Have central banks become debt black holes?

In an interesting post on Golem XIV, the ECB swallowed the market, the argument was presented that the central banks have piled on so much debt that they have effectively made it impossible for the financial market based on private funding to re-emerge.

While I agree with the author's conclusion that there is a barrier to the financial markets being taken off of central bank life support, I disagree that the barrier is the debt on the central bank balance sheets.

The reason that the financial markets are still on life support was the decision at the beginning of the bank solvency led financial crisis to adopt the Japanese model for handling the crisis.

Under the Japanese model, banks hid on and off their balance sheets the true extent of their losses and only recognize losses to the extent that they generate earnings in excess of banker bonuses, shareholder dividends and de minimum increases in book capital.

All banks know that every other bank is hiding losses.  This is why the interbank loan market froze at the outset of the financial crisis and why it refroze as the Eurozone sovereign debt crisis gained momentum.

The response by the central banks has been to step in and provide the liquidity that the interbank lending market would provide.  In doing so, the central banks have taken collateral for their loans.

The central bank programs are reversible if, and only if, policymakers and financial regulators adopt the Swedish model for handling the crisis and require banks to provide ultra transparency.

It is only when every bank is able to access the current asset, liability and off balance sheet exposures of every other bank on an on-going basis that each bank can independently assess the risk of each of its competitors and determine the amount and price of any loan to these competitors.

The problem is this. The Central banks have chosen to lend to insolvent private banks and to the nations that already bankrupted themselves trying to bail out their unbailable banks. 

In an attempt to make their lunacy seem sensible, the central banks assured everyone that they would only accept as collateral for the money they were lending out, the best assets the banks possessed. So the best of the insolvent banks’ assets were sucked in and cheap central bank loans flooded out.  

The central banks said that ‘now the banks were stabilized’ they hoped the banks would lend to the market and to each other thus allowing the broader economy and the banks themselves to be funded ‘by the market’. 

Neither happened. Why? Well the banks continued not to trust the quality of the assets they were offering each other as collateral. Not entirely surprising since the banks had already pledged the best of them to the central banks. Without trust-able assets as collateral – no loans. 

So the banks were forced back to the ECB and the Fed for more loans. Of course they had already pledged their best assets. So began the gradual but inexorable loosening of criteria for what the ECB would accept as collateral. At first it was only AAA rated. Then it was bonds from ailing nations. Then it was anything that came to hand.   

Which made the ‘market’, AKA other banks, even less keen on accepting as collateral whatever was left. And so on round and round. We have long since reached the point where the central banks like the ECB, either directly or washed first through a national bank such as The bank of Greece or Spain, has begun to accept almost anything as collateral. 

When I say washed what I mean is the national bank in Spain or Greece or Ireland may accept some asset which is thoroughly sub-prime in return for a sovereign bond. That bond is then acceptable to the ECB as collateral because it is a Sovereign bond, which as we all know are AAA rated, for sure, for sure never going to default. 

However the more sub-prime, stinky, slimy paper the national banks are stuffed with, the more the sovereign debt is backed by a national bank which resembles a sewer of rotting rubbish, a nation in the grip of austerity and a contracting economy. 

Whatever pretty prime-time fictions you get hosed with each evening, this is the reality that dare not be reported. And we all know it. Ireland is in recession, Spain’s economy is contracting and so is Portugal’s. That is why ‘the market’ keeps hiking the interest it insists upon for lending to National banks.  

The result is that the private banks have already pledged anything good they had. They will not therefore lend to each other because they know none of them has any assets left which are worth anything. Thus they are forced to go back to the ECB and Fed for more money and those institutions are forced to take even more ropey assets in return for issuing even more loans.  Each time round, each new QE and new lot of money, sucks in more bad assets and makes any possiblity of private funding even more remote. 

The Central banks have swallowed the market. All debt and debtors are being drawn into ever tighter orbit. None will escape.

While the author has clearly described a reinforcing spiral where the banks become ever more dependent on the central banks, the description ignores the simple fact that when making a loan, the first question to ask is will the borrower pay it back.

In the absence of ultra transparency, banks do not know which of their competitors can or cannot repay a loan.  The interbank lending market is frozen because banks don't know which banks can repay a loan.

Provide ultra transparency and the dependency on the central bank is ended.

Now you might object that I have simply missed the point of the official policy. Certainly the National banks and the Central Banks have removed huge amounts of the toxic loan/assets from the private banks… and this we are assured is a good thing. 

This is called ‘cleaning up’ the banks. The rubbish is removed and in its place ‘good’ national and central bank bonds are put in their place, giving the private banks lots of good assets. And it does sound possibly OK when you hear it put that way and don’t think too hard about it. 

But we have to remember a couple of things. 

First the bad assets have not ‘gone’. They still exist. They are still money which was lent out, which itself was often borrowed and thus has to be repaid, but which is not now bringing in any profit. Those losses are still warm and moistly rotting, just doing it in National and Central bank vaults now. 

The author makes a very important point that the losses still exist.

However, pledging an asset that contains the loss to a central bank does not transfer the loss to the central bank.  The borrowing bank is still on the hook for the loss.  It is expected that the borrowing bank will repay the loan in full and get the asset containing the loss back.

Second, for all that the banks do now have sovereign and Central bank bonds to pledge, they are still, all of them, coming back to the ECB and the Fed for more QE easy money loans. This is because even though the banks have used that QE money to speculate on commodities and currencies to try to make a fast and out-sized profit – still chasing high risk and return – they still have huge liabilities (money they owe) not being paid for from income which is  not coming in from yet more bad assets which are nevertheless still  being held at imaginary values so as to make the assets side of the balance sheet look like it might balance out those liabilities....  

One of the reasons that ultra transparency is needed is so the market can exert discipline on the bankers and stop them from gambling on redemption.  The experience of the US Savings & Loans was that in the absence of ultra transparency, bankers gambled on redemption, lost and dramatically increased the cost to the taxpayers.

My main point is that the banks, despite 4 years of never-quite-materializing recovery, still need loans from the central banks and still need to pledge assets to get them. How many more assets do they have? Probably many hundreds of billions. But they are increasingly awful.... 

The question is why do the banks need to pledge increasing amounts of assets to the central bank?

Because market participants are becoming increasingly unwilling to fund the banks!

This takes several forms.  First, there is the frozen interbank lending market.  Second, there is the unsecured bank debt market which also froze due to a lack of ultra transparency and an inability to determine which banks can repay their debt.  As loans from both of these frozen markets mature, they must be repaid... hence a need for central bank funding.

The third form of market participant unwillingness to fund the banks is the on-going bank run in Ireland, Greece, Spain, Portugal and Italy.  As deposits flow out, banks turn to the central banks for funding.

Please note, all three ways that market participants show their unwillingness to fund the banks are addressable and reversible if the banks were required to provide ultra transparency.

'Start your own rating agency' Moody's tells governments

In a Telegraph article, Richard Blackden reports how Moody's is challenging governments who complain about the rating agencies to start their own.

Ray McDaniel, the chief executive of Moody's, described the conditions under which such an agency needs to operate

To win the confidence of financial markets, such an agency would have to ensure it was independent of governments and that its opinions were widely available.

The governments should take Mr. McDaniel up and do him one better.

Rather than set up a single rating agency, the governments should adopt ultra transparency across the financial system and create the environment under which many new rating agencies can be formed.

By eliminating the barrier to entry to the rating business, which is access to information and not analytical expertise, the new rating services can use the Internet to globally disseminate their ratings.

Adopting ultra transparency is consistent with the role of governments under the FDR Framework.  Furthermore, under this framework governments are explicitly barred from offering their opinion about an investment.

The reason for this explicit ban is it creates moral hazard.  For example, let's look at what happens when governments announce the result of bank stress tests.  The governments become morally committed to bailing out depositors, bond holders and equity investors should the bank run into solvency problems.

Adopting ultra transparency and expecting new rating agencies to form is also consistent with the FDR Framework.  Remember that under this framework, investors are responsible for all gains and losses.  As a result, they have an incentive to use the data made available through ultra transparency.

Naturally, if they are unable to assess the data themselves, they are likely to use a third party expert... hence, there is a demand for the new rating services.

"Public institutions that have both the expertise and credibility among market participants should provide views on sovereigns," said Ray McDaniel, the chief executive of Moody's. 

To win the confidence of financial markets, such an agency would have to ensure it was independent of governments and that its opinions were widely available, Mr McDaniel wrote in a paper called 'A Solution for the Credit Rating Agency Debate.' 

The suggestion from the head of one of the world's big two agencies is both a rebuke and a challenge to governments who have lambasted the agencies. 

European leaders, led by French President Nicolas Sarkozy, have accused them of deepening Europe's debt crisis by downgrading the ratings of key countries in the euro. 

"Rather than stifle those opinions, policy makers should neutralise private-sector rating opinions by introducing a public-sector voice to contribute competing views," according to Mr McDaniel.... 

Some European critics have argued that the agencies should be banned from making public their opinions on the creditworthiness of governments, but Mr McDaniel argued that will not stop investors from speculating and making their own judgements. 

In the paper, Mr McDaniel suggested that establishing a public credit rating agency was down to the strength of political will there is to do it. 

The agencies have faced a wave of criticism from European governments over the last 12 months, and this week the European Union's top markets regulator delivered its own warning. 

The European Securities and Markets Authority said that the companies must improve their internal processes or face possible action from the regulator. Moody's said that it was committed to "continuing to enhance its rating process."

Head of derivative structuring: Structurers are like snakes

The Joris Luyendijk banking blog on the Guardian provides a monologue by a former head of derivative structuring.  The monologue touches on several of the issues discussed on this blog.

A rule of thumb in trading that I learnt very early on, says: there is a fool in every trade. You have to know who the fool is, because if you don't, then you are the fool. 

The financial markets are a shark tank, it's in the nature of the beast. Trading is a zero-sum game. Either you win, or you lose. There's no middle ground.... 

"Structuring is a bit like project management, in a way. You need to work out what it is that your client, often a corporation, wants, because they often come to you with rather vague ideas. 

Then you break it down into pieces and work your way down the list of what needs to be done. Figure out which financial instruments they need, work down the legal and tax aspects, and so on.... 

"All the Greek stuff that happened, where investment banks helped the Greek government move many of its debts off balance so their budget would look better – that was typically the job of structuring. 

Here is an example where structuring is not about laying off some type of financial risk, but rather helping the client to deceive other market participants.

"Lots of the derivative business is tax-driven. There is the so-called stamp duty tax of 0.5% on particular financial transactions. Banks and other members of the London Stock Exchange are exempt. You may structure a derivative for a client in such a way that technically it's the bank doing the transaction, saving you the stamp tax.... 

"Generally, I'd say that 80-90% of all derivatives are morally ambiguous, to say the least. It's mostly to do with accounting, legal or tax needs, with greed or fear or with gambling. .... 

"There is value in some of this. Derivatives can help you eliminate certain risks, for example price fluctuations. The textbook example is of farmers who could sell their harvest months in advance for an agreed-upon price with a future. 

"Great example. Except my own grandparents were farmers. They never used futures because they considered them too complicated.

However, interest rate swaps were not considered too complicated for RBS to sell to a 19 year-old.

"So why did I quit? It was like the story of Dr Faustus, where you sell your soul to the devil. I sold my soul for worldly riches. The price the devil demanded was my moral bankruptcy. 

"For a long time I was OK with that, until I wasn't. What triggered this change of heart? There was not one particular moment. You have to look yourself in the mirror every morning. I imagined a future son or daughter ask me, daddy what do you do for a living? What was I going to say? 'Well, sweetie, daddy rips clients off?' ...

"Obviously I read the Greg Smith resignation letter. He raises valid points, but I take issue with the idea that the toxic practices he describes are that different from what went on in the past. The main difference is that it's now much bigger, and even more complex.... 

"The advisory part of investment banking, mergers and acquisitions and corporate finance, are still more like the banking of old. There it's about nurturing relationships with clients over many years, very refined and working on trust. 

The trading floor is more like a poker table. People look at odds instead of trust. Put simply: the advisory part of investment banking is about clients who need money, the financial markets-part about clients who have money. That's the difference.

Investment bankers have clients, traders have counter-parties.

"These days I believe regulators need to become much, much firmer. I have been thinking about joining them, in fact. 

My sense is that regulators have good intentions, but the complexity of the industry makes it very difficult. And there's the lobbying. The Dodd-Frank act in the US is supposed to prevent another Lehman Brothers-type crash. It is over 2,000 pages long by now. 

"This financial crisis has crippled the western world, and the consequences will be with us for another ten years, at least. It is really big, and something like that can happen again. I'm sure that in four or five years, some smart structurer will find a clever way to get around this regulation, and God knows what will happen then. 

"There are always unintended consequences of any new regulation. Do we need all this complexity? I kind of agree with the joke making the rounds among bankers that the last useful financial innovation was the ATM machine – and that was 40 years ago....

Requiring ultra transparency is the simplest regulation that there is.  It is easy for banks to provide on an on-going basis their current asset, liability and off-balance sheet exposure details.

"I am still pro-free market, no mistake about that. Companies need to raise money to invest, innovate, expand. Ordinary people need returns on their savings so at some point they can retire. This should be the raison d'etre for the financial sector. 

But by now the sector has grown so much in size and complexity ... And as a result the opportunities to abuse the system have multiplied by many times. Many times.

Complexity that is not needed to support either companies or ordinary people.

Complexity that is only there so that the banks can make more money and hide how much they are making.

"A term like 'derivatives' puts people off but it's not terribly complicated, once you get beyond the lingo. Equity is roughly the same as shares. Equity derivatives are products that derive their value from them. 

"There are options, when you can buy or sell shares for a particular price at a particular moment. There are futures, when you oblige yourself to buy or sell something for a particular price at a particular moment. My favourite example: When I order pizza delivery, I agree to buy a product for a particular price at a particular time. That's how a future works. There are swaps when you agree to exchange something at some point in the future. 

"A big thing in derivatives is figuring out the value of these contracts. You don't know what the price is going to be of a certain share in three months time. So what is the contract worth that allows or obliges you to buy that share in three months time? There are complicated simulations for determining the value. 

The problem lies with the assumptions underlying those simulations. For instance the assumption there will always be buyers and sellers. In times of crises, that is not the case. 

"Everything we built was bespoke, specifically designed for the client. Now, the trouble was that such a bespoke product would be sold on, and then it would be sitting somewhere in the financial system. But where? 

"This doesn't really matter, until you have a major event like the collapse of Lehman Brothers, and suddenly everybody worries about so-called counterparty risk. Who is holding what financial obligations to whom?... 

Hence the reason that ultra transparency needs to be required on a global basis.

In equity derivatives there are different categories of clients. 

You have got retail customers, ordinary people if you will, who are pretty well protected. 

There is also the class of professional investors or market counterparties and with them it's anything goes, really. The assumption is that professional counterparties should know what they are doing, caveat emptor and all that. 

"Now there are very sophisticated parties out there. But there are also smaller players who basically have no idea what they're doing. Some small Spanish savings bank perhaps or some municipality in Sweden. What got to me after a while is how I'd be lying in the faces of these less sophisticated parties. And I'd be thinking, wow, this is my parents' pension money down the drain.... 

Worth re-reading as lying to less sophisticated parties was okay because these parties had to protect themselves under caveat emptor.

"Structuring people would be like snakes.

BoE says that banks urgently need to raise more capital

According to a Telegraph article, the Bank of England's Financial Policy Committee feels that UK banks are still undercapitalized in relation to the risks they face and that they should move quickly to raise additional funds.

British banks are still not holding enough capital to protect them against further shocks and must take action "as early as feasible" to raise funds, the Bank of England has warned. 

The warning from the Bank's new Financial Policy Committee, created as a new risk watchdog, underlined the ongoing fragility of the banking system. 

A statement released following the FPC's meeting on March 16 said: "The Committee remained concerned that capital was not yet at levels that would ensure resilience in the face of prospective risks and noted that the ability to make further progress via greater restraint of cash distributions was limited. 

"It therefore advised banks to raise external capital as early as feasible". 

The FPC said that banks had gone as far as they could to raise capital by keeping down pay, dividends and share buybacks.

How much capital do UK banks need to raise?

As we know from RBS's Stephen Hester's confession, regulators have blessed UK banks hiding losses on and off their balance sheet.  So we know that capital is needed to fill the hole left by existing losses.

Why would anyone buy stock in a bank and absorb these losses?  After all, there is a reason that Stephen Hester referred to investing in banks as dumb.

Setting aside that question, clearly the Bank of England feels that there is a need in the short term for additional capital beyond these losses.  How much more capital is needed?

Without banks providing ultra transparency and disclosing on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants have no way of assessing the risk of each bank and the amount of capital necessary to support this risk.

The bottom line is between the hidden losses and the lack of disclosure it is impossible for market participants to figure out exactly how much more capital the banks need.

As a practical matter, this is okay because, as the OECD tells us and this blog has presented the supporting reasons, bank capital is meaningless.  This is best illustrated by the simple fact that so long as a bank has access to a central bank for liquidity and depositors think the state's guarantee of their funds is good, a bank with negative book capital can continue to operate for decades until the financial regulators close it.

Given that the lack of ultra transparency makes it impossible for the market to figure out how much capital is needed and the fact that capital is meaningless, how come the Bank of England wants more of it quickly?

Zero Hedge: Why breaking the tyranny of ignorance is the only solution

Periodically, I like to provide readers of this blog with another perspective on why ultra transparency needs to be adopted to cut through the fog and shed light on all the opaque corners of finance.

This perspective is provided by Zero Hedge which explains why breaking the tyranny of ignorance is the only solution.

In order to bring some clarity to the matter we present two of the seminal pieces on the topic: first, from the IMF: "The (sizable) Role of Rehypothecation in the Shadow Banking System" and then from one of the best scholars of shadow banking, Gary Gorton, "Haircuts."

Your humble blogger first introduced readers to Professor Gorton over a year ago.  Besides acting as a derivatives consultant to AIG prior to its massive bailout, Professor Gorton also wrote a number of academic papers based on the concept of informationally insensitive debt.

Your humble blogger debunked his idea that there is such a thing as informationally insensitive debt.  For example, he cited demand deposits as informationally insensitive.  Even a 6 year-old knows demand deposits are informationally sensitive.  They aren't handing their money over to a banker without knowing that the government is guaranteeing they will get it back.

We will let readers digest the wealth of information contained in these two pieces on their own, however, we will point out the two key messages: ...

And the other one comes from Gorton who explains why haircuts [on repurchase agreements] are the functional equivalent of information arbitrage: 

"Increases in repo haircuts are withdrawals from securitized banks—that is, a bank run. When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive; liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent." 

And the punchline: "Liquidity requires symmetric information, which is easiest to achieve when everyone is ignorant. This determines the design of many securities, including the design of debt and securitization." 

Reread the last statement as it explains perhaps better than anything, the true functioning of modern capital markets and why they are terminally broken: in order to preserve the system, the banking cartel need to make everything of virtually infinite complexity so that no one has a clear understanding of what is going on! 

Which is where sites like Zero Hedge step in - to expose "shadowy" places where things are best left unseen.

Under Japanese model, repealing disclosure laws seems reasonable Part II

As discussed in Part I, one of the consequences of pursuing the Japanese models for handling a bank solvency led financial crisis is policymakers and financial regulators get comfortable with the idea that it is acceptable for banks to hide losses on and off their balance sheets.

It is a small step from this act of deception to the idea that maybe disclosure isn't needed for other firms.

As Professor Simon Johnson discusses in his post on BaseLine Scenario, the only person who stands between repeal of the 1930s disclosure laws that have served our financial markets well for 70+ years and a return to the type of opacity that produced the Great Depression is President Obama.

The question is will President Obama sign the bill and cement his place alongside Herbert Hoover or will President Obama veto the bill?

As it currently stands the "JOBS" bill now before the Senate would gut investor protection in the United States....

The "JOBS" bill would permit even very large companies to avoid all public disclosures.... 

Big companies like [the "JOBS" bill] ... the idea of escaping SEC [and the market's] scrutiny greatly appeals to them. 

Clearly, if the "JOBS" bill passes and President Obama signs it into law, the bill will go down as Wall Street's Opacity Protection Team's greatest victory.

Of course, the losers will be the 99%.

Ben Bernanke tells EU to clean up its banks

In a classic case of do what I say and not what I do, Fed Chairman Ben Bernanke says that the EU should clean up its banks.

Given that the US has also adopted the Japanese model for handling a bank solvency led financial crisis, perhaps the Fed should take its own advice and clean up the US banks.

For anyone who believes that the US banks are not insolvent, ask yourself "if the banks have nothing to hide, how come they insist on providing disclosure that makes them resemble black boxes and allows them to hide everything?"

As reported by the Telegraph,

“More needs to be done. Full resolution of the crisis will require a further strengthening of the European banking system,” he told Congress, calling for a “significant expansion of financial backstops, or ‘firewalls’, to guard against contagion in sovereign debt markets.” 

Regular readers know that no more bailing out of the banking system is needed.

Banks are fully capable of absorbing all of the losses hidden on and off their balance sheets and continuing to provide the credit needed by the real economy.

Yes, banks will be operating with negative book capital as a result of recognizing the losses.  But, banks can operate for decades likes this so long as depositors believe the deposit guarantee is good, central banks provide liquidity against good collateral and there is ultra transparency so market participants can see that the banks are not gambling on redemption as they rebuild book capital.

Strains in global financial markets “continue to pose significant downside risks”, he said but stopped short of criticising EU bank stress tests for banks. However, his comments reflect strong doubts in Washington over Europe’s strategy.

Washington doubts Europe's strategy because the same strategy is not working in the US.

The US stress tests are widely viewed as more rigorous, modelling the shock effects of a 5pc fall in GDP, a 52pc drop in equities, and a further fall of 21pc in house prices.

US stress tests are widely viewed as a renewal of the government's pledge to bailout the banks and prevent depositors, bond holders and equity holders from loss.

By contrast, the EU tests have already been overtaken by events, with both economic contraction and unemployment in Spain certain to exceed the worst case scenario for 2012.... 

US banks have little exposure to the Club Med bloc, but face “more material” risks in the eurozone core. European holdings amount to 35pc of US money fund assets of prime US money market funds, and these funds remain “structurally vulnerable”, he said....

What exactly are these "more material" risks to the eurozone core?

While Washington forced US banks to raise capital during the crisis, the EU has given its banks the choice of slashing loans books instead to meet core Tier 1 capital ratios of 9pc. The result has been to aggravate a credit crunch in southern Europe. 

Cheap three-year loans from the European Central Bank have prevented a collapse of weaker banks, but the cost has been to distort the EMU financial system, storing up trouble for the future.

The Fed has engaged in similar activity propping up the Too Big to Fail. 

Expert says financial regulators fell down on the job of enforcing rules

In an Independent article, Professor Gerard Caprio observed that much of the financial crisis could have been avoided if the global financial regulators had not failed to do their job and enforced the rules.

More importantly, he goes on to say that the issue of who guards the guardians to make sure that the global financial regulators are doing their job needs to be addressed.

Regular readers know that one of the reasons your humble blogger has been advocating for requiring banks to provide ultra transparency is with the disclosure of this data market participants have the information they need to make sure the financial regulators are doing their job.

More importantly, if the regulators don't do their job, the financial system is not put at risk as banks are still subject to market discipline as market participants use the data to adjust both the amount and pricing of their  exposures to the banks based on an independent assessment of each bank's risk.

THE Irish financial regulator missed one of the basic warning signs when it ignored the fact that Anglo Irish Bank was breaking its own lending rules, a leading US expert on banking said yesterday. 

Professor Gerard Caprio said this was part of a widespread failure of regulators in many countries to enforce existing rules which could have prevented much of the financial crisis. 

"The breach of a bank's own lending limits is a warning that management is no longer putting the safety of the bank as its number one goal, and the regulator needs to take action quickly." 

The Irish regulator, then headed by Patrick Neary, wrote to Anglo about the rapid growth in its loan book, which exceeded the bank's own guidelines, but took no action. 

"Lesson one in how to regulate banks is: 'Stop rapid lending'," Prof Caprio said. 

"The Occupy Wall Street people shouldn't be in Wall Street -- they should be outside the Federal Reserve. I understand people's anger, but I never think that bankers are working for me. I hope the regulators are working to protect me, and they fell down on the job." 

Prof Caprio, who worked with Central Bank Governor Patrick Honohan in research on banking, argues in a new book that regulators need to have an outside body keeping check on how they are doing their job. 

"We call it the sentinel. It would need to be a high-powered, independent body, with forensic financial accountants, lawyers and economists on it, which wouldn't come cheap," he said. 

"Regulators who fail to enforce the rules should face losing their jobs, or even financial penalties like loss of pension."

Requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details allows the market to oversee both the regulators and the banks.

Prof Caprio, who is professor of economics at Williams College in Massachusetts, said he thought Ireland had done more to get to the causes of the banking crisis than the US. 

"Ireland now has very good people working in regulation but it needs to get away from depending on having the right people, and more on creating structures that will work," he said.

The necessary structure being the requirement that banks provide ultra transparency.

Brookings Institution's Douglas Elliott makes the case for ultra transparency

In explaining why the Volcker Rule will not fix banks, the Brookings Institution's Douglas Elliott makes the case for why banks must be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

In a CNN Money Markets column, he wrote

The core problem is the Volcker Rule purports to eliminate excessive investment risk at banks without measuring either the level of risk or the capacity of banks to handle it, which would tell us whether the risk was excessive. 

Instead, the rule focuses on the intent of the investment. 

This subjective and vague approach means the Volcker Rule will do a poor job of identifying or eliminating excessive investment risk, will be costly even when it correctly identifies risk, and will be even more costly when it discourages risk that is incorrectly treated as if it were excessive....

The only way to measure the level of risk or the capacity of a bank to handle the risk is by looking at the bank's exposure details.

This is exactly what a bank's internal risk management team does.

As the opaque sub-prime mortgage backed securities showed, without this exposure detail it is impossible to assess risk.

There are at least four core problems with the Volcker Rule: 

Measuring risk. It is unclear why we should care very much about a bank's intent. 

It's the level of risk relative to the ability to bear that risk that is of prime interest.... 

Which is precisely why banks should be required to provide ultra transparency.

Defining 'prop trading.' The concept of "proprietary investments" is a very subjective and arbitrary one. 

Many supporters of the rule seem to be particularly concerned about investments made by banks that are funded with depositor money and on which the shareholders collect any gain.
However, that defines essentially any investment made by a bank, since depositor funds are basically interchangeable with all the other funds gathered by a bank. And the shareholders always benefit from any gains on investments. 

I therefore surmise that the underlying rationale for the rule must be to try to separate out activities that are integral to banking from those that are not. 

By focusing on investments alone, the Volcker Rule implicitly assumes that lending is good. 

In addition, some investment activities are recognized as integral to banking, while others are not. 

This raises several concerns.... it is often extremely hard to draw the line between acceptable and unacceptable activities. 

For instance, securities dealing requires the holding of securities to meet potential customer demand in a timely manner. 

At what point does the inventory shift from being an appropriate size to being at a level that indicates speculation of a type the Volcker Rule prohibits? 

Perhaps more fundamentally, finance has evolved over the last few decades to the point where corporate borrowers switch easily between borrowing via loans and via securities. 

This means that securities activities are now integral to modern banking, just as lending has always been. Treating loans as good and securities transactions as suspect, which is implicit in the Volcker Rule, leads to bad policy.

Therefore, good policy would be to require ultra transparency as it does not matter in assessing the risk of the bank and its capacity to handle the risk whether the exposure is a loan or a security.

Guessing the intent. Operationalizing the arbitrary and subjective distinctions created by the Volcker Rule forces regulators to peer into the hearts of bankers. 

The proposed rules are inevitably very complex, as regulators make an honest effort to obtain enough information to guess the intent behind investment actions. 

We are in danger of forcing regulators to micromanage the actions banks take in one of their core activities, the ownership and trading of securities. That raises costs and discourages legitimate activities.

Implementing ultra transparency is very simple and it eliminates any complexity that arises in worrying about arbitrary and subjective distinctions in the intent behind investment actions.

High risk investments. By focusing on intent, we are almost certain to miss large swathes of investments that are taken on for an acceptable purpose, but which carry excessive risk. 

Almost all of the AAA-rated mortgage-backed and asset-backed securities on which banks lost money in the financial crisis would have passed the Volcker Rule tests easily.

With ultra transparency, market participants will have the information they need to identify large swathes of investments which carry excessive risks and impose market discipline on the banks to reduce their risks.

We will survive the Volcker Rule, but it is an unnecessary, self-inflicted wound. Congress should repeal it. 

Failing that, Congress should clearly instruct regulators to stop only those activities that very clearly violate the Volcker Rule without halting activities where the intent of the transactions is unclear. 

Regulators should also be encouraged to implement the rule in the least burdensome manner possible.

The least burdensome manner of implementing the Volcker Rule just happens to be by requiring ultra transparency.

By requiring traders to disclose their positions as of the close of business every day, ultra transparency allows the market to assess whether the position is "inventory" or a "proprietary trade".

Naturally, if it looks like a "proprietary trade" market participants might engage in activities like front running or trading against the position that reduce the profitability of the proprietary trade or inflict outright losses on the bank.

Regardless of which activity market participants engage in, the intent of the Volcker Rule was to stop banks from proprietary trading and ultra transparency provides a mechanism by which the market can enforce this stoppage.

Deutsche Bank escapes from Dodd-Frank

The Wall Street Journal ran an article that describes how Deutsche Bank avoided having to comply with the Dodd-Frank Act by simply changing the legal structure of its US operations.

By making this change, the bank reduced both the amount of capital it will have to hold to support its US operations and regulatory supervision.  Another stake through the misguided notion of having the market rely on either meaningless bank capital or the regulators.

Perhaps more importantly, it made the SEC its primary US regulator rather than the Federal Reserve.  Readers will recall that prior to the financial crisis, the SEC was the primary regulator for Bear and Lehman.

At a minimum, what this action by Deutsche showed is how easy it is for the global financial institution to game the new bank capital and regulatory infrastructure.

Regular readers know that ultra transparency applies globally and is not subject to this type of gamesmanship.

Under ultra transparency, banks are required to disclose on an on-going basis all of their current asset, liability and off-balance sheet exposure details.  Ultra transparency needs to apply across the entire organization if there is to be market discipline.  After all, how can the market assess the risk of a firm if it sees less than 100% of its exposure details?