Why the G20 Leaders and their Financial Regulators Cannot Rein in Bankers

In a CNBC article, Bankers Running Rings Around Regulators, Gordon Brown sheds light on what the G20 leaders were thinking and doing at the start of the credit crisis.  Even more importantly, he shows the dependence of regulators on the surviving bankers for guidance in how the regulators should respond to the credit crisis.

Stephen Lewis, Chief Economist at Monument Securities, discusses how listening to the surviving bankers assured that reform would not address the heart of the problem.

As long time readers of this blog know, the heart of the problem is the failure by the regulators to insure that all useful, relevant information is made accessible to all market participants on an appropriate, timely basis.  This applies equally to structured finance securities and current asset/liability level data at financial institutions.  All useful, relevant information is needed if market participants are going to be able to analyze the risk and properly price investments in structured finance securities or financial institutions.

Last weekend Brown admitted the great and the good meeting at the G20 that week in March 2009, when global equity markets bottomed, didn’t really understand what was going on. 

“We didn't understand how risk was spread across the system, we didn't understand the entanglements of different institutions with the other and we didn't understand even though we talked about it just how global things were, including a shadow banking system as well as a banking system,” said Brown in a speech in New Hampshire in the United States. 

"That was our mistake, but I'm afraid it was a mistake made by just about everybody who was in the regulatory business," he said. 

This admission is stunning and definitely worth reading a second time.

Here is a key figure in the global response to the credit crisis admitting that the G20 leaders and their financial regulators didn't really understand what was going on and made a mistake.

Then to get out of having to take responsibility for the failure to understand what was going on, he offers up the excuse of nobody understood where risk was in the system and how market participants were interconnected.  How could the G20 leaders and their regulators be blamed for their not having solved these incredibly complicated problems?

It is most definitely true that the G20 leaders and their regulators had no idea how the global financial system actually worked when the credit crisis began.  The leaders and regulators did not understand that since World War II the global financial system has been based on the FDR Framework and its philosophy of disclosure combined with the principle of caveat emptor (buyer beware).

If the leaders had understood the principles underlying the FDR Framework, they would have seen that opacity drove both Wall Street's profitability leading up to the credit crisis and the freezing up of the financial system.

• As noted by Yves Smith, nobody on Wall Street was paid for designing transparent, low margin products.

• As noted by the Financial Crisis Inquiry Commission, the financial system froze when nobody could figure out a) the value of the opaque structured finance securities and b) the solvency of any entity holding these securities.

If the G20 leaders and their regulators had understood the principles underlying the FDR Framework, the regulators would have focused on their responsibility to ensure that all market participants had access to all the useful, relevant information in an appropriate, timely manner.  At a minimum, this would have greatly reduced the severity of the credit crisis.

Instead, given their lack of understanding of the principles underlying the global financial system and

...aware of the fact that they where ill-equipped to make tough decisions on banking, the politicians turned to those bankers lucky enough to have survived for advice on change the rules. 

“Needless to say, the advice they received, while recognizing the political necessity of offering a few banker-bashing concessions, strongly favored preserving the structure of the banking system in its pre-disaster form. The politicians were warned that any other course would threaten global economic stability” said Lewis. 

Since before the credit crisis began, your humble blogger was warning about opacity in structured finance securities and advocating a simple fix.  Subsequent to BNP Paribas' August 9, 2007 acknowledgement that it could no longer value structured finance securities, your humble blogger and the simple fix were the subjects of articles in the mainstream media.

Your humble blogger also spent a great deal of time and effort reaching out to the regulators and the G20 leaders.

Given that enforcement of the FDR Framework would eliminate their profits from opacity, it is no surprise that the banks were not fans of the FDR Framework and instead pushed to have the financial system restored to its pre-crisis opacity driven form.

By adopting the bankers' advice and failing to enforce the FDR Framework, the G20 leaders and their financial regulators have added at least $1 trillion to the cost of the credit crisis that must be paid by taxpayers.

The subsequent piecemeal approach to banking reform has been unsatisfactory according to Lewis. 

“A striking example has been the Dodd-Frank legislation in the USA, which has required banks to desist from proprietary trading in capital market instruments. Dodd-Frank has failed to please anybody, however, partly on account of the arbitrary distinctions it draws between those activities that are proper to banking and those that are not, and partly because it is already seen to be failing as a means of preventing the revival of market practices that led to the 2007-08 crisis,” Lewis said.

Whether the reforms in place or to be put in place can prevent another crisis remains a big doubt. 

“I think we have seen this movie before” said Ted Price, from Canada’s Office of the Financial Institutions last month. “But the amazing thing is we continue to expect a different ending.” 

The Dodd-Frank Act created the Office of Financial Research.  The focus of this office is to look at risk and the interconnectedness of the financial system.

The proponents of this office envisioned it being like the national weather service.  Collecting, analyzing and disseminating information.

Unfortunately, the banks were able to add to the mandate of this office.  To preserve opacity in the financial system and effectively neuter the office, the banks added that all data collected by the office is confidential.

While the office could collect all the current asset and liability level data from Goldman Sachs, it could not share this data with the market participants who would have an incentive to and knowledge of how to analyze this data and turn it into useful information.

Instead, the office will have to rely on its in-house experts.  The problem is attracting experts.  While there are plenty of PhD's who claim to be an expert, if an individual is really good at turning this data into useful information, the individual could earn far more money working on Wall Street.

Lewis said a number of investment banks are now taking on more risk in order to meet profit targets. 

“They do not apparently regard a reduction in those targets as an acceptable trade-off for operating in a safer financial system. As long as banks are driven by short-term profitability goals, it seems, there will be a bias in the financial system towards undue risk-taking and a significant chance that another systemic crisis will erupt,” he said. 

“It will not make any difference to systemic risk that rules on pay have been introduced. If bankers do not know where future dangers to profitability lie, they will not know what to avoid, however they are paid,” he added. 

The FDR Framework has an enforcement mechanism to restrain risk taking.  When market participants have all the useful, relevant information, they are able to analyze and properly price the risk of these banks.  If a bank chooses to increase its risk profile (and market participants believe that the taxpayers will not bailout the bank if it fails), the bank's cost of debt will increase and its stock price will fall to compensate investors for the higher risk.  It is this increase in cost of funds and falling stock price that restrains bank risk taking.

Myths and Fallacies Watch: Stress Tests

This is the first of a series of posts that looks at Myths and Fallacies related to financial regulation.  It will focus on stress tests given their recent prominence.   In Ireland, the stress tests were suppose to reveal all the problems in its banking system.  Next up was the announcement by European financial regulators of new, tougher stress tests.

Myth and Fallacy:  Stress tests help to restore confidence in the capital markets.

Fact:  The stress test that the global regulatory community points to as proving that stress tests restore confidence in the capital markets was the first stress test run in the US in 2009.

What is conveniently ignored was the announcement at the time the results were released that the US would guarantee the solvency of the 19 banks tested.  The capital markets reacted to the guarantee and not to the results of the stress tests.

Myth and Fallacy:  There is enough information provided as a result of the stress tests so that investors do not expect to be bailed out for solvency related losses incurred by the banks.

Fact:  The first stress test explicitly guaranteed that unsecured debt and equity holders would not lose money as a result of insolvency.  Subsequent stress tests implicitly reaffirmed the government guarantee.

After all, nobody expects investors to be willing to take solvency related losses on an investment in a bank after the government has declared that it has passed a stress test showing the bank to be solvent.

Myth and Fallacy:  Stress tests show that financial regulators are up to the task of monitoring and managing risk in the financial system.

Fact:  The first round of stress tests in Europe was discredited in a few months when banks that passed the stress test in Ireland needed to be bailed out.

Myth and Fallacy:  Disclosure of current asset and liability-level data is not needed as the results of the stress test substitute for investors being able to do their own analysis and risk assessment.

Fact:  As discussed above, the stress tests implicitly reaffirm the government guarantee of bank solvency.

The stress tests do show that the financial regulators have a monopoly on all the useful, relevant information on financial institutions.  However, as the Governor of the Irish Central Bank pointed out, the failure to provide all the useful, relevant information to the market so it can confirm the results of the tests for itself sends the message that the financial regulators have something to hide.

Until all the useful, relevant information is disclosed to the market, taxpayers are trapped to support the implicit solvency guarantee provided with each round of stress tests.

A Pound of Cure Watch: Independent Commission on Banking and Ring-Fencing

This is the first of a series of posts that uses Ben Franklin's adage, an ounce of prevention is worth a pound of cure, to highlight specific aspects of the ongoing financial reform efforts.

Long time readers of this blog immediately understand that the FDR Framework is the ounce of prevention.  The focus of the FDR Framework is ensuring that all the useful, relevant information is made available to all market participants in an appropriate, timely manner so that they can analyze this information and use it in their actions in a buyer beware capital market system.

Long time readers of this blog also understand that regulatory efforts that do not involve ending the regulators' monopoly on all the useful, relevant information for financial institutions fall into the pound of cure category.

In a preliminary report, the UK's Independent Commission on Banking (ICB) recommended that the retail business be ring-fenced from the investment banking business.  That way, if the investment banking business blows up, the regulator can let it go while preserving the retail business at no cost to the taxpayer.

Will this work for a global financial institution with hundreds of subsidiaries in different countries (temporarily setting aside the issue of contagion)?

Nobody knows including the members of the ICB.  What is known is that the only way we find out is if one of these global financial institutions fails.

What is also known is that this is a pound of cure if the global financial institution runs into trouble.

Since its inception, this blog has advocated for an ounce of prevention.  If the market has all the useful, relevant information, it is possible for the market to exert discipline on the global financial institution and get it to modify its behavior so that it does not fail in the first place.

The FDR Framework, Global Financial Institutions and Effective Supervision

Global financial institutions create two interesting challenges.

• they can be too big to regulate since they have operations in many different countries; and

• they can be too big for their host country to save.

Why does having operations in different countries create a regulatory problem?

Regulation is national.  Even when there is international agreement on standards, it is left to the discretion of the national regulators whether or not to enforce the standards.

For example, the Basel Committee, which is made up of regulators from several countries including the US, approved the Basel II capital requirements.  However, the US elected to never formally enforce these requirements.

It is the differences in how regulation is enforced that allows the global financial institutions to engage in regulatory arbitrage.

Yves Smith expands on this point in a recent NakedCapitalism post

It isn’t discussed often enough that one of the roots of the inability to regulate banking properly is the so-called home-host rule. Even though banks that are licensed in foreign markets are subject to local laws in many respects (everything from securities compliance to branch hours), in most areas of bank regulation, the home country regulator is more influential than the host country, particularly as far as capital adequacy is concerned. Crudely speaking, the result is often that the host country operations are permitted to carry very little capital; they are treated as being able to ring the mother ship as needed. And if the host country sees practices it thinks are worrisome but are outside its scope, all it can do is alert the home country regulator, who may or may not act (in extremis, they can yank the local licenses, but first line responses are limited). 

If in the wake of the crisis, we had decided to move to a system of more powerful national regulation of all financial entities in its borders, including having each bank licensed to do business in a particular country subject to its capital regulations, it would have reduced the tight coupling of the financial system by balkanizing them a bit (with certain customers, the banks would still have latitude as to where they booked the business, but for quite a few, the choices would be circumscribed).

Given the current debt loads of the major governments, is there any country that does not suffer from what Mervyn King described as a mismatch between the large, global financial institutions and the resources of the country they turn to in times of crisis?

No.

This raises the interesting question of can effective international supervision be reconciled with sovereignty?

Yes.  It requires a new approach.  The new approach recognizes that the only entity big enough to really supervise the large, global financial institutions is the market.  Specifically, all the national regulators have to use all the other market participants to help supervise.

How can this be done?

By following the FDR Framework and providing all market participants with access to all the useful, relevant information on the global financial institutions in an appropriate, timely manner.

With this data, the other market participants, including competitors and regulators from other countries, can help the national regulators assess the risk of each global financial institution.  The more eyes looking at the data, the higher the chance of spotting and correcting a problem earlier.

Why is this solution not subject to regulatory arbitrage?

Since it can easily be linked to a requirement that financial institutions hold 100% equity against any exposure to another financial institution that does not disclose all its useful, relevant information in an appropriate, timely manner.

This capital requirement makes sense since the financial institution that does not disclose clearly has something to hide!

Greenspan and Frank are both wrong: What It Takes to Reform Finance

For those of you who may have missed it, Congressman Barney Frank responded with an op-ed in the Financial Times to the column written last week by former Fed Chairman Alan Greenspan.

Congressman Frank defends the position that we can reform finance and offers up the Dodd-Frank Act as proof of that.  He cites various aspects of the Act to rebut the claims by Mr. Greenspan.

Since the passage of the Wall Street Reform and Consumer Protection Act, known as Dodd-Frank, many commentators have suggested ways in which it might be improved.

Since Congressman Frank asked, the FDR Framework will be used to show what it would take to reform finance versus what the Act delivers.

But until last week no one had seriously suggested that we should have done nothing in response to the financial crisis.  

The issue is not whether something should have been done in response to the crisis, the issue is 'Was what was done an appropriate response to the crisis?'

Congressman Frank would say yes.  Chairman Greenspan would say emphatically no.

Yet, writing in these pages, Alan Greenspan suggests that we should not even have tried. By and large, he says, things went well over the long period of deregulation and light-touch oversight, and he argues that the global financial system is now so “unredeemably opaque” that policymakers and legislators cannot hope to address its complexity.

A previous post on Chairman Greenspan's column noted that his focus on the "unredeemably opaque" set of interactions between market participants is misguided.

It is not the set of interactions that should be focused on.  It is the conditions under which each interaction takes place.  Under the FDR Framework, the conditions under which each interaction takes place in our capital markets are governed by the principles of a philosophy of disclosure combined with caveat emptor [buyer beware].

Mr Greenspan is wrong on both counts. ...  The assertion that regulators can never get “more than a glimpse” of the financial system is self-fulfilling if regulators are not given the mandate or the tools to do so, or if they fail to use the tools they have. 

Congressman Frank is right in saying that relying solely on the market to police itself did not work.  However, he and the Act are are wrong in focusing solely on the regulators for policing the market.  Under the FDR Framework, it is a combination of the regulators and the market participants that are responsible for policing the market.


Under the FDR Framework, regulators have two very distinct roles:

• Ensuring that all useful, relevant information is accessible by all market participants in an appropriate, timely manner; and

• As an investor, since that is the position the government is in as a result of its insuring deposits and guaranteeing mortgages, using this information to both evaluate the risk of and manage the amount and pricing of the insurance and guarantees.

• Requiring banks to hold more capital is an example of regulators acting as an investor and adjusting both the amount and pricing of the government's exposure for risk.

When the roles of the regulators are looked at in this way, it becomes clear what regulators did leading up to the crisis and what they are currently doing that was not addressed in the Act.  Specifically, regulators have been and currently are acting as gatekeepers to the current asset and liability-level information for both financial institutions and structured finance securities. 


As gatekeepers, regulators violate their role under the FDR Framework of ensuring that market participants have all the useful, relevant information in an appropriate, timely manner. 

• As gatekeepers, regulators have and continue to contribute to the misallocation of capital.  Without this information, investors cannot properly evaluate the risk of investing in financial institutions or structured finance securities.

• As gatekeepers, the regulators make all other financial market participants dependent on them for accurately evaluating the risk of financial institutions and structured finance securities.  History shows that the regulators have not always been able to accurately evaluate the risk [for example, Less Developed Country lending debacle, Savings & Loan Crisis, and the recent credit crisis].

• As gatekeepers, regulators have and continue to contribute to financial instability.

• As gatekeepers, the regulators do not get the benefit of the expertise of all the other financial market participants in evaluating the risk of financial institutions and structured finance securities.

Congressman Frank continues

Economist Mark Zandi notes that one of the mistakes leading to the crisis was that, despite having authority to set mortgage lending standards, the Fed “just never acted on it. That was a clear policy decision”. When technology can track billions of transactions in real time, a failure to pierce the opaqueness of the system is mostly a question of will, not capacity.

Congressman Frank is right that it is a question of will, not capacity.


Under the FDR Framework, what market participants require is visibility and access to all the useful, relevant information in an appropriate, timely manner.  It is the responsibility of the market participant to do their homework on this information as they know that it is buyer beware when they make an investment. 

The question is 'Will regulators stop acting as gatekeepers and require financial institutions and structured finance securities to disclose all the useful, relevant information in an appropriate, timely manner?'

Congressman Frank then continues with a list of tools that have been provided to regulators by the Act.  There is one tool that needs to be highlighted as it shows the Act's reliance on the regulators and its non-compliance with the FDR Framework.

... The law also increases transparency through a new office of financial research, to give regulators access to information about the entire financial system.

Congressman Frank goes on and highlights how the Act prescribes one-off regulatory solutions for problems created by the regulators acting as gatekeepers of all the useful, relevant information instead of curing the problems by disclosure of all the useful, relevant information.

Institutions able to create risk and then shed it, along with the collapse of prudent underwriting, contributed to the crisis. So we have also ensured that the “originate to distribute” model, which allowed banks to expand their lending businesses with little risk, will be replaced by one in which all lenders have skin in the game. 

This, combined with the new Basel III capital standards and the ability of regulators to insist on even greater capital, will ensure more prudent and productive lending. 

Finally, Congressman Frank touches on the issue of the size and profitability of the financial sector.

This blog has frequently noted Yves Smith's observation that no one on Wall Street is paid to develop low margin, transparent financial products.  The profitability is in the opacity.

Under the FDR Framework, it is the role of the regulators to require that all financial products disclose all the useful, relevant information in an appropriate, timely manner so that investors can make a fully informed investment decision.

If the regulators shine sunlight into these products, it is reasonable to expect that investors will require a more appropriate return for the risk they are assuming.  As a result, the profitability and ultimately the amount of capital in the financial sector will decrease.

Mr Greenspan ends his article by worrying that these tools may reduce the size of the financial sector as a share gross domestic product. But as Adair Turner, chair of Britain’s financial regulator, and others have noted, growth in the relative size of this financial sector may just divert capital from productive activity to speculation, resulting in lower living standards and efficiency. 

This “financialisation” of developed economies is a question that deserves thoughtful, careful attention. Pending its outcome, however, policymakers must ensure that whatever its size, the financial sector is operating transparently under clear rules that protect taxpayers and promote the stability and growth of the broader economy.

Disclose or Not to Disclose, That is the Question

The Irish Independent ran an article on BlackRock and the role it played in the Irish bank loan portfolio review and related stress tests.

All eyes this week were on the results of the stress tests on the Irish banks' loan books.

Unless the EU/IMF had control over the results of the loan review and stress test, the Irish government and its regulators faced a choice heading into these stress tests and the fifth bailout of its banking system:

• It could repeat the strategy of "reviewing" the loan portfolios of the banks and announcing how much capital was necessary; or 

• It could also disclose current loan-level data to the market and let the market determine how much capital was necessary.  The reason disclosing the data under the FDR Framework is important is because without this data, investors have nothing to independently analyze and as a result there is no logical stopping point in the devaluation of the troubled loans other than zero.  

The Irish government and its regulators were aware of this choice.  Prior to the announcement of the stress tests in November 2010, Irish Central Bank Governor Patrick Honohan, as reported by GFSNews,

[L]aunched an incendiary attack today on credit analysts who he said 'assume the worst' about the country's banking sector.

Governor Patrick Honohan, in an address to a conference of chartered accountants in Dublin, argued that credit analysts do not have enough information about the health of the Irish banking sector and should undergo 'euthanasia'.

Honohan said: 'If there is no information, the credit analyst tends to assume the worst. They think, 'if the actual situation were good, would the bank not have been at pains to disclose it. Since it is not disclosed, it must be bad'.

....  He said that banks should try to boost confidence by disclosing more information to the market, such as on the ageing and migration of loans and status of residential mortgage books....

'Communicating more information to the market would not only enlist the expertise of market credit analysts in a way helpful to all, but could lower the cost of term borrowing as investors regain confidence.

According to the Irish Independent, Mr. Honohan observed

[T]he banks might do well to call in the leading credit analysts and find out what information would be of greatest use to them in identifying tail risks. And then provide it.

The Irish government and its regulators were fully aware of the need to disclose information to the credit market analysts and that they should ask the credit analysts what information would be of greatest use to them.

Still, the choice was made to try to find a half-way house between disclosing all the useful, relevant information in an appropriate, timely manner and the government maintaining its information monopoly on the current asset and liability-level data of its banking system.

According to the Irish Independent article on BlackRock,

The strategy used by the Irish government to review the loan portfolios was to hire a number of high priced consultants, headed up by BlackRock. tests were carried out on behalf of the Central Bank by US investment and consulting firm BlackRock. 

As an investment and consulting firm, BlackRock of course has many built in conflicts of interest.  Since the market operates under the principle of buyer beware, investors a) recognize that BlackRock has these conflicts of interest, b) understand that there is no way to tell how these conflicts of interest will influence the results of BlackRock's analysis and c) do not rely on BlackRock's findings.

Unlike last July's stress tests, which were carried out by European Committee of Bank Supervisors and gave both AIB and Bank of Ireland a clean bill of health, BlackRock didn't pull its punches.

Given its conflicts of interest that at a minimum include the fact that it would like to be hired by other governments as a consultant, how does the Irish Independent know that BlackRock didn't pull its punches?

The Irish government would like to have market participants believe this is true, but where is the data market participants can use to independently verify the accuracy of this statement?

It carried out a root-and-branch review of the Irish banks' loan books, which included processing the details of millions of individual loans through its powerful computer systems. 

This type of review is exactly what many market participants would do if they had access to the loan-level data.  The type of market participants who would do this type of review include competitors of BlackRock like Pimco and Federated, both American and European banking competitors of the Irish Banks like JP Morgan and Deutsche, rating services like Moody's and S&P, private equity investors like JC Flowers and WL Ross, and loan valuation services to name just a few.

Had the Irish government disclosed this loan-level data to the market, rather than have an opinion on the value of the loans tainted by a conflict of interest, it would have the market's consensus opinion on the value of the loans.

Instead, borrowing from Professor Honohan's observation above, the credit analysts, under the principle of trust, but verify, have to wonder why was the loan-level data not disclosed.

• If the loan-level data would confirm BlackRock's analysis, then releasing it would help to restore confidence in the banking system.  

• By not releasing it, should the credit analysts assume that the loan-level data would indicate that BlackRock's analysis presents a rosy picture?

The Irish Independent article continues,

BlackRock's findings don't make for pleasant reading. It calculates that the Irish banks are looking at total losses of up to €40bn on their current loan books. Throw in the near-€60bn which the Irish banks, including Anglo and the Irish Nationwide, have already written off on bad loans and that brings the total to at least €100bn, almost a quarter of their peak end-2007 loan book of just over €400bn.  

Just how unpalatable BlackRock's loan-loss projections, which cover the entire life of the loans, were was evidenced by the fact that the Central Bank also published its own, much lower, loan-loss projections for the period 2011 to 2013. 

While BlackRock expects the Irish banks' loan losses to range from €27.5bn under its base scenario to €40bn under its stress scenario, the Central Bank is pencilling loan losses ranging from €20bn under its base scenario to €27.7bn under its stress scenario for the period to the three years to the end of 2013. 

However, even after putting the best possible gloss on the numbers, the Central Bank has determined that the Irish banks will require an additional €24bn of fresh capital, with the original six banks shrinking to just two. 

This will bring the total cost to the taxpayer of bailing out the Irish banks to €70bn, making this country's banking collapse by far the most expensive in recorded financial history when measured as a proportion of our economic output. 

To put the findings of BlackRock and the Central Bank in perspective, Alan Dukes, who had access to loan-level data due to his position as chairman of Anglo Irish Bank, according to a February 2011 Irish Independent report placed the amount of capital needed to clean up the banks at a much higher level.

Ireland will have to go to the IMF/EU for another €15bn -- on top of the €35bn already earmarked -- to save the banking system, the government-appointed chairman of Anglo Irish Bank warned last night. 

In a bombshell revelation, Alan Dukes said we will need 40pc more, or €50bn, to properly clean up the banks. 

The former finance minister also sensationally suggested €75bn would be needed to fund the existing NAMA operation and a so-called 'NAMA 2' to take more bad loans from the banks. 

His claims sparked a furious rejection from the Department of Finance who said that Central Bank Governor Dr Patrick Honohan had pinpointed a much lower figure. 

Without releasing the loan-level data, market participants still have no way of knowing if Mr. Dukes or BlackRock and the Central Bank are right.

The Irish Independent article on BlackRock continues,

The bad news from BlackRock didn't come cheap. While Central Bank governor Patrick Honohan refused to say how much the firm had been paid for its trawl through the entrails of the Irish banks' loan books, he did concede that the bill came to "tens of millions" of euro. 

Had the Irish government chosen to disclose the loan-level data to the market, it could have had not only BlackRock analyzing the loans, but the many other market participants discussed above who are equally qualified analyzing the loans for free too.

The cost to the Irish taxpayer of providing loan-level disclosure to all market participants on a one-time basis would have been substantially less than hiring BlackRock et al as valuation experts.  As a practical matter, all the work needed to disclose loan-level data to the market had to be done in order for BlackRock to get the data so that it could analyze the loans itself.

While paying a fortune for bad news is never a pleasant experience, the truth is that we didn't have any choice. After last July's fiasco, when the rapidly worsening problems of the Irish banks forced the Government to seek an EU/IMF bailout just four months later, the market was in no mood for another whitewash. Coming clean, no matter how awful the facts, was the only option.

Actually, there was another choice.


Under the FDR Framework, the obvious choice would have been to disclose the loan-level data to the market.  It was also the least expensive choice and the only choice that involved coming clean, no matter how awful the facts!


When compared to what Alan Dukes thought was needed to clean up the bankings system, the choice made by the Irish government and its regulators in fact looks like another whitewash.  Without disclosing loan-level data, there is no way to know that it is not.

When it comes to analysing the loan books of distressed banks no one has more experience than BlackRock....

Actually, there are many market participants with as much if not more experience analyzing the loan books of distressed banks.  For example, every global commercial bank has more experience as they not only have information systems that are comparable to BlackRock's, but they have a far larger army of loan officers who understand how to interpret loan files.

...  By using BlackRock's services, the Irish Government has bought itself time to sort out the Irish banks. However, with the eurozone financial crisis showing no signs of easing, don't be surprised to see other single-currency countries employing BlackRock's expertise as they seek to reassure nervous investors.

As reported in a Bloomberg article discussing whether the stress tests would be successful in buying time,

Ireland is trying to convince investors at home and abroad that it’s finally plugged all the holes in the banking system... 

“Our initial impression is that the question of whether this is enough will continue to linger,” said Marchel Alexandrovich, an economist at Jefferies International in London. “The figure is credible enough for now and buys time to see how economic growth unfolds over the next year.” 

... “People may stop worrying about banks and senior haircuts,” Ivan Zubo, a banking analyst at BNP Paribas in London, said in an interview. “But they may start worrying about the sustainability of the sovereign.”

So, what did the Irish taxpayer get for either the Irish or EU/IMF regulators' choice of not disclosing the loan-level information to the market and instead buying time to sort out the Irish banks and sovereign debt issues?

• A very large bill, measured in the "tens of millions", to pay for all of the firms that the regulators engaged to help them with reviewing the loans.  This bill vastly exceeded what it would have taken to actually disclose all the loan-level data to the market.  Disclosure is low cost, hiring consultants like BlackRock, Boston Consulting and the accounting firms is high cost.

• Ongoing financial instability as investors and other market participants are still unable to verify that the results of the stress tests are correct.  While investors and other market participants would like to trust that the results are correct, without the loan-level data they cannot verify this for themselves.  

Verification is extremely important.  Ireland has a history of regulators relying on high priced consultants and saying that the size of the hole in the banking system is X and several months later the hole turns out to be much bigger.

Market analysts will continue to ask the question of did 24 billion euros really draw a line under the capital needs of the banking system.   Any data that suggests that this is not enough will generate significant financial instability.

• A long slog to restore credibility in the banking system.  

If the market could verify the results of the stress tests today, it would dramatically speed up the restoration of confidence in the Irish banking system.  

With confidence restored, investors would be willing to deposit money in the surviving banks - the ECB could be repaid.  With confidence restored, banks would be more willing to make loans - hard to lend money when economy is contracting and collateral value is uncertain.

Instead, as reported in a Reuter's article,

"Ireland may have constructed a road to recovery for its banks, but the prospect of funding problems and massive loan sales in a weak economic environment mean there could still be potholes ahead. 

... But the prospect of investing in the banks still makes some investors wary and funding remains a big concern. 

'There are still many points outstanding which make valuing the existing equity in the banks near impossible... (we) would advise investors to await the capital raise details before deciding on whether or not to get involved,' said Eamonn Hughes, analyst at Goodbody Stockbrokers." 

• A chance at maximizing the cost of the banking crisis.  Since the loan-level data has not been shared with the market, it was not possible for the market to determine the fair value of the loans.  Without this fair valuation, how does anyone know that the opaque auction process required to shed some of the loans will yield fair value. 

• The Irish regulators testing the idea that investors will buy equity in one of the two remaining banks without disclosing all the useful, relevant information in an appropriate, timely manner to them.  

The experience of Spain shows that ultimately the investors are going to want to see the loan-level data before they are willing to invest.  As reported in a Bloomberg article on Spain's efforts to recapitalize its savings banks,

"The unravelling of the merger of four Spanish savings banks may deter potential investors in similar tie-ups because of concern over hidden real-estate losses.... 

'It shows there are still uncertainties around the issue of asset-quality risk and how big the losses are going to be,' said Daragh Quinn, an analyst at Nomura International in Madrid. 'It would confirm for some would-be investors that there will have to be absolute clarity on what they are buying.'"

Municipal Bonds and the FDR Framework

The applicability of the FDR Framework is not restricted to financial institutions and structured finance securities.  It applies globally to all financial markets, their participants and their securities.

The US municipal securities market is a $2.7 trillion market.  It is a source of funds for local governments, including towns, cities and states.

There are two basic types of municipal securities

• General obligations bonds that are supported by the taxing power of the issuer; and
• Revenue bonds that are supported by revenue generated by the specific project they were issued to finance.

Does the municipal securities market comply with the FDR Framework?

No.

Under the FDR Framework, all markets are built on the philosophy of disclosure combined with the principle of caveat emptor [buyer beware].  

• It is the responsibility of the government to assure that all market participants have access to all the useful, relevant information in an appropriate, timely manner.  
• It is the responsibility of market participant to do their homework as they know that it is buyer beware when they make an investment.

For the municipal securities market, the government and the issuer fail to provide access to all useful, relevant information in an appropriate, timely manner.

In a paper, Transparency Problems in the Municipal Debt Market and Their Effect on Fiscal Conditions, Kelly Shea observes

While many cities  in the U.S. are in trouble financially, the true state of their fiscal affairs is often hidden.

Why is all the useful, relevant information not made available in an appropriate, timely manner?

According to Kelly,

... cities and states are not subject to the same disclosure requirements of specific financial information before offering bonds publicly, this [is] due to a 1975 amendment to the Securities and Exchange Act of 1934 known as the Tower Amendment. This Tower Amendment effectively limits regulation by the Securities and Exchange Commission and other federal oversight authorities.  In some cases, this allows municipalities to simply not disclose important financial obligation information before a bond offering.

Just like we saw for structured finance securities and financial institutions, Kelly observes that the absence of all useful, relevant information in an appropriate, timely manner results in mis-pricing.

... Because of a lack of accurate financial information, the municipal bond market has not
yet reflected these [rising revenue shortfalls, soaring pension liabilities, and a host of other fiscal issues] risks.  Cities and states are not held to the same financial disclosure standards
as corporations when issuing bonds .... The lack of consistency and transparency in state and municipal financial disclosures has caused the municipal bond market to become more risky than most investors believe. Due to this lack of transparency, it is impossible to accurately gauge to what extent cities and states are misstating their financial health until it is too late.

Fed's release of credit crisis loan data confirms FDR Framework works

Recently, under a Freedom of Information Act request by Bloomberg, the Fed released thousands of pages documenting the loans that it made during the credit crisis.

One of the fundamental reasons why the FDR Framework for financial markets actually works is that regardless of how much data or the ease with which the data can be analyzed, there are market participants who will analyze this data and turn it into information.

As Yves Smith observed in a post on NakedCapitalism,

A further remark: the fact that Bloomberg can say anything intelligent at this juncture is a testament to the cleverness of its reporters. The central bank quite deliberately responded to the request by providing the information in the most disaggregated, difficult to work with form imaginable. 

The central bank did a version of the same trick with its data on Maiden Lane II. The holdings of that asset management vehicle were various real estate exposures, some of which were hedged. The hedges were reported separately from the bonds and loans. Clearly, Blackrock, the asset manager, had far more useful and understandable reports that they used internally and provided to the New York Fed, but those were withheld. 

This [loan] data will presumably be as enticing as the Wikileaks cables, so enough eyeballs on it will eventually overcome the Fed’s efforts to hinder analysis. 

Given the voluminous amount of information provided, future FOIA requests may need to explicitly include that the relevant government body provide information in the form in which it is used internally, including any higher level aggregations, to prevent future “fuck yous” in the form of technically permissible but nevertheless obstructionist compliance.

Ireland's fifth bailout - Trust, but Verify

The Irish government and its EU/IMF partners have gone to great lengths in analyzing the loan portfolios and stress testing the Irish banks.  They have hired numerous high priced consultants (including BlackRock, Boston Consulting and accountants) to add credibility to their findings.  Finally, they have announced that their banks need another 24 billion euros of capital.

What will investors think of these findings?

The FDR Framework would suggest that investors will initially trust this figure, but they will want to verify it for themselves.

If the Irish government wants to retain the trust of the market participants, it will immediately adopt the FDR Framework and announce that it will make current asset and liability-level data available on the banks.

This is the data that the market needs to independently verify the results.  This is the data that the market needs to retain trust in the Irish banking system.

If the Irish government does not adopt the FDR Framework, it is the equivalent of raising a giant red flag and saying "do not trust the results."

Without this data, market participants are left to wonder if BlackRock plugged in the result that the Irish government could fund through the existing EU/IMF bailout facility and backed into the loss estimates.

For the fifth time, the Irish government is asserting that its estimate of losses is conservative.  Are they?  It is only with access to each bank's current asset and liability-level data that investors can answer that question for themselves.

The FDR Framework passes the test of our times

Alan Greenspan wrote a column for the Financial Times in which he observed that the Dodd-Frank Act was based on the assumption that

... much of what occurred in the market place leading up to the Lehman Brothers bankruptcy was excess (hardly controversial) and that its causes would be readily addressed by this wide-ranging statute (questionable).

The act requires regulators to create a couple of hundred detailed regulations.  The potential problem with this he observes is that

... the regulators are being entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are
importantly altered. No one has such skills. 

This is why this blog has urged regulators to adopt the FDR Framework.  Adopting the FDR Framework first simplifies the task and provides regulators with guidance as they create the new detailed regulations under the Dodd-Frank Act.

Mr. Greenspan then goes on to confuse opacity with the Adam Smith's "invisible hand".

... The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems. Today’s competitive markets, whether we seek to recognise it or not, are driven by an international version of Adam Smith’s “invisible hand” that is unredeemably opaque. With notably rare exceptions (2008, for example), the global “invisible hand” has created relatively stable exchange rates, interest rates, prices, and wage rates. 

In the most regulated financial markets, the overwhelming set of interactions is never visible. This is the reason that interpretation of contemporaneous financial market behaviour is subject to so wide a variety of “explanations”, especially in contrast to the physical sciences where cause and effect is much more soundly grounded. 

Under the FDR Framework, visibility into the overwhelming set of interactions is not necessary.

What market participants require is visibility and access to all the useful, relevant information in an appropriate, timely manner when they consider an investment.  It is the responsibility of the market participant to do their homework on this information as they know that it is buyer beware when they make an investment.

Mr. Greenspan then goes on to argue that financial complexity was a contributor to today's standard of living and productivity.

Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago? That may not be possible if we wish to maintain today’s levels of productivity and standards of living. During the postwar years, the degree of financial complexity has appeared to grow with the rising division of labour, globalisation, and the level of technology. 

...The vexing question confronting regulators is whether this rising share of finance has been a necessary condition of growth in the past half century, or coincidence. 

In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living.

The answer is that we must return to the principles on which our capital markets were based over a half century ago.  These principles, which are reflected in the FDR Framework, combine a philosophy of disclosure and the practice of caveat emptor (buyer beware).

Where complexity exists in financial products, it is the regulators' responsibility to make sure that this complexity does not create opacity with regards to all the useful, relevant information.

Where opacity exists in looking at a financial institution's current asset and liability-level exposures, it is the regulators' responsibility to make sure that this opacity is eliminated and that all useful, relevant information is made available to all market participants.