Tuesday, July 31, 2012

Bank of England's Andy Haldane admits economists share blame for financial crisis and recession

In a must read Telegraph article, Andy Haldane, the Bank of England's executive director for financial stability, admits that economist in both academia and the government share in the blame for both the financial crisis and the ongoing recession.

Regular readers know that the Queen of England pointed out this simple fact with her question of how if everything was going so well did the economics profession not see the financial crisis coming.

Mr. Haldane's statement confirmed what your humble blogger has said (see the Queen's question) about why the economics profession failed to see the crisis coming and in fact contributed to the crisis and the ongoing recession.
Andy Haldane ... said economists misled policymakers in the years before the crisis by promoting a “blinkered” view of the world based on the assumption their theories were unfailingly correct. 
The academic establishment, including central bankers, needs to own up to its mistakes, he added....
Please note that in the case of central banks, the economists were the policymakers.  Therefore the economists dominated and still dominate monetary, fiscal and regulatory policy.
In an interview with OurKingdom, the UK arm of openDemocracy, Mr Haldane said: “It’s right that it should shoulder some of the blame [for the financial crisis]. In part, this is because thinking within the wider academic economic community did start to shape and influence public policy in important ways.” 
He added: “I think looking ahead, central banks – this isn’t remotely just about the Bank of England – are going to need ... to say when they’ve got it wrong, to admit to mistakes when they’ve been made.” 
The profession’s mistake was to allow “a rather restricted and blinkered view of the dynamics of social and economic systems [to be] carried across into how public policy was thought about and executed”. 
He said the error was not driven by economists seeking financial gain but “the quest for certainty”. But their error was to think of the assumptions used to build economic models as cast-iron laws. 
“A concept gets formalised and then gets socialised and then believed as an almost theological doctrine,” he said. "The notion of not knowing, of imperfect information, of uncertainty, got lost from economics and finance for the better part of 20 or 30 years.
Please re-read Mr. Haldane's comment on imperfect information.  Your humble blogger has been saying since the beginning of the financial crisis that it was the result of imperfect information.  Imperfect information that was brought about by Wall Street as it capitalized on building opacity into the financial system.
“I think one of the great errors we as economists made was that we started believing the assumptions of economics, and saying things that made no intellectual sense. 
We started to believe that what were assumptions were actually a description of reality, and therefore that the models were a description of reality, and therefore were dependable for policy analysis. 
“With hindsight, that was a pretty significant error.”
The major assumption being that there was transparency in the financial system when in fact Wall Street was creating vast opaque areas (think banks and structured finance securities).

I thought that readers might find the following NY Times' Economix column interesting as it expands on the idea of economists believing that their assumptions are facts.
An economist's mea culpa

With admission of Libor involvement, will Deutsche Bank realize it needs to provide ultra transparency to restore trust

The Guardian reports that Deutsche Bank has admitted involvement in the Libor interest rate manipulation scandal.

It is trying to blame a few rogue individuals that it has already fired claiming they were the only ones involved.

Sensing that firing these individuals will not be enough to protect it from the backlash from the market when the true extent of its involvement is disclosed, Deutsche has announced a new effort to clean up its culture.

Regular readers know that the only way to truly clean up a banking culture and restore trust is by having the bank disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

It is only with this level of disclosure that sunlight can provide the best disinfectant for Deutsche bank's culture.

So the question is, will Deutsche Bank adopt ultra transparency and really clean up its culture or will it go through a meaningless review of personal conduct codes and continue to indicate to the market it has something to hide and cannot be trusted?

Germany's biggest bank, Deutsche Bank, prepared the ground for regulatory action in the Libor rigging scandal by admitting that a "limited number" of its staff had been involved.... 
Deutsche said "action had been taken accordingly" against those staff found to have been involved.... 
Deutsche's supervisory board head Paul Achleitner insisted in a letter to staff that "no current or former member of the management board had any inappropriate involvement". 
Deutsche's admission follows a warning by Royal Bank of Scotland that it too expects to be drawn into the Libor debacle in the wake of the £290m fine slapped on Barclays.... 
Deutsche's new co-chief executive Anshu Jain used to run the investment banking operations of the bank, but the internal probe has cleared him of any involvement. 
Jain yesterday announced plans to cut 1,900 jobs – largely outside Germany – and clean up the culture of banking. Bonuses are to come down and codes of "personal conduct" are being reviewed.

Spain's banks plan fire sale of toxic housing exposure

The Guardian reports that Spain's largest banks are planning a fire sale of their toxic housing exposure.

If the banks go through with it, Spain will discover what the real market value of housing is in a country with 24+% unemployment.  As the question is where will the buyers come from?

House prices continue to fall across the Iberian peninsula, with the ratings agency Fitch predicting a further 15% decline in Portugal and Spanish banks vowing to sell off unwanted stock at rock-bottom prices. 
Spain's second-biggest bank, the BBVA, said it would be accelerating its sales of toxic property assets, lowering prices as necessary. 
It has €8.7bn (£6.8bn) of real estate on its books including building land and thousands of built and half-built residential properties. 
Most of that property is connected to developers who have been unable to repay loans since the housing market crashed four years ago. "We will adjust prices month by month to speed up sales," BBVA's chief executive, Angel Cano, said on Tuesday. 
The Sabadell bank, which has absorbed the loss-making Caja de Ahorros del Mediterráneo (CAM) savings bank, recently said it would be selling off new properties at a 38% discount. 
Spain's largest bank, Santander, has reportedly dropped prices by 35% to 45%. Anecdotal evidence suggests discounts of up to 68% in some previously unsold promotions on the Costa del Sol. 
Spanish house prices have already fallen about 25% since their peak. But many analysts are expecting another 10% fall, which would make the overall decline similar to that seen in Ireland. 
Experts warned that further shrinkage of Spain's economy, which is in a double-dip recession and affected by strong austerity measures, could force prices still lower. 
Lower house prices seem like a safe bet as the Irish banks have still not taken the action that BBVA is talking about and lowering the price until it sells.

If business needs misfits, does ending the financial crisis need misfits too?

The Economist magazine carried an interesting article on how business needs people with disorders like Asperger's syndrome.

IN 1956 William Whyte argued in his bestseller, “The Organisation Man”, that companies were so in love with “well-rounded” executives that they fought a “fight against genius”. 
Today many suffer from the opposite prejudice. Software firms gobble up anti-social geeks. Hedge funds hoover up equally oddball quants. Hollywood bends over backwards to accommodate the whims of creatives. And policymakers look to rule-breaking entrepreneurs to create jobs. 
Unlike the school playground, the marketplace is kind to misfits.
It turns out that individuals with these disorders tend to be creative and look for better ways to do things.


Because people with Asperger's/autism/non-verbal learning disabilities tend to have
an obsessive interest in narrow subjects; a passion for numbers, patterns and machines; an addiction to repetitive tasks; and a lack of sensitivity to social cues
Some joke that the internet was invented by and for people who are “on the spectrum”, as they put it in the Valley. Online, you can communicate without the ordeal of meeting people. 
Wired magazine once called it “the Geek Syndrome”. Speaking of internet firms founded in the past decade, Peter Thiel, an early Facebook investor, told the New Yorker that: “The people who run them are sort of autistic.”...
These autistic people are exactly the type that are absent from the discussion of the policies to address the bank solvency led financial crisis.

Think about it?

Could an individual who lacked sensitivity to social cues be appointed as a senior financial regulator?  No.

Could an individual who lacked sensitivity to social cues become a politician?  No.

Could an individual who lacked sensitivity to social cues become a central banker?  No.

The result of the absence of these autistic people in policy discussions is that the creativity they bring to solving a problem is absent.  This can clearly be seen by the fact that the EU, UK and US are trying all the failed policies that Japan has trotted out over the last 2+ decades.

To an autistic person, trying policies what has never worked is a dumb idea.

To an autistic person, the idea of adopting policies to directly or indirectly (think ZIRP) bail out banks makes no sense.  An autistic person is likely to observe that virtually no one knows how much book capital their bank had at the end of last quarter as they are looking to an explicit and implicit government guarantee that they will get their money back.  An autistic person is also likely to observe that bankers are paid to make loans, so as long as there is loan demand, they will do what they are paid for doing.

To an autistic person, pursuing zero interest rate policies after the man who wrote the book on central banking  (Walter Bagehot and Lombard Street) said in the 1870s not to lower rates below 2% makes no sense.

An autistic person can understand how a computer can suggests that low rates will have a positive effect on spurring economic growth, but Mr. Bagehot observed that investors couldn't stand lower rates.  Perhaps Mr. Bagehot was influenced by Mark Twain's observation that he was more concerned with the return of his money than on his money.

An autistic person would simply observe that as rates stay at zero, investors have elected not to chase yield but instead opt to protect their principal.

To an autistic person, actually analyzing the financial crisis to distinguish what caused the crisis from what was a symptom of the crisis makes sense.
  • For example, once per month reporting of the performance of the underlying sub-prime mortgages made it impossible to value these structured finance securities (see BNP Paribas August 9, 2007 press release saying it couldn't value these securities).
  • For example, the interbank lending market freezing in 2008/2009 because lack of disclosure by banks meant that banks could not tell who was solvent and who was not (see Financial Crisis Inquiry Commission report).
To an autistic person, a pattern emerges of where there is opacity in the financial system that prevents market participants from independently assessing the risk of and valuing a security, the financial system broke down.

To an autistic person, or at least your humble blogger who has a non-verbal learning disability, it makes sense to restore valuation transparency across the financial system and see if this doesn't fix the problem.

"Funding for Lending", yet another failed central bank experiment imported from Japan

In his Wall Street Journal column, Alan Blinder makes the case for the Fed to follow the Bank of England's lead in encouraging banks to lend by starting a "Funding for Lending" program.

Regular readers know that banks are awash in liquidity and fighting to achieve meaningless bank capital ratios.

So the question that should be asked is why does anyone think that access to funding is what is restricting bank lending as oppose to financial regulators crushing lending through regulation of bank capital ratios?

As the Telegraph reports about the UK "Funding for Lending" program,

[Danny Gabay of Fathom Consulting] was sceptical about the latest growth strategy of “funding for lending” to lower the cost of credit, arguing that households needed to reduce their debt by about a third – or about £440bn in current money. 
He said: “The Government wants banks to lend more to households when house prices on most metrics are still overvalued. It doesn’t sound like sensible policy to us. We need to be encouraging households to deleverage.” 
Ms [Deanne] Julius said that although it was “worth a try” she “does not have huge hopes” for funding-for-lending. 
“I met some Bank of Japan officials who said they had tried something similar and it had been another contributory factor to their zombie banks.” 
Sir John [Gieve] welcomed the effort and the indication that policy is joined-up between the Bank, the Treasury and the Financial Services Authority, but said: “I don’t think its going to make a massive difference.”
Not exactly a ringing endorsement for a program.

George Osborne says using trade data in setting Libor to be considered

Bloomberg reports that
U.K. Chancellor of the Exchequer George Osborne set out guidelines for a review aimed at preventing the manipulation of Libor, saying it should consider whether the benchmark should be based on actual traded rates rather than those banks choose to report.

The report by Martin Wheatley of the Financial Services Authority will form the basis for amendments to legislation currently making its way through Parliament. Wheatley is due to present his findings by the end of September, the Treasury said. 
“It is clear that urgent reform of the Libor compilation process is required,” Wheatley said in a statement released by the Treasury in London today....
Regulators must now find a balance between restoring credibility and minimizing disruption to Libor, the benchmark for more than $500 trillion of securities, including $350 trillion of interest-rate swaps and $10 trillion of loans, according to the U.S. Commodity Futures Trading Commission. Any material changes to the mechanism for setting Libor risks invalidating millions of existing financial contracts, lawyers say....
Because submissions aren’t based on real trades, the potential exists for the benchmark to be manipulated by traders hoping to profit on where the rate is set.
With Barclays' admission, it is not a question of potential for the benchmark to be manipulated, but rather a matter of fact.
That has spurred calls for regulators to base the rate on how much banks pay to borrow unsecured cash rather than estimates of how much they might have to pay if they were to borrow. 
“The idea that one can base the future calculation of Libor on the idea that ‘my word is my Libor’ is now dead,” Bank of England Governor Mervyn King said at a press conference to present the central bank’s Financial Stability Report in London on June 29. 
“It will have to be based in the future, in my judgment, on actual transactions in order to bring back credibility to the system.’
Regular readers know that banks need to disclose these actual transactions as part of disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This broader disclosure is necessary so that market participants with deposits to lend can independently assess the current risk of the banks looking to borrow.  Without this ability to independently assess the risk of the borrowing banks, the interbank lending market will remain frozen.

Monday, July 30, 2012

Does jail await bankers found to have rigged Libor?

The Telegraph reports that the UK's Serious Fraud Office intends to bring criminal charges against bankers guilty of manipulating Libor.

If this is true, does that mean that Barclays' former second in command, Jerry del Messier, is looking at up to 10 years in prison?

After all, the case should be a slam dunk given that he has admitted to ordering Barclays to manipulate its Libor submissions?

Bankers found to have rigged Libor could face jail after the SFO said it will look to bring criminal charges against those who attempted to manipulate the world’s key borrowing rate. 
David Green QC, director of the SFO, said existing legislation could be used to bring criminal actions against banks implicated in the Libor rigging scandal. 
Mr Green did not specify the precise charges that could be brought but it is possible bankers found guilty of manipulation could receive prison sentences of up to 10 years. 
The decision to pursue prosecutions comes just over three weeks after the SFO formally announced an investigation into Libor and in particular whether it was possible to launch criminal proceedings against individual banks and bankers found to have rigged borrowing rates. 
In a statement the SFO said it was “satisfied that existing criminal offences are capable of covering conduct in relation to the alleged manipulation of Libor and related interest rates”.

Banks urging Congress to extend insurance on all deposits a signal policies adopted to battle financial crisis haven't worked

Reuters reports that banks are urging Congress to extend insurance on all deposits in a clear signal that the policies adopted under the Japanese model for handling a bank solvency led financial crisis have not worked.

Regular readers know that there was absolutely no reason to believe that the Financial-Academic-Regulatory Complex's (FARC) embrace of the Japanese model would work.  It has a history of long-term failure.  Just look at Japan.

By asking Congress to extend insurance on all deposits, banks are saying that the opacity that made it impossible to tell which banks were solvent and which were not at the beginning of the financial crisis is still with us.  [Something that we also knew because the interbank lending market is frozen.]

It is this opacity that causes problems for the banks.

Bankers realize that large depositors are not fooled by the stress tests and meaningless bank capital ratios.  Neither of these has prevented banks in the EU from having to be closed.

Bankers realize that large depositors do not trust them after the Libor scandal showed that the bankers were willing to lie for profit or to present their institution in a more favorable light.

The bottom line is that bankers realize that large depositors are not going to keep their deposits in the bank if they cannot independently assess its solvency and understand their risk of loss unless the government insures that the depositors will not lose money.

The expiration of special U.S. deposit insurance at the end of the year has spurred banks to lobby Congress to extend the program out of fear that companies will withdraw billions of dollars. 
At issue is the Transaction Account Guarantee (TAG) program, which insures all bank deposits in checking accounts above the $250,000 coverage already provided by the Federal Deposit Insurance Corp. 
TAG primarily benefits businesses and local governments that need quick access to large amounts of cash for payroll and other needs. 
About $1.3 trillion of TAG-insured deposits that do not pay interest sit at large and small U.S. banks. 
The TAG program was created by bank regulators and the U.S. Treasury during the 2008 financial crisis to attract cash for banks and reassure depositors that their money was safe.... 
Without this program, this $1.3 trillion in deposits would be hot money that could leave the banking system for higher returns elsewhere.
Without another extension, businesses are likely to shift their deposits to prime money-market accounts and other short-term alternatives.
"This program is the best deal around," said Robert Haas, senior treasury associate in charge of cash management and investments at the National Railroad Passenger Corp., the parent of Amtrak. 
It addresses treasurers' two primary concerns: safety and a return on cash that comes from discounts banks give on other services in lieu of interest, he said.....
End the program and what looked like a stable deposit base shrinks considerably.
The U.S. government is trying to exit many of the emergency financial programs set up during the crisis....
The fact that the US government is still trying to exit many of its emergency financial programs is a sure sign that the policies adopted under the Japanese model have not worked.

The only way off these programs is to reintroduce transparency into the financial system and adopt the Swedish model for handling a bank solvency led financial crisis.
Many analysts shrug their shoulders at the controversy. 
Big banks don't need the cash. They have fixed the liquidity problems that plagued them during the financial crisis and cannot invest or lend their excess deposits at a rate that benefits shareholders.... 
Bank of New York was so awash in deposits last summer that it threatened to charge companies with more than $50 million in deposits to offset the fees the bank pays to the FDIC. The bank retreated from the plan but is now considering charging European clients who are flooding it with eurodeposits, Chief Financial Officer Todd Gibbons told Reuters this month. 
Noninterest-bearing client deposits at Bank of New York totaled $63 billion at the end of the second quarter - 46 percent higher than year-ago levels.
If $1.3 trillion in deposits were to leave the US banking system it would send a pretty strong message to European clients that maybe the US banking system isn't the best place to park cash.

Economic policy in the hands of the few, serves those few dates back to Adam Smith

In a terrific Guardian column, David Wearing turns to Adam Smith for insight into how to deal with the  problem that economic policy in the hands of the few serves those few.

Smith, the 18th century Scottish philosopher, is of course best known for advocating the liberalisation of markets .... However, what is less well known is that Smith shared some of the key concerns of today's critics of neoliberalism. 
His most famous work, The Wealth of Nations, offered a powerful political critique of the "one per cent" of his day, to borrow the terminology of the Occupy movement. In what he himself described as a "very violent attack" on an unjust status quo, Smith repeatedly emphasised the role of power, influence and class in distorting economic policy to serve the interests of a narrow elite.
Your humble blogger has made a similar argument when looking at the choice to pursue the Japanese model for handling a bank solvency led financial crisis (which has never worked) over the Swedish model (which has worked everywhere it has been tried including the US in the Great Depression, Sweden and Iceland).
Smith noted that the "English legislature has been peculiarly attentive to the interests of commerce" because policymakers were continually "imposed upon by the sophistry of merchants". 
The vested interests "like an overgrown standing army … have become formidable to the government, and upon many occasions intimidate the legislature". They argue their case "with all the passionate confidence of interested falsehood", predicting national ruin if their demands are not met. Of course, all this has a very familiar ring.
Please re-read the highlighted text as it nicely summarizes what the Financial-Academic-Regulatory Complex (FARC) has been saying.
The politician who serves the one per cent, Smith noted, "is sure to acquire not only the reputation of understanding trade, but great popularity and influence with an order of men whose numbers and wealth render them of great importance. If he opposes them [he is subjected to] the most infamous abuse and detraction"....
In the revolving door that exists between policymaker and finance, there is a significant incentive to serve.  Just look at the 2.5 million pounds per year that former prime minister Tony Blair makes from being a part-time senior advisor to JP Morgan.
Smith observed that "all for ourselves and nothing for other people, seems, in every age of the world, to have been the vile maxim of the masters of mankind". 
The class power of wealth and big business makes the elite the "principal architects" of policy, "an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it". 
Hence the reason why it seems perfectly reasonable to chose protecting banker bonuses and bank book capital levels (the Japanese model) over society (the Swedish model).
Smith repeatedly stresses that while the mercantile system does not serve the public interest, it does benefit the "principal architects" of policy, which is no less true of today's hyper-financialised, neoliberal capitalism....
But the larger point is that when power and influence over policymaking is heavily concentrated within an economic elite, policy will be designed to serve that elite, often at the public's expense.
This is the reason that the Financial-Academic-Regulatory Complex is worse for society than the military-industrial complex feared by President Eisenhower.

Libor review chief Martin Wheatley says urgent reform is needed

In what is probably a classic understatement, the Telegraph reports that Libor review chief Martin Wheatley says urgent reform is needed in the way the rate is compiled.
Mr Wheatley's review will look at:
• Whether participation in the setting of Libor should be regulated
• How the rate is constructed and whether actual trade data can be used to set it
• Governance of Libor
• Sanctions for abuse of Libor - regulators have complained that they do not have sufficient powers to tackle the problem of rigging.
At present the rate is supervised by its sponsor, the British Bankers' Association.
As outlined by the Chancellor, the review will report by the end of the summer in order to enable the Government to consider recommendations with a view to taking legislative changes forward through the Financial Services Bill, which is currently being scrutinised in the House of Lords. 
Mr Wheatley will publish a discussion paper on August 10 to kick off a four-week public consultation with final conclusions by the end of September.
Regular readers know that actual trade data can and should be used.  This data needs to be part of a broader disclosure requirement placed on banks.  Under this broader disclosure requirement, banks must disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

This broader disclosure requirement is needed so that the currently frozen interbank lending market will unfreeze.  The reason this disclosure will unfreeze the interbank lending market is that banks with deposits to lend will be able to assess the riskiness of and monitor the current risk of banks that are looking to borrow.

By restoring liquidity to the interbank lending market, there is a lot more actual trade data to use and the actual trade data becomes a much truer measure of the risk adjusted cost of bank borrowing.

Of course, the banks and the rest of the Financial-Academic-Regulatory Complex (FARC) will fight requiring banks to make this broader disclosure.

For example, they might make an argument for basing Libor off of some other interest rate.  In making this argument, they are hoping that no one notices that it was the fact that Libor was suppose to represent the unsecured cost of funds to the banks that made it a benchmark interest rate.  Changing interest rates ends this relationship and the logic for why Libor is a benchmark.

French regulator: most post-crisis measures are justified

In an IFLR interview, Edouard Vieillefond, a managing director of France's financial regulator, asserted that taken individually, most post-crisis measures are justified.

A defense of the regulatory response to the financial crisis is exactly what should be expected from the Financial-Academic-Regulatory Complex (FARC) as their response exacerbated the financial crisis and has done almost nothing to prevent the next crisis.

One of the key pillars of the regulatory response has been to require banks to achieve a much higher level of capitalization.  For example, EU banks had to reach a 9% Tier I capital ratio by the end of last month.

The result of this drive for higher capital levels has been two-fold: retention of zombie loans on bank balance sheets and an EU-wide credit crunch for creditworthy borrowers.

Together, these have had a major negative impact on the real economy.  Supporting zombie loans siphons capital out of the real economy that is needed for reinvesting in the real economy.  The credit crunch for creditworthy borrowers crushes growth in the real economy.

Equally importantly, the focus on higher capital levels is completely misplaced as a modern banking system is designed so that banks can protect the real economy by absorbing the losses in the financial system.  Banks can do this because with deposit insurance and access to central bank funding banks can operate for years with negative book capital levels.

Regular readers know that the regulatory response by FARC was designed to protect FARC and not to actually address the causes of the underlying financial crisis.  As a result, the French regulator is out trying to defend the indefensible.

We had a crisis that resulted from opacity in the financial system.  Specifically, opacity that prevented market participants from having access to all the useful, relevant information in an appropriate, timely manner.

Examples of this type of opacity are banks (think BoE's Andrew Haldane's "black boxes") and structured finance securities (think your humble blogger's "brown paper bags").

None of the regulatory responses address this type of opacity as doing so would greatly reduce the need for financial regulations.

When it comes to influencing the direction of regulatory reform in Europe, France has a leading role. Indeed, the Autorité des Marchés Financiers (AMF) identified the problems posed by money market funds (MMFs) and exchange traded funds (ETFs) long before they became key issues on the international agenda.   
And France is now witnessing a unique phase in global economic history. Banks are scrambling to meet new recapitalisation requirements imposed to stave off another financial crisis, the eurozone is entrenched in a debt crisis and, with the seemingly unstoppable rise of the Chinese super-power in the east, the world economic order looks set to change dramatically.  
Against a backdrop of so much uncertainty, IFLR took the opportunity to speak with Edouard Vieillefond, the managing director in charge of the regulatory policy and international affairs division of the French regulator. It was a chance for Vieillefond to set the record straight on the views of the AMF, one of the key players on the international stage at this crucial juncture.... 
the French regulator discusses everything from the huge changes in financing economy and what he has learnt from the eurozone crisis, to whether he worries about unintended consequences of regulation. 
Most European banks are on course to implement Basel III ahead of schedule. Do you think we run this risk of going overboard with financial regulation? 
The consequences of Basel III will be crucial for everyone. It will mean big changes in the way the European economy is financed. Sometimes there are complaints about the unintended consequences of regulation. We should be reasonable: taken individually, most of the post-crisis measures such as Basel III are justified.
They are only justified if they address a cause of the financial crisis and not a symptom.
Let’s remember what happened and the reasons why we are asking for more capital and more liquidity. There wasn’t enough capital, probably not enough liquidity and there was insufficient collateral in transactions.
Lack of capital and liquidity were symptoms of the problem.  The problem was opacity.  With opacity, market participants cannot tell if the banks have adequate capital and/or liquidity.
Today banks have two constraints: capital and liquidity. In future, they will have three, with collateral soon to be added to the list thanks to rules such as Emir [the European market infrastructure regulation].
 This doesn't address the opacity problem.  In fact, as discussed above, it only makes the situation worse.
But we probably need to be mindful at the cumulative consequences of all regulations and take into account the overall regional effect of MiFID II [markets in financial instruments directive], Emir, Basel III, and Solvency II for the insurance sector. 
Banks should avoid deleveraging at the expense of the economy. Instead, they should seek where possible to use other tools to reinforce their capital. According to the European Banking Authority (EBA), around 80% of bank restructuring in Europe is carried out not through deleveraging but through the addition of more capital, the transformation of hybrid products into equity, selling non-strategic assets and so on.
As your humble blogger predicted, so long as bank balance sheets are opaque black boxes, there is no one who is going to want to invest in the banks. There is no way to assess the risk of the bank.  You cannot trust what the financial regulators say (just look at how many banks have had to be nationalized after passing stress tests).

As a result, buying equity in a bank is not investing, but rather blindly betting.

With no investors, it was easily predictable (I did) that the banks would not avoid deleveraging at the expense of the real economy.  In fact, what banks have done in the pursuit of higher capital ratios has been devastating to the real economy.
We need to find the right balance between risk and reward and keep in mind that the financing of the economy will shift to equities and long-term products. We therefore need to keep investors interested in buying equities and bonds. That is especially important since more activity will happen through markets than before because there will be less bank financing
I can understand why the large banks with investment banking operations would want to grow the EU bond market.

However, it is the market for the debt of small businesses and individuals that needs to be restarted.  This is a market that is only coming back when there is transparency.  Transparency that results from observable event based reporting.  With observable event based reporting, all activities like payments involving the collateral backing the security are reported to market participants before the beginning of the next business day.

Sunday, July 29, 2012

Stephen Hester: 'RBS faces huge fine over Libor scandal'

In a Guardian article, RBS's Stephen Hester acknowledged that RBS will face a huge fine over its participation in the Libor scandal.  More importantly, he showed that he is part of the problem with reforming the culture of banking.

He blamed a few 'rogue' individuals as oppose to realizing that manipulating Libor reflected a systemic problem.

The boss of the Royal Bank of Scotland is warning the bank faces a further hit to its reputation – and a huge fine – from the Libor scandal, which has engulfed Barclays and caused a fresh wave of anger against bankers. 
While the £290m fine slapped on Barclays has helped to distract from the computer meltdown at RBS, which prevented up to 13m customers accessing their accounts for up to a month, Stephen Hester, RBS's chief executive, said the rate-rigging scandal was bad for the entire industry. 
"RBS is one of the banks tied up in Libor. We'll have our day in that particular spotlight as well," Hester said in an interview with the Guardian. He did not know the size of the RBS fine but said that the investigation by the Financial Services Authority was "in process". 
Hester is preparing to represent first-half figures – showing another loss – on Friday, when the bank's exposure to interest rate swap mis-selling will also be a focus. RBS is said to have paid £25m to just one businessman who was mis-sold products intended to protect against interest rate rises.
On Sunday, HSBC will publish profits for the first half of the year, ahead of a yet be disclosed multimillion-pound penalty for money laundering and other offences through its US arm.
Bad behavior by bankers occurred everywhere that there was and is opacity in the financial system.

The list continues to grow:  Libor manipulation, mis-selling interest rate swaps and money laundering.  A list like this doesn't come about because of a couple of rogue individuals.  It is the result of a culture that encourages bad behavior in pursuit of profits.
Hester said: "Even though when all the Libor [fines] are out most of it is going to be around the wrongdoings of a handful of people at a number of banks. Those wrongdoings taint a whole industry beyond the handful of people and that makes it a huge problem."...
Libor manipulation is a huge problem because it shows that bankers will lie for personal gain, higher bank profits and also to distort the perception of their institutions.
"An element of banks became detached from society around it, an element was for traders making money for themselves or the banks, and customers [were] the means of making money. We have to be sure that banks do it the other way around."
The only way to be sure that banks adopt the right culture is for them to adopt transparency in everything they do.

For example, they need to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.  This way, Libor can be based off of actual trades and not off of make-believe.
Hester has 18 months left to go of his "clean up" operation of a bank that made record £24bn losses in 2008....The clean up will move a step closer to completion later this year when he expects the bank to exit the asset protection scheme, set up to insure some £300bn of the bank's most toxic assets. 

The adverse link between sovereigns, banks and the real economy

One of the main themes of this blog has been the adverse link between sovereigns, banks and the real economy is the direct result of the policymakers' and financial regulators' choice of the Japanese model for handling a bank solvency led financial crisis.

Under the Japanese model, bank book capital levels are protected at all costs.  This has negative consequences for both the sovereign and the real economy.

In the case of the sovereign, it increases the debt at the sovereign as the state becomes the source of new capital to inject into the banks.

In the case of the real economy, it transfers the capital needed for supporting and growing the real economy to servicing the excess debt in the financial system.  At a minimum, this constrains growth in the real economy.  As the current financial crisis has shown, it puts the real economy into a downward spiral as capital that is needed to maintain the real economy is being transferred to debt service.

Of course, the downward spiral in the real economy feeds back negatively into the sovereign as it reduces tax revenues and the sovereign's ability to service its debts.  This in turn feeds back negatively into the real economy as the sovereign cuts its expenditures, including on social programs.  This is a self-reinforcing negative feedback loop that sacrifices society for the benefit of the bankers.

Protecting bank book capital levels at all costs has other negative consequences.  It crushes interbank lending as banks with deposits to lend still don't know who is solvent and who is not solvent.  It shatters the monetary transmission mechanism because protecting the zombie borrowers drives out loans to the creditworthy.

Regular readers know that your humble blogger champions the Swedish model for handling a bank solvency led financial crisis.

Under the Swedish model, banks protect the sovereign and the real economy.  Banks do this by recognizing all of the losses on the excesses in the financial system today.

Banks can protect the sovereign and the real economy because of the way that a modern banking system is designed.  Deposit guarantees and access to central bank funding mean that a bank can continue to function and support the real economy even if it has negative book capital levels.

As a result of the deposit guarantees, the taxpayers step up as 'silent' equity partners when the banks have negative book capital level.  Please note that as silent equity partners there is no need for an explicit bailout of the banks and a capital injection.

The choice to directly bailout the banks under the Japanese model was and still is driven by bankers wanting to protect their bonuses and policymakers and financial regulators agreeing to protect these bonuses.

The Swedish model was first used in the US by the FDR Administration to break the back of the Great Depression.  It has subsequently been used successfully in Sweden in the 1990s and by Iceland in the current financial crisis.

The Swedish model could still be used today to end the global financial crisis.

I have argued that the Swedish model should be adopted because protecting society (the real economy and the state) is far more valuable than banker cash bonuses.  This is an opinion that is not shared by the Financial-Academic-Regulatory Complex (FARC).

In the 1950s, President Eisenhower identified the military-industrial complex and said that it needed to be carefully watched and controlled less it bring great harm to society.

Unfortunately, nobody bothered to watch FARC.   As much as President Eisenhower feared the military-industrial complex, FARC has been much more damaging to society.

Saturday, July 28, 2012

German Left Party proposes new way to save euro

As reported by Der Spiegel, the German Left Party has put forth a proposal based on the idea of rebooting the market economy and then cushioning the fall.

Regular readers know that this is the basis for your humble blogger's blueprint for saving the financial system.

Step one in the blueprint was for the excess debt in the financial system to be written down and losses realized by the banks.

Step two was to realize that banks can continue to operate and support the real economy even with negative book capital levels.  They can do so because of deposit insurance and access to central bank funding.  The deposit insurance means that taxpayers are 'silent' equity investors in the banks while they have negative book capital levels.

Step three was to require the banks to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details.  With this disclosure, market participants could confirm the banks had absorb the losses on the excess debt and exert discipline on the banks to restrain their risk taking.

The German Left Party proposed
First and foremost, [Sahra] Wagenknecht calls for a radical debt haircut. "The EU member states should resolve that all sovereign debt above a certain level will not be paid back," she writes. 
Wagenknecht proposes using 60 percent of a country's annual gross domestic product as the cutoff -- meaning that even Germany, with its debt load worth some 80 percent of GDP, would have to partially default.
A call for recognizing losses on the excess debt in the financial system.
Such a euro-zone-wide partial default, of course, would result in the bankruptcies of several European banks and insurance companies due to the amount of European sovereign bonds they carry on their balance sheets. 
"The financial industry has seriously underestimated the risks associated with sovereign bonds," Wagenknecht writes. Banks and insurance companies, she notes, provided euro-zone member states with fresh capital to the extent that their debt loads have now become unmanageable. Her plan, she adds, merely reflects that "risk and liability are linked in a market economy."
It is important to repeat that as a result of taking the losses the banks would have negative book capital levels.  However, they would not have to be closed.

Rather, those banks that had a franchise that was capable of generating earnings could retain 100% of pre-banker bonus earnings until such time as they had restored positive book capital levels.
It is a sentence that could just as well have come from the party platform of the business-friendly Free Democrats on the center-right of the political spectrum. Indeed, the same could be said for large parts of Wagenknecht's approach to the euro crisis. 
But the Left Party politician has also included measures that would reduce the economic effects of a banking crash. 
Following a "technical moment of insolvency," her plan calls for the state to inject fresh capital into the banks so that they can continue serving those sectors that are required for the economy to function. 
In other words, they would manage customer accounts and extend loans to companies in the real economy, thereby fending off a recession.
My blueprint differs from her suggestion because the banks can continue to manage customer accounts and extend loans to companies in the real economy without being recapitalized by the state.
Much of the investment banking sector, on the other hand, would be liquidated as part of the insolvency proceedings.
In my blueprint, the proprietary trading area of the investment banking sector would be eliminated because the banks were required to provide ultra transparency.  The fact that all market participants could see what the banks were doing would make it difficult to profit from proprietary trading.
The state would also guarantee up to €1 million ($1.2 million) per person in savings and life insurance value. "Anything beyond that would be defaulted as part of the insolvency," Wagenknecht writes.
Since the state does not have to invest in recapitalizing the banks, it might set higher guarantees on savings and life insurance value. 
Under her plan, of course, it would not only be banks that became insolvent, but also countries. And when that happens, those countries are generally shut out from international financial markets for many years. 
Wagenknecht, however, believes she has found a way around that problem. 
Euro-zone states would be able to receive a certain amount of financing directly from the European Central Bank (ECB), but only up to a certain maximum -- Wagenknecht suggests capping it at 4 percent of GDP annually. 
Under her plan, the ECB would remain independent and continue to focus on controlling inflation and maintaining full control over the money supply in the euro-zone. However, most of the fresh money the bank pumped into the euro zone would no longer flow into the banks but, rather, it would directly benefit national budgets. 
"At the moment, the ECB is pouring money into the banks in the hope that they will invest a small percentage of it in sovereign bonds," she writes. "It would be much more efficient to give this small percentage directly to the states." 
Finally, she envisions having banks extend loans almost exclusively on the strength of the deposits of their customers.
The experience of Iceland suggests that countries can return to the financial markets fairly quickly.

Rather than try to stretch the ECB's mandate, it might be easier to use the IMF.  It is funded and it has a mandate to support these types of loans until a country can return to the capital markets.
Still, there are a number of positives to Wagenknecht's approach. Her model would finally let the air out of Europe's gigantic debt bubble -- one that has hung over the global economy for almost a decade now. 
As would following my blueprint.
Furthermore, the application of strict market economy principles to the banking crisis could cure them of their addiction to high-stakes gambling. 
Requiring banks to provide ultra transparency would cure them of their addiction to high-stakes gambling.
After all, the supposedly "mandatory" steps that have characterized the euro zone's response to the crisis thus far have done nothing but reward banks for their incredibly risky business models.
This is the result of having adopted the Japanese model for handling a bank solvency led financial crisis.  Banks get to continue doing what they did that led to the solvency problem in the first place.

The German Left Party is effectively endorsing the Swedish model for handling a bank solvency led financial crisis.  They are requiring the banks to recognize the losses hidden on and off their balance sheets.

Barclays is 'working to become more transparent'

In reporting Barclays' half-year results, its Board Chairman, Marcus Agius turns to transparency to restore both integrity and market participants' trust in Barclays.

Our Citizenship agenda is now more important than ever; we have ambitious commitments that we must deliver and continue to evolve to address the issues that matter most to those we serve. 
We must focus on getting the fundamentals right – serving our customers and clients with integrity and maintaining the highest standards of service – while reviewing our business values and working to become more transparent.  
The question is:  will Barclays actually deliver transparency and begin disclosing on an ongoing basis its current global asset, liability and off-balance sheet exposure details?

This is the level of disclosure that is consistent with a bank that says "I can stand on my own two feet and I have nothing to hide".

If Barclays doesn't deliver this level of disclosure, the question is: why would anyone trust Barclays given that it has confessed to lying for the benefit of its bankers and itself and is clearly hiding something?

Friday, July 27, 2012

While writing rules, financial regulators talk to banks 5 times more often than reform organizations

The American Banker reports that Dodd-Frank rule makers met 5 times more frequently with the big banks than with reform organizations.

Regular readers know that these meetings are one of the ways that banks influence the Financial-Academic-Regulatory Complex (FARC).  Specifically, to the extent that the regulators rely on the banks or their lobbyists for technical understanding, the banks or their lobbyists shape how the final rule turns out.

Let me give you an example from the SEC's proposal to revise the disclosure requirements for structured finance securities.  The SEC is proposing that loan level data be disclosed.

The banking industry and its lobbyists have put forth the idea that while loan level detail makes sense for a mortgage-backed security with 1,000 to 5,000 mortgages, it does not make sense for a credit card receivable backed security with 40 million receivables.

The SEC has accepted that this is true.  Proof of this acceptance can be shown by the inclusion of this argument in a recent paper written by Henry Hu, a former senior SEC official.

However, to anyone with any experience using a computer or monitoring a loan portfolio, they know this statement is factually not true.

Nobody looks at 1,000 or 5,000 mortgages by hand.  They use a computer.

A computer doesn't care if it looks at 1,000, 5,000 or 40 million records (and yes, the buy-side can afford computers that can process 40 million records).  So if it makes sense for 1,000 to 5,000 mortgages, it also makes sense for 40 million credit card receivables.

In Mr. Hu's case, he confesses that he doesn't really know anything about computers.  Hence, he is susceptible to being manipulated by the banks and their lobbyists for their benefit.
Regulators implementing Dodd-Frank met with big banks nearly 1,300 times in the past two years, but held only 242 meetings with reform-oriented organizations, according to a reportfrom the Sunlight Foundation. 
The numbers “call attention to the intensity of resources that big banks are devoting to Dodd-Frank rulemaking," Lee Drutman of the Sunlight Foundation tells American Banker’s Rob Blackwell. 
Though it does not necessarily prove influence, “to the extent that regulators are relying on bank representatives to understand the technical side of these rules, they are likely to see the world from the banks' perspective. This is bound to have at least some impact on how the final rules turn out," Drutman says.

Tim Geithner's handling of the Libor scandal exemplifies why financial markets should not be dependent on regulators

A Wall Street Journal column looked at Treasury Secretary Tim Geithner's handling of the Libor scandal and concludes that it is a mistake to make the global financial system more dependent on regulators.

It is always nice to have the Wall Street Journal agreed with your humble blogger.
Timothy Geithner sure does lead a charmed life. As a powerful regulator [before], throughout the financial crisis and its aftermath, he gets to blame every mistake or scandal on the evil bankers while claiming he was hot on their case all along. 
This pose is wearing especially thin on the much-ballyhooed Libor rate manipulation scandal. 
Facing Congress this week, the Treasury Secretary stuck to his story that as president of the New York Federal Reserve in 2008 he was blowing the whistle on Libor manipulations even as he let everyone in the world continue to use Libor as a benchmark—including his own Fed. 
Mr. Geithner told a House committee that he "personally raised [the matter] with the Governor of the Bank of England" and later sent him "a very detailed memorandum" on how to fix the "incentive" and "opportunity" for banks to "underreport" their borrowing costs under Libor. 
Regular readers will recall that the email from Mr. Geithner to the Governor of the Bank of England failed to mentioned that a Barclays trader had told the NY Fed that its Libor submissions were fraudulent.

Regular readers will also recall that the very detailed memorandum on how to fix the "incentive" and "opportunity" for banks to "underreport" their borrowing costs under Libor was a series of six talking points from the banks that were manipulating Libor.

Naturally, none of the six talking points would have done anything to stop the ongoing manipulation of Libor.  Not one talking point suggested that Libor be based off of actual transactions.  Not one talking point suggested that banks provide far greater transparency so that market participants could see how the transactions included in Libor compared with all the transactions the banks did.
At the same time, however, he admitted that the Fed used Libor as the benchmark for several bailout programs because it was "the best rate available at the time." If a rate that the head of the New York Fed knew was subject to manipulation was "the best rate,"....
There really is not much more that needs to be said when one of the most important financial regulators makes the argument that a manipulated rate was 'the best available at the time'.

Not only that, but we know the other financial regulators agreed with him because he had told them Libor was manipulated and they still used it as the benchmark for several bailout programs.

The only conclusion that can be drawn from this statement and the related actions is that where ever possible, the stability of the financial system must be independent of whether or not the financial regulators perform their job.

Based on this conclusion, it is imperative that the financial regulators be stripped of their monopoly on all the useful, relevant information on each bank.  Stripping the regulators of their information monopoly requires that the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, Libor can be based off of actual trades.

With this disclosure, market participants can end their dependence on the financial regulators and independently assess the risk of each bank.  With this assessment, they can adjust the amount and price of their exposures to reflect the risk of each bank.

With this disclosure, market discipline replaces regulatory oversight throughout the financial system.

With this disclosure, market participants can hold regulators accountable for doing their job.
Democrats are defending Mr. Geithner, which is consistent with their line since the crisis that every scandal is another excuse to blame the bankers and give even more power to the same regulators who missed or abetted the scandal. 
Clearly, the Wall Street Journal does not think it is a good idea to give more power to the same regulators who missed or abetted each scandal in the financial system.
Pending more evidence, we're inclined to think Mr. Geithner was more right in 2008 than he is now. But if Libor really was a vast criminal enterprise, then regulators need to be held accountable for doing so little about it for so long.
Former SigTARP Neil Barofsky suggested
Geithner and other regulators should be held accountable, they should be fired across the board.  If they knew about an ongoing fraud, and they didn't do anything about it, they don't deserve to have their jobs. I hope we see people in handcuffs. 

Dodd, Frank rush to defend Dodd-Frank Act

To no one's surprise, Christopher Dodd and Barney Frank have rushed to defend (see here and here) the Dodd-Frank Act and its huge expansion of the financial/academic/regulatory complex in the face of the assault by Sandy Weill with his call for 'complete transparency' and 'breaking-up' the Too Big to Fail.
Former Sen. Chris Dodd defended his signature financial services legislation on Thursday, drawing a sharp contrast with former Citigroup Chairman and CEO Sanford I. Weill, who a day earlier called for breaking up large Wall Street banks.... 
The retired senator staked out different territory from Weill, arguing that “it’s not just the size of an institution,” but the amount of risk carried on its books. 
Dodd told CNBC’s “Squawk Box” that forcing all large banks to downsize was “too simplistic,” saying that Citi's former chief was wrong to call for an end to financial supermarkets. 
“Just breaking up the banks is not the solution,” Dodd said, even as he insisted the tools of Dodd-Frank could, in extreme circumstances, force a systemically risky institution to break up. 
Mr. Weill did not just say break up the banks.  He also said that banks should be required to provide complete transparency.

Regular readers know that it only with ultra transparency where banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details that market participants can assess the risk carried on bank books and exert discipline to restrain this risk.
"The legislation allows for that Draconian step to be taken if necessary, not just with banks but with institutions that pose substantial risk to the country," Dodd said. "They have the power and authority under this legislation to actually do that."...
Senator Dodd takes the position that the decision to downsize a bank should be made by regulators.  In addition, regulators should decide how the downsizing should be done.

With ultra transparency, both of these decision would be made by the market.  The market would vote by how it valued the bank and its individual businesses before and after downsizing.
Many critics in Congress and Wall Street have complained about the law's burdensome requirements and complexity, and have called to have the legislation undone completely. 
But in his interview with CNBC, Dodd rejected calls to repeal the law, saying that critics should "give this a chance to see if it's doing its job."
Repealing Dodd-Frank and replacing it with transparency would greatly reduce the size of the financial/academic/regulatory complex.

First, it would end the markets dependence on the regulators to craft regulations that can achieve the same outcomes as transparency.

Second, it would end the markets dependence on regulators accurately assessing the risk of the banks and exerting discipline on the banks to reduce their risk.  With ultra transparency, market participants can independently assess the risk of the banks and exert discipline.

Now's not the time to talk about breaking up the banks, Rep. Barney Frank (D-MA), told CNBC’s“Closing Bell” on Thursday.... 
Since the economy is still recovering and Europe is dragging us down, Frank said, “The notion that at this point we would do something drastic to a major part of the U.S. economy is not a very good idea.” 
“You can accomplish much of what Sandy Weill says he’s now for with the Volcker Rule,” Frank said. The Volcker Rule (Volcker Rule explained) says that banks should not be involved in certain trading and other non-lending activities, he said. 
Frank also refuted the notion that it's difficult to discern between proprietary and non-proprietary trading. 
Under the Dodd-Frank Act (Dodd-Frank Explained), regulators can order divestment for particularly institutions so you don’t need to break-up every single institution, Frank said.
Regular readers know that implementation of the Volcker Rule is simple:  require the banks to provide ultra transparency.

With ultra transparency, market participants, including regulators, have the information they need to discern between proprietary trading, which is against the Rule, and non-proprietary trading.  Naturally, market participants will be only to happy to flag for regulators each bank's proprietary trades.

Will scandals cost banks any of their clout?

In his NY Times' column, Floyd Norris argues that with the Libor scandal and JP Morgan credit default swap trading losses, banks may finally have seen a reduction of their clout with politicians and financial regulators.

Not a chance.

Regular readers know that there is a financial/academic/regulatory complex with the banks at the center.

For example, when the NY Fed needed suggestions for how to prevent manipulation of Libor, who did it turn to?  It turned to the banks that were manipulating Libor.

After the financial crisis, nothing was more surprising than the speed with which the banks regained their self-confidence and their influence, not to mention their haughtiness. 
“They feel more powerful to me than they did before the crisis, when they were healthy,” one regulator told me recently.
 Banks should feel that way after all policymakers and financial regulators are implementing the Japanese model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels and banker bonuses are protected at all costs.

Given that neither the banks nor the bankers experienced any negative consequences from the financial crisis and the bankers are back to making near record amounts of money, it should not be surprising that bankers feel like Masters of the Universe.
That sense of power may have peaked this spring, before JPMorgan Chase disclosed its $2 billion — now $5.8 billion and counting — “hedging” loss and before the public firestorm erupted, largely in Britain, over the Libor scandal. 
In trying to understand how it is that an industry whose excesses nearly brought down the world economy could recover so quickly, it may be helpful to remember the answer attributed — probably erroneously — to Willie Sutton, the Depression-era criminal, when asked why he robbed banks: “That’s where the money is.” 
The banks, for all their sins, remain the principal source of capital for people and companies, particularly small ones. Getting them to lend more — without resorting to the excesses that caused the crisis — is a reasonable goal for public policy. That means that any regulation that bankers oppose may be vulnerable to arguments that it will hurt the economy. 
And then there are campaign contributions. People who make millions of dollars a year can make big ones.
Please re-read the highlighted text as Mr. Norris has nicely summarized how banks control the financial/academic/regulatory complex.
Now there is a question as to whether that power is in danger of being broken as a result of public revulsion over the JPMorgan hedging fiasco and the Libor scandal. 
The banks had turned this year’s debate into one about “excessive regulation,” and seemed likely to at least win a few concessions.....
Regular readers know that banks like prescriptive regulations as they are a substitute for requiring the banks to provide transparency that the banks can easily circumvent.

Consider the Volcker Rule.

The regulators published a 300-page opus filled with prescriptive regulations for complying with the simple requirement that banks are not allowed to take proprietary bets.  According to JP Morgan's Jamie Dimon, this would not have prevented the credit default swap trade.

Now compare the 300 pages of prescriptive regulations to the 2 pages the Volcker rule would be if banks were required to provide ultra transparency.

  • On page one, in very large type, it would say "financial institutions are prohibited from taking proprietary bets".  
  • On page two, also in very large type, it would say "on an on-going basis, financial institutions shall disclose all of their current global asset, liability and off-balance sheet exposure details".  With this disclosure, market participants, including regulators, could see if the banks were taking proprietary bets and violating the rule.

Does anyone imagine that JP Morgan could have built up the exposure they did in the credit default swap market without anyone noticing?  Does anyone think that JP Morgan would not have built up this position if everyone could see what it was doing for fear that the market would trade against it?
To understand how the world may have changed, it is worth looking at how perceptions have changed regarding both the JPMorgan loss and the Libor scandal since they were originally disclosed.... 
The invisible hand of the market has many benefits, but it sometimes needs to be restrained. “People of the same trade seldom meet together,” wrote Adam Smith, the patron saint of free markets, “even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” 
Market manipulation is at the heart of the Libor — London interbank offered rate — scandal. The idea that such a thing could happen seems not to have occurred to bank regulators for years, a reality that speaks volumes about their mind-set....
Regular readers know that the necessary condition for the invisible hand to operate properly is transparency (disclosure of all the useful, relevant information in an appropriate, timely manner) so that the buyer knows what they own.

The Libor manipulation could only occur because the financial regulators let it be set in an opaque manner.  Had banks been required to provide ultra transparency, Libor could have been based off of actual trades.
It is a strange fact that effective regulation can empower banks. American banks are now far better capitalized than most European institutions because the American regulators forced them to raise capital.
This is an assertion of opinion as without banks providing ultra transparency there is no supporting evidence.   We know that US financial regulators have been engaged in regulatory forbearance, so there is no telling how bad the losses hidden on and off the US bank balance sheets are.
Before the current crisis of confidence, that had encouraged banks to step up campaigns to blunt the new rules. European banks, which were not forced to raise capital, face the specter of more regulation, with some of it coming from euro zone institutions that may be less easy to manipulate than were national regulators.
For banks, all of these institutions and national regulators are easy to manipulate.  That is because the regulators' job is dependent on helping the banks protect opacity.  Imagine who many fewer regulations would be needed if banks had to provide ultra transparency! 

Sir Mervyn King admits policymakers made 'major mistakes' leading to financial crisis

The Telegraph reports that the Bank of England's Sir Mervyn King has admitted that policymakers made 'major mistakes' that lead to the financial crisis.  Naturally, Mr. King focuses on economic policies and fails to understand that opacity was the necessary, critical factor.

Mr. King's comments are very important as they demonstrate just why monetary policy and bank supervision should never be combined in the same organization.

Mr. King would have us believe that if the central bankers had managed interest rate policies differently the opaque areas of the financial system like banks and structured finance securities would not have collapsed.

Sorry, but even the Financial Crisis Inquiry Commission was able to identify the simple fact that interbank lending markets froze not because of macro economic policies but for the simple reason that lending banks could not tell which borrowing banks were solvent and which were not.

The interbank lending market has not unfrozen because lending banks still cannot answer this solvency question.

Mr. King is right that economic policies contributed, but the necessary condition for the crisis to occur was the financial regulators let huge areas of the financial system become opaque.  This meant that market participants could not assess the risks of or value securities in these areas.  

As a result, when central banks kept interest rates too low, it was like pouring gasoline on a fire, it led to over investment in the opaque areas where investors were chasing yield and simply blindly betting.

Your humble blogger has previously observed and Mr. King's comments confirm that macro economists do not make good bank supervisors.  By training and temperament, they like to look at the big picture.  Good bank supervision is all about looking at the details.

If you look at the details, you see that opacity was the basis for bank profitability.  It also allowed bankers to engage in bad behavior by hiding this behavior.  As Yves Smith said, 'no one was compensated on Wall Street for creating low margin, transparent products'.

If you look at the details, you see that the financial system stopped functioning every place there was opacity.

If you look at the details, you see that it was opacity that made assessing the risk or value of banks and structured finance securities impossible.

If you look at the details, you see the "run on the repo" was the result of the simple fact that opacity made it impossible to assess the risk or solvency of the borrower or, in the case of structured finance securities, the value of the security being pledged (the financial crisis started when BNP Paribas announced it could not value subprime mortgage backed securities).  The run was nothing more than simple recognition of the fact that  you don't lend money if you don't think you will get it back.

If you look at the details, you see that opacity prevented market participants from exerting discipline on the banks to restrain their risk taking.

If you look at the details, you see that bank regulators are the only ones with transparency into banks and they are dependent on each bank to explain what it is doing.  They cannot ask experts like the bank competitors for analytical help because opacity means these experts don't have all the useful, relevant information.

If you look at the details, you see that banks regulators do not restrain a bank's risk taking.  This is the result of the simple fact that regulators are not in the business of approving or disapproving any position a bank takes.  This is the market's capital allocation function.  Rather, bank regulators try to estimate the potential loss from a position and try to ensure there is adequate book capital to absorb the loss.

If you look at the details, you find that transparency is the source of trust and confidence in the financial system.  It is only when market participants have all the useful, relevant information and can independently assess the risk of an investment is there trust and confidence.  This trust and confidence comes because the market participants trust their own analysis.

If you look at the details, leading up to the financial crisis, market participants trusted others for help in assessing the risk in the opaque areas of the financial system.  Market participants trusted the analysis of the financial regulators when they said that the risk of the banks was greatly reduced and the rating agencies when they said structured finance securities were rated AAA.  When the financial crisis hit, market participants rediscovered the importance of not trusting others and having transparency so they can do their own analysis.

If you look at the details, even if there had been perfectly co-ordinated macro economic policy around the world, there was and still is so much opacity in the system that a crisis was inevitable.
Speaking at the Government’s Global Investment Conference in London,Sir Mervyn gave the clearest signal yet that as head of Britain’s central bank he is partly to blame for failing to act before the crisis took hold in 2008. 
He said it was “false” to suggest that the crisis was caused by the bad behaviour of bankers. 
“Of course there was bad behaviour. 
But this was a crisis which emanated from major mistakes in macro economic policy around the world, and fundamentally the inability to successfully co-ordinate macro economic policy so that globally you wouldn’t get the imbalances, the capital flows, that created the difficulties in the banking system. 
“We saw this going into the crisis, we kept meeting at the IMF, but we did nothing to solve it collectively, and I don’t think that this was a problem that could have been solved individually.” 
Sir Mervyn said the global crisis will require a collective response....
The governor said that global banking had taken a “series of wrong turns”, but that the reform agenda in the UK would create a more stable framework for the future. He said the measures recommended in the Vickers report should be implemented, and “then [we can] come back and see if we need to go further.”