster the capital base. 

Although the BOI was critical of the structured repos, it was hamstrung because no rule was broken.... 

The fact that the derivatives deals did not violate accounting rules does not mean that the Bank of Italy could have have publicly questioned the quality of Monte Paschi's earnings and mentioned the use of these structured repos in achieving these earnings.

But the way in which [the BOI] has handled the affair has led to allegations of subterfuge that have pulled in Mr. Draghi, now president of the European Central Bank. 

Those charges may be wide of the mark, but the political fuss is a timely reminder that bank supervision is a highly charged activity requiring delicate judgments to balance competing interests. 

One of the benefits of requiring banks to provide ultra transparency is that it eliminates the need for bank supervisors to balance competing interests.

With ultra transparency, bank supervisors can concentrate on protecting the taxpayers.

Mr. Draghi will be fully aware just how much more politically sensitive banking regulation will become when conducted cross-border by the ECB as part of the euro zone's proposed banking union. 

Indeed, the discretion required for bank supervision sits uncomfortably with the transparency the ECB deploys in the conduct of monetary policy where clear communication is essential to the management of expectations. 

By requiring banks to provide ultra transparency, we end bank supervision discretion.  As a result, the ECB can continue to provide clear communication about its conduct of monetary policy.

JP Morgan e-mails show with current loan-level performance information investors could have known how bad deals were

Since the beginning of the financial crisis, your humble blogger has been saying that if structured finance securities offer observable event based reporting on all activities like payments and delinquencies involving the underlying collateral before the beginning of the next business day, investors could know what they own or what they are buying.

The New York Times' Dealbook ran an article on JP Morgan where a series of e-mails confirms that observable event based reporting would allow investors to know what they own or what they are buying.

Equally importantly, the article establishes that observable event based reporting is necessary if the information advantage currently enjoyed by Wall Street is going to be eliminated.  Without this information advantage being eliminated, investors will be reluctant to return to this market as they recall how much money they lost due to Wall Street's use of this informational advantage.

When an outside analysis uncovered serious flaws with thousands of home loans, JPMorgan Chase executives found an easy fix. 

Rather than disclosing the full extent of problems like fraudulent home appraisals and overextended borrowers, the bank adjusted the critical reviews, according to documents filed early Tuesday in federal court in Manhattan. 

As a result, the mortgages, which JPMorgan bundled into complex securities, appeared healthier, making the deals more appealing to investors.

Please re-read the highlighted text as it nicely summarizes why observable event based reporting must be a requirement for all structured finance deals.

The trove of internal e-mails and employee interviews, filed as part of a lawsuit by one of the investors in the securities, offers a fresh glimpse into Wall Street’s mortgage machine, which churned out billions of dollars of securities that later imploded. 

The documents reveal that JPMorgan, as well as two firms the bank acquired during the credit crisis, Washington Mutual and Bear Stearns, flouted quality controls and ignored problems, sometimes hiding them entirely, in a quest for profit.

Let me repeat, the profits from Wall Street's information advantage comes from having tomorrow's news today.  Wall Street had access to observable event based reporting on the underlying mortgages and the investors did not.

When it comes to rewriting disclosure regulations for structured finance securities, Wall Street is protecting its access to tomorrow's news today.  It does this through the sell-side dominated industry trade groups, the American Securitization Forum (ASF) and the Association for Financial Markets in Europe (AFME), that keep lobbying the global financial regulators to focus on data templates and NOT when the data is disclosed.

The lawsuit, which was filed by Dexia, a Belgian-French bank, is being closely watched on Wall Street. 

After suffering significant losses, Dexia sued JPMorgan and its affiliates in 2012, claiming it had been duped into buying $1.6 billion of troubled mortgage-backed securities. 

The latest documents could provide a window into a $200 billion case that looms over the entire industry. In that lawsuit, the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, has accused 17 banks of selling dubious mortgage securities to the two housing giants. At least 20 of the securities are also highlighted in the Dexia case, according to an analysis of court records....

The Dexia lawsuit centers on complex securities created by JPMorgan, Bear Stearns and Washington Mutual during the housing boom. As profits soared, the Wall Street firms scrambled to pump out more investments, even as questions emerged about their quality.... 

JPMorgan routinely hired Clayton Holdings and other third-party firms to examine home loans before they were packed into investments. Combing through the mortgages, the firms searched for problems like borrowers who had vastly overstated their incomes or appraisals that inflated property values. 

According to the court documents, an analysis for JPMorgan in September 2006 found that “nearly half of the sample pool” — or 214 loans — were “defective,” meaning they did not meet the underwriting standards. The borrowers’ incomes, the firms found, were dangerously low relative to the size of their mortgages. 

Another troubling report in 2006 discovered that thousands of borrowers had already fallen behind on their payments....

Please re-read the highlighted text as it shows that if the investors had access to the underlying mortgages on an observable event based reporting basis, they too could have known that the mortgages were bad.

Investors could have done the analysis for themselves or hired an expert like Clayton Holdings.

What is important here is that if there had been observable event based disclosure, these deals would never have been done on the terms they were done on.

Fed's Jeff Lacker: financial reform "is the question of our time"

As reported by the American Banker, Jeff Lacker, president of the Federal Reserve Bank of Richmond, sees financial reform as "the question of our time".  He thinks that the policy of financial failure containment is wrong and wants to see a financial system where banks can fail and their investors absorb the cost of this failure.

Mr. Lacker would be a natural for supporting the FDR Framework and its role in supporting the policy of financial failure prevention.

The FDR Framework, which is the basis for our financial system, combines the philosophy of disclosure with the principle of caveat emptor.  This promotes market discipline by making investors responsible for the losses on their investments.

That Lacker's answers differ from those held by a majority of his Federal Reserve colleagues will surprise few. ... And on banking policy, he's convinced the Dodd-Frank Act of 2010 handed way too much power to federal regulators. 

At its core, Dodd-Frank is all about substituting the combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

As the current financial crisis has shown, the combination of complex rules and regulatory oversight is not up to the task of preventing a financial crisis.

"I worry about people taking away from the crisis the lesson that what's key is to respond with maximal force and to provide regulators with maximal discretion across the widest possible terrain," Lacker says. 

"Enhancing the scope for intervention and enhancing the tools just spreads the poison that boxes us in, in a crisis."

Please re-read the highlighted text as Mr. Lacker is making clear that the current financial crisis is not over and the policy of financial containment has made the situation worse.

That neatly sums up the divide among policymakers that has emerged since the 2008 crisis.  

One camp — the one that's firmly in charge — believes the path to financial stability is paved with rules, oversight and enforcement while the other is desperately searching for ways to rebuild market discipline....

Please re-read the highlighted text again as it nicely summarizes the battle over substituting complex rules and regulatory oversight for the combination of transparency and market discipline.

But Lacker ... wants the government to reverse years, even decades, of rescuing any large financial company that gets into trouble. He wants to tie the government's hands so regulators have no funds to finance these bailouts. Only then, he argues, will market participants believe bailouts are over and begin to discipline financial companies themselves. 

"The linchpin seems to be the credibility about what we say about who we will rescue," Lacker explains. "We deliberately fuzzed that up in the '80s and '90s with constructive ambiguity. We wanted to maintain the fiction that we would not intervene, but at the same time we tried to preserve the flexibility, the discretion to intervene. 

"Well, markets see through that."...

Your humble blogger disagrees with Mr. Lacker over what is the linchpin to credibly end bailouts.  I think the linchpin is 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 data that the market participants have the information they need to independently assess the risk of each bank, to take responsibility for any losses on their exposures to a bank and to exert market discipline.

Without ultra transparency, banks are 'black boxes' and market participants are dependent on the bank supervisors to assess and properly convey the risk of the banks.

One of the lessons learned during the financial crisis is that bank supervisors are more concerned with the issue of safety and soundness of the banking system than accurately conveying what is going on inside a bank.

With the discretion to not fully disclose the risk of each bank comes the moral obligation to bailout the banks and by definition their investors who relied on the bank supervisors' representations about the risk of the banks.

The best way to convince markets that the era of bailouts has ended is to let a big financial company fail, he says. 

"Credibility is going to require us to take actions that will be painful to some, painful to financial markets," including "guiding a large financial institution through the bankruptcy process, unaided with government taxpayer funds."

Actually, the best way to convince markets that the era of bailouts has ended is to require ultra transparency.

With ultra transparency, investors once again become responsible for their losses.

Asked if the government could simply stand by when markets freeze up, Lacker questions the question. 

"Freeze up is a loaded term. There is a lot of implicit theorizing going on when people use metaphors like pipes and ice when they talk about markets," he says. "People on the sell side in a crisis often throw around the phrase that things are frozen or clogged or jammed or dysfunctional, and it's really just people not getting the prices they want. 

"As a government official I think we ought to be really shy about coming to the judgment that some market isn't doing what it ought to do, that we know better than market participants what a piece of financial paper ought to be worth."...

Sometimes the market really does freeze and when it does it is always the result of opacity.

For example, the unsecured interbank lending market froze at the beginning of the financial crisis and remains frozen because banks with deposits to lend could not and still can not determine the risk and solvency of the banks looking to borrow.

For example, the sub-prime mortgage-backed securities market froze and remains frozen because nobody knows how the underlying collateral is performing.  The same lack of information on collateral performance has also limited the number of deals since the beginning of the crisis in the broader private label mortgage-backed securities market.

Yes, there are some gamblers in the form of hedge funds who are buying these securities, but the truth is they are blindly betting on the contents of a brown paper bag and hoping a bigger fool will buy the securities from them.

Unlike Hoenig and Fisher, Lacker is not arguing for a breakup of the largest banks. "I'm an agnostic on that," he says. "If you want to break up the banks, fine. But how do you know how far and when to stop?" 

Ultra transparency takes care of this issue because market discipline in the form of linking a bank's cost of funds to the risk it takes will put pressure on the banks to reduce risk.

How the banks reduce risk is management's decision.

The critical point is that risk in the banking system are reduced.

He doesn't support reinstating the walls between commercial and investment banking either. 

"Those schemes fail to limit the safety net without achieving a measure of commitment not to rescue creditors of large firms whether they are on one side of the Glass-Steagall wall or the other," he says. "It treats a symptom but it doesn't really address the fundamental problem, which is that commitment, the inability or unwillingness to commit to limiting rescues." 

That's the fundamental reform Lacker keeps coming back to: breaking what he calls the "rescue-regulate-bypass" cycle where government officials rescue firms, then regulate them and then stand by while businesses find ways around the oversight. 

Lacker began beating this drum before Dodd-Frank was even enacted, saying in March 2010. 

"Regulatory improvements alone, as essential as they are, won't be enough. This cycle of crisis, rescue and bypass is destined to recur, and with ever more force, unless we alter what market participants believe will happen when a financial firm becomes distressed." 

And the only way to alter what market participants believe will occur is to provide market participants with ultra transparency.  Then, market participants have a stake in making sure that banks don't fail as they become responsible for the losses.

Elizabeth Warren: CFPB, Dodd-Frank and a trade with the Republicans

Bloomberg ran an article on how the Republicans are united in their efforts to restrict the independence of the Consumer Financial Protection Bureau and Senator Warren has the opportunity to forge a compromise.

Your humble blogger would like to suggest that Senator Warren take the Republicans up on their offer and propose the following compromise:

In exchange for ensuring accountability and transparency at the CFPB, the rest of the Dodd-Frank Act is repealed and replaced with a law requiring transparency, specifically valuation transparency, be brought to all the opaque corners of the financial system.  Under this law,

• Banks would be required to provide ultra transparency under which they disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
• Structured finance securities would be required to provide observable event based reporting on all activities like a payment or delinquency involving the underlying collateral before the beginning of the next business day.

How can the Republicans possibly decline the opportunity to let the market function properly?  After all, it is well known that the necessary condition for the invisible hand of the market to actually work is valuation transparency.  Specifically, that market participants have access to all the useful, relevant information so they can independently assess this information and make a fully informed decision.

How can the Republicans possibly decline the opportunity to get rid of the explosion in complex rules and regulatory oversight like the Volcker Rule that make up Dodd-Frank?  In an era of endless budget deficits, here is an opportunity to save substantial sums of money.

How can the Republicans possibly decline the opportunity to get rid of the Office of Financial Research (aka, the government agency where transparency goes to die)?  The whole point of bringing transparency to all the opaque corners of the financial system is not to have agencies like OFR having a monopoly on information that market participants need if they are to have all the useful, relevant information.

How can the Republicans possibly decline the opportunity to end the market's reliance on supervision by bank regulators and the related taxpayer funded bank bailouts when supervision fails? With ultra transparency, the market can exert discipline on each bank to reduce its risk of failure.  If it does fail, market participants can absorb the loss because they could assess what was happening at the bank and have limited their exposure to what they can afford to lose.

Neil Barofsky: Geithner doctrine lives on in Libor scandal

In his Financial Times editorial, Neil Barofsky looks at the results of the policy of financial failure containment championed by Tim Geithner.  His conclusion:  the policy is a disaster and needs to be abandoned.

Regular readers know that there is an alternative to the policy of financial failure containment and that is the policy championed by your humble blogger and built into our financial system:  financial failure prevention.

Our financial system is based on the FDR Framework.  Under this framework, the government is responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate timely manner so the market participants can independently assess this information and make a fully informed decision.

Under this framework, market participants have the incentive to use this information as they are responsible for all losses on their exposures under the principle of caveat emptor (buyer beware).

By design, the FDR Framework is focused on preventing a systemic financial crisis.  It achieves this because each market participant has an incentive to limit their exposures to what they can afford to lose.

The reason we had the financial crisis that began on August 9, 2007 is that global financial regulators, led by the US Treasury adopted the policy of financial failure containment.  By adopting this policy they effectively abandoned the government's responsibility to ensure access to all the useful, relevant information (no reason to butt heads with Wall Street over what to disclose if you plan on mopping up after the crisis hits).

If you look at the financial system, what you see is that adoption of the policy of failure containment coincided with a dramatic increase in the size of the opaque parts of the financial system (think banks and structured finance securities).

Bottom line:  we are not having a financial crisis in the parts of the financial system where the legacy of the policy of failure prevention still prevails and we have transparency and market discipline.  We are having a financial crisis in the parts of the financial system where the policy of failure containment was adopted.

In his editorial, Mr. Barofsky shreds the policy of financial containment.

Now that Tim Geithner has resigned as US Treasury secretary, it is time to survey the damage wrought from four years of his approach to the financial crisis. 

The “Geithner doctrine” made the preservation of the largest banks, no matter the consequences, a top priority of the US government. 

Aside from moral hazard, it has also meant the perversion of the US criminal justice system. The US faces a two-tiered system of justice that, if left unchecked by the incoming Treasury and regulatory teams, all but assures more excessive risk-taking, more crime and more crises.

Please re-read the highlighted text as Mr. Barofsky nicely summarizes the policy of financial containment (his term is the "Geithner doctrine", but this gives too much credit to Mr. Geithner as the policy was adopted under Robert Rubin's leadership) and the practical fallout from pursuing it.

The recent parade of banking scandals, such as the manipulation of Libor rates by Barclays, Royal Bank of Scotland and other major banks, can be traced back to the lax system of regulation before the financial crisis – and the weak response once disaster struck.

One result of the adopting the policy of financial containment is that banks were not required to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details.

Had they been required to provide ultra transparency, the Libor scandal would not have occurred as Libor would have been based off of actual trades that market participants could see and confirm.

Take the response of the New York Federal Reserve to Barclays’ admission in 2008 that it was submitting false Libor rates and was not alone in doing so. Mr Geithner’s response was to in effect bury the tip. 

He sent a memo to the Bank of England suggesting some changes to the rate-setting process and then convened a meeting of regulators where he reportedly described only the risk but not the actual manipulation of the rate. He then put the government imprimatur on the rate via bailout programmes. His inaction helped permit a global crime to continue for another year.

The changes that Mr. Geithner suggested and that are being belated adopted would in fact not have prevented Libor from being manipulated.  The NY Fed got the proposed changes from the very banks that were manipulating Libor.

The only way to prevent the manipulation of Libor is by requiring that banks provide ultra transparency  and base the rate on actual transactions.  With ultra transparency, banks with deposits to lend can assess the risk and solvency of banks looking to borrow.  This keeps the unsecured interbank market unfrozen.  Once the trades have occurred and been reported, it is easy for market participants to select the trades on which to base Libor and similar benchmark interest rates.

When it was UBS’s turn to settle its Libor charges, even though a significant amount of the illegal activity took place at the parent company level, only a Japanese subsidiary was required to take a plea. 

Eric Holder, US attorney-general, demonstrated his embrace of the Geithner doctrine (a phrase coined by blogger Yves Smith) in explaining the UBS decision. He said that a more aggressive stance against the parent company could have a negative “impact on the stability of the financial markets around the world”. 

This week we saw the latest instalment of the saga. In fining RBS £390m, the DoJ only indicted one of the bank’s Asian subsidiaries, avoiding the more damaging result that would have stemmed from charging the parent company. 

Instead of seeking deterrence and justice, the US government increasingly appears to have fully absorbed the Geithner doctrine into its charging decisions by seeking a result that has a minimal impact on the target bank but will generate the best-looking press release. Some banks today are still too big to fail – and they are still too big to jail. 

The lack of robust enforcement is of course not limited to the Libor scandal. 

It was seen in the recent settlement talks with HSBC, when Treasury officials reportedly pressed the DoJ to consider the broad economic consequences that would follow an indictment. After hearing these arguments the DoJ chose not to criminally charge HSBC. 

And, of course, it is seen in the stunning dearth of criminal prosecutions arising out of the crisis. 

This was all but preordained given who the government turned to when the crisis struck: the same captured regulators who had blindly advanced bankers’ self-serving calls for a “light touch” before the crisis and who unsurprisingly embraced the Geithner doctrine afterwards. 

Having done so, of course, there would be no criminal prosecutions while the banks still teetered on the brink of collapse. The risk of causing them to fail, and thereby undoing all of the bailout efforts, was too high.

Please re-read the highlighted text as Mr. Barofsky makes the critical point that so long as banks are perceived by policymakers to be fragile, they will escape any form of discipline either from the market or the judiciary.

But that these arguments continue to resonate with officials in 2013 shows that the Geithner doctrine, perhaps justified by the conditions in 2008-09, has planted deep roots in our system of government. 

Again, what Mr. Barofsky and Yves Smith refer to as the Geithner doctrine has its roots in the policy of financial failure containment established during Mr. Rubin's years heading the US Treasury.

The policy of financial failure containment is the Treasury's default policy.

Unfortunately, it is also the Federal Reserve's default policy.  This policy is a legacy of the Volcker Era and can be seen in the attempt to handle behind closed doors the failure of Continental Illinois and the savings and loans.

Of course, Alan Greenspan took this policy to new heights with his explicit statement about how it was hard to identify a bubble and the role of monetary policy was to clean up afterwards.

This forbearance will have potentially devastating long-term effects, as each settlement on favourable terms reinforces the perception that, for a select group of executives and institutions, crime pays. 

It is only rational. They know that they will get to keep all of the ill-gotten profits if they go undetected, and on the small chance that they’re caught, most probably only the shareholders will pay – and only a relatively minor fine at that. 

The lack of meaningful consequences for those committing these frauds encourages future fraudulent conduct. Ultimately, the financial crisis was a game of incentives gone wild, and the lack of accountability in the aftermath of the crisis has only reinforced those bad incentives. 

The financial crisis was about opacity and the use of opacity by bankers whose incentives had gone wild.

It is only by restoring transparency to all the opaque corners of the global financial system that we are going to restore accountability and create proper incentives (after all, sunshine is the best disinfectant).

Breaking those incentives requires ditching the Geithner doctrine, which has led to the banks becoming even larger and more systemically significant than they were before the crisis. 

It means ditching the whole policy across the government of financial failure containment and returning to the policy of financial failure prevention that worked for 7+ decades.