Wednesday, October 31, 2012

German taxpayers to get stuck with the Greek losses that banks should have taken

In a classic case of socializing the losses, Ambrose Evans-Pritchard discusses in his Telegraph column how it is now unavoidable that Germany's taxpayers will get stuck with losses related to Greece.

Left unsaid was that without a series of bailouts, these losses would have been taken by the banks instead.  Bailouts that were the direct result of the German government's decision to protect bank book capital levels and banker bonuses at all costs.
Every detail of the Greek economy is worse than officially forecast just weeks ago....

In fact Greek GDP contracted by 4.5pc in 2010, 6.9pc in 2011, and will shrink 6.5pc this year, and now 4.5pc next year. 
The cumulative error is colossal. 
The IMF's former deputy chief John Lipsky told an HSBC forum in London earlier this month that it was impossible for the Fund to make any accurate forecast, given the crazy circumstances in Greece. 
I don't wish to be unduly harsh on the IMF – a superb organisation – but actually the Greek Labour Institute and the think-tank IOVE did predict this level of contraction. 
The IMF simply lost its political way in Greece. It knew – or should have known from dozens on rescue operations around the world – that Greece would crash into a self-feeding spiral without a rapid debt restructuring and a devaluation....
The policy never had any chance of working for Greece. The IMF under Strauss-Kahn went along with the EMU agenda, pretending all was well, sacrificing the Greeks to gain time for the European financial system to build up safety buffers.
The Japanese Model for handling a bank solvency led financial crisis never has a chance of working anywhere.

There are a number of reasons that it fails including that placing the burden of servicing the excess debt on the real economy crushes the real economy.

One of the ironies of the Japanese Model is that a substantial portion of the benefit from sacrificing the Greeks to gain time for the European financial system to build up safety buffers flowed out in the form of bonuses to bankers.

Your humble blogger has argued for adoption of the Swedish Model and requiring banks to recognize up front the losses on the excess debt since the beginning of the financial crisis.  One of the advantages of making the banks absorb the losses upfront is that while the banks are rebuilding their book capital levels earnings are not siphoned off to pay banker bonuses.
Thomas Wieser, the head of the European Working Group handling Greece, said today that press reports of further debt restructuring and official "haircuts" in the current Troika talks are pure fantasy. 
If that is so – and what he means is that Germany, Holland, Finland, and Austria will not tolerate a haircut on their holdings of Greek debt – then the creditor countries are trying to maintain a ridiculous illusion for their own internal political reasons. 
Greece cannot claw its way out of a 190pc of GDP debt load. The official haircut is coming sooner or later, and it will be an explosive political moment.
Chancellor Angela Merkel will have to account for direct losses to the Bundestag. A line will have to be written into the German budget covering the X billions of euros. Other line items may have to be cut. Welfare support for Germans, perhaps.
Please note how by socializing the losses, the burden falls on the taxpayer rather than the banks.

If the banks take the losses, then there is no reason to cut welfare support or other similar programs for Germans. [Your humble blogger has proposed a method transferring the losses back to the banks, so it is not too late to adopt the Swedish Model and protect the real economy and German society.]
Having insisted for over two years that German taxpayers face no risk of loss on the Club Med rescue packages – and having indeed told them it generated a profit – she will have to explain why this has gone horribly wrong. 
No doubt she will try to delay this awful moment until after the German elections late next year. 
But the calendar of simmering revolt in Greece is not in her hands. One of the three parties in the pro-Memorandum coalition has already refused to go along with the budget plans. The Government majority is thinning fast. 
My guess is that Mrs Merkel will be forced to admit to the German nation that contingent liabilities are turning into real liabilities long before her elections.
Following up on his column, the Telegraph carried an article on Greek death spiral raises heat on creditors, specifically states and official institutions, to accept debt-forgiveness.

More importantly though, the article confirms what your humble blogger has been saying about the destroying the real economy by putting on it the burden of servicing the excess debt.
A study by Britain’s National Institute Economic Review said the eurozone’s austerity strategy is "fundamentally flawed" and has become self-defeating. "Even on its own terms, it is making matters worse." 
The institute said synchronized fiscal tightening by a group of countries in the middle of a slump does deep damage to the productive economy and may actually worsen the debt ratio, pushing some countries into a "death spiral". 
It said the "fiscal multiplier" rises sharply when interest rates are already near zero and monetary policy cannot easily offset the budget squeeze. "We do not appear to be in normal times but in a prolonged period of depression, which we define as when output is depressed below its previous peak. The impact of fiscal tightening during a depression may be very different," said the paper by Dawn Holland and Jonathan Portes. 
While debt may fall, it cannot keep pace with falling output, as has occurred in Greece. 
"Our simulations suggest that coordinated fiscal consolidation has not only had substantially larger negative impacts on growth than expected, but has actually had the effect of raising rather than lowering debt-GDP ratios. Not only would growth have been higher if such policies had not been pursued, but debt-GDP ratios would have been lower." 
"The direct implication is that the policies pursued by EU countries over the recent past have had perverse and damaging effects." 

Discussion of bank ring-fence failure misses point; ultra transparency is a better solution

The Telegraph carried an article on how Martin Taylor became the second prominent regulator, after the Bank of England's Andrew Haldane, to observe that if ring-fencing fails, the banks should be broken up.

Why should we be experimenting where the cost of failure could be substantial when there is a simpler alternative solution that we know works and achieves the same result?

In the case of ring-fencing, ultra transparency is a much simpler, more effective solution.

By making the banks disclose on an ongoing basis their current asset, liability and off-balance sheet exposure details, proprietary trading is effectively ended.  In addition, we bring about a culture change as ultra transparency ushers in sunlight to act as the best disinfectant (no more manipulation of Libor and other rates).

Britain's lenders will have to be broken up if the ring-fence to protect their retail banking operations from “casino” investment banking proves to be “permeable”, warned Martin Taylor, one of the policy’s architects . 
By definition the ring-fence will be permeable.  The question is how many loopholes there will be in the complex rules implement ring-fencing.
Martin Taylor, who sat on the Government’s Independent Commission on Banking (ICB) that proposed ring-fencing, said “there would be a case for going further” if the firewall was “unworkable”....
Given that the bank lobbyists were able to undermine Glass-Steagall, you can rest assured that the firewall will prove "unworkable".
Asked by the Parliamentary Commission on Banking Standards whether full separation would have been preferable, Mr Taylor, a former Barclays chief executive, said ... “If the industry is unreformable, then a full split will be necessary.”...
We already have confirmation through the customer conduct issues and the manipulation of Libor and other interest rates that the industry is un-reformable.
While welcoming the Government’s decision to adopt ring-fencing, Mr Taylor said the Chancellor had made a “mistake” in watering down other proposals. 
Letting banks build balance sheets that are 33 times their capital base, rather than the 25 times recommended, was “simply a mistake”, and allowing derivatives inside the retail bank was “the thin end of the wedge” as such complex instruments could be used to breach the rules. 
“I prefer prohibition. It’s very simple,” Mr Taylor said. “Because I want to keep the ring-fence impermeable, I want to keep things simple.”...
If Mr. Taylor wants simplicity, then he should love requiring the banks to provide ultra transparency.

When market participants can see what the banks are doing, it is easy for market participants to exert discipline and restrain the banks from risk taking and bad behavior.
Mr Taylor also claimed that regulation has not helped by treating the industry as a “rapacious” animal that need to be “tied up in red tape” rather than focus a “duty of care to clients”. 
“We have dangerous dogs walking around with muzzles on. What I would like to see is some family pets as well.”
Regular readers know that complex regulation and regulatory oversight are a substitute for transparency and market discipline.

Transparency and market discipline are much more effective at turning banks into socially useful organizations.

Financial Stability Board calls for transparency and says banks should provide more data

As reported by Bloomberg, the Financial Stability Board is well on its way to embracing ultra transparency and banks disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
Banks should increase the data they disclose to investors on how well they measure up to Basel capital rules and on their performance in internal stress tests, according to global regulators. 
Supervisors at the Financial Stability Board also called for lenders to disclose all off-balance sheet commitments, as part of a push to curb banks’ risk taking.
The only way that market participants can assess how well the banks measure up on Basel capital rules or internal stress tests is if the banks provide ultra transparency.  After all, model assumptions without the underlying data to test them on are completely worthless.

It is only with the exposure details that the market participants can independently confirm how the banks measure up on Basel capital rules or internal stress tests.
“Rebuilding investors’ confidence and trust in the banking industry is vital to the future health of the financial system,” an FSB task force said in an e-mailed statement yesterday. Better disclosure by banks of the risks they are running “is an important step in achieving that goal.”....
Please re-read the highlighted text as the FSB makes the same point that your humble blogger has been making about the need for better disclosure.  I am thrilled that the FSB agrees with me and my call for banks to provide ultra transparency.
Regulators have warned that banks avoided the full force of earlier Basel standards by using complex accounting procedures and off-balance sheet entities.
Ultra transparency end this issue.
Lenders should “outline plans” to meet the new Basel rules, and explain the models they use to measure their capital requirements, according to the report. 
Ultra transparency lets market participants independently assess the models and apply their own models to measure bank compliance with capital requirements.  One of the benefits of market participants using their own models is then the risks of the banks are all measured the same way.
Other data requirements concern the collateral held against derivatives trades, and whether such transactions have passed through clearinghouses. 
On stress tests, lenders should set out their internal procedures for running the exams, and explain the role they play in assessing capital needs.
With ultra transparency, market participants can independently re-run these stress tests and run stress tests with their own assumptions.
The FSB brings together regulators, central bankers, and finance ministry officials from the Group of 20 nations.

The Brown Paper Bag Challenge: a test of fitness for purpose for financial regulators

Regular readers know that your humble blogger has been calling for bringing transparency to all the opaque corners of the financial system since before the beginning of the financial crisis.

One particularly opaque corner I have focused on is structured finance.

Regular readers will recall that it was on August 9, 2007 that BNP Paribas issued a press release saying that it could not value subprime mortgage backed securities in 3 funds.  Shortly thereafter, these securities were associated with the words opaque and toxic.

So what has happened to bring transparency to structured finance securities in the 5 years after it was publicly recognized that these securities could not be valued because they are opaque?

I have been engaged in a worldwide battle with the sell-side.

A battle in which the global financial regulatory community is a major participant.

But that should be good for bringing transparency to structured finance because, under the FDR Framework, the regulators are responsible for ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.

The assumption that the regulators involvement is good for transparency rests on the idea that regulators  understand structured finance well enough to know what all the useful, relevant information in an appropriate, timely manner is.

The Brown Paper Bag Challenge was developed to help politicians and regulators understand both "what" needs to be disclosed and "when" it needs to be disclosed.  As a result, the Brown Paper Bag Challenge has become a test of fitness for purpose for the global regulators.

Either the global regulator passes the Brown Paper Bag Challenge and understands what it takes to bring transparency to securities ranging from covered bonds to structured finance or they do not.

At the five year mark, there is one legislative body and one financial regulator that have passed the Brown Paper Bag Challenge.

The legislative body was the European Parliament which adopted the European Commission's recommendation in Article 122a of the European Capital Requirement Directive that requires

  • investors, broadly defined to include banks and institutional investors, need to know what they own when it comes to their holdings of structured finance securities; and
  • issuers need to provide the data so that investors can know what they own.
The financial regulator was the US National Association of Insurance Commissioners.  It is not surprising that this regulator passed given that it represents the buy-side and the firms it regulates buy directly or indirectly more that 40% of the par value of the structured finance securities.

The list of regulators that I have spoken to and have failed includes, but is not limited to:
  • in Europe, the ECB and the European Banking Authority (aka, the Committee of European Banking Supervisors); 
  • in the UK, the Bank of England and the HM Treasury; 
  • in Australia, the Reserve Bank of Australia and the Australian Securities and Investment Company; and 
  • in the US, the Federal Reserve, the SEC, Treasury and the FDIC.
At this point, it is appropriate to talk about what exactly is the Brown Paper Bag Challenge and how can a regulator fail the challenge.

A bag is the physical model of an asset backed structured finance security ranging from covered bonds to securitizations.  For all of these securities, assets are identified and set aside for the benefit of the investor (as if put into a "bag").

Furthermore, for all of these securities, reports on the performance of the individual assets are provided to the investors.  These reports are intended to disclose information that would be useful for the investor in making an investment decision.

So the questions become, "what" is in the reports and "when" are the reports made available.  While "what" is an interesting question, "when" is the question addressed by the Brown Paper Bag Challenge.

Please recall that subprime RMBS are called opaque.  These securities disclose information on the underlying loan performance once per month.  It is easy to prove that it is the once per month frequency of disclosure that causes them to be opaque.

For each global regulator, I offered an individual on the team in charge of bringing transparency to structured finance securities the opportunity to take the Brown Paper Bag Challenge.

The Brown Paper Bag Challenge is simple.  I created a structured finance security by putting $100 into a brown paper bag at the beginning of last month.  Since that time money has been taken out of the bag.  A once per month report has been generated and it shows that there was $75 in the bag at the end of the month.

The question is:  what is in the bag currently?

To add some spice to the challenge, I agree to "sell" the regulators the contents of the bag.  If the value of the contents of the bag is greater than the sale price, I send them a check for 10 times the difference.  If the value of the contents of the bag is less than the sale price, they are to send me a check for 10 times the difference.

100% of the regulators refuse to take the Brown Paper Bag Challenge.

Why?  Because as they all say "it would be inappropriate of them to gamble".

This is a great response!  It has combines two very important issues.

First, there is the perception that taking the Brown Paper Bag Challenge is a "gamble".

Why do they think it is a "gamble"?

They all reply something along the lines of "because they do not know what is in the brown paper bag right now".

Please re-read that statement.  Like everyone else, the regulators know that you are blindly betting when you cannot see the contents of the bag.  [They also suspect the challenge is rigged and I will not "sell" them the contents of the brown paper bag unless they owe me money.]

Fortunately, there is a reporting frequency that allows everyone to see the contents of the bag as if they were in a clear plastic bag:  observable event based reporting.

Observable event based reporting is the answer to the question of "when" must reports be generated on structured finance securities to end their opacity.

Second, the regulators all understood that it is "inappropriate" to "gamble".  As shown with the brown and clear plastic bags, it is inappropriate to buy a structured finance security that does not offer observable event based reporting because this involves gambling as one is blindly betting on the contents.

Ok, so how did the global financial regulators fail the test?

Each of the financial regulators failed the test because it either is willing to let its organization "buy" or it encourages investors to buy structured finance securities that do not provide observable event based reporting.

In the absence of observable event based reporting, even if a data warehouse delivers standardized information on the loan-level performance, investors do not know what is inside the bag currently and would be blindly betting to buy these securities.

Why exactly are the regulators at the Bank of England, the Federal Reserve, the European Central Bank and the Reserve Bank of Australia who wouldn't take the Brown Paper Bag Challenge because it is inappropriate to gamble willing to let their organization gamble with billions of dollars of taxpayer money when they accept structure finance securities which don't provide observable event based reporting as collateral?

Walter Bagehot's number one rule for central banks was to lend against "good" collateral.

In the absence of observable event based reporting, there is simply no way for a central bank to know if it has good collateral when it accepts a structured finance security.

Barclays or any other bank appropriately provisioned, you must be joking

In a terrific column, the Telegraph's Harry Wilson looks at the banks and sees a host of problems for which there is no chance that banks have set aside adequate provisions for losses.

His list includes credit losses, losses related to customer conduct issues (payment protection insurance and interest rate swap mis-selling), and losses related to manipulating Libor and other interest rates.

Add up all the losses and a cabinet minister concludes that at least one major bank could go under.

What this suggests to your humble blogger is that we have reached the time to stop protecting bank book capital and banker bonuses at all costs.  It is time to adopt the Swedish Model and require the banks to recognize upfront all of their losses on excess debt and non-credit losses.

Banking is really all about risk management. .... judging how much risk to take and when. 
Since the financial crisis, we have learned that most banks were very poor managers of risk.
In the run-up to the financial crisis, we also learned that financial regulators are not good at assessing risk being taken by the banks.  How many times did the Fed say that as a result of financial innovation the risk of the banking system had been reduced?

The combination of these two lessons makes the case for requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposures.

Using this information, market participants can independently assess the risk of the banks and adjust their exposures based on this assessment.
They lent big, long and more often wrong and the result was trillions of pounds of write-downs and a financial crisis that caused the collapse of several major institutions.
Regular readers know that all of the write-downs have not yet been taken and that there are losses hidden on and off the bank balance sheets.

Confirmation that the banks have losses is provided by the interbank lending market.  Banks with deposits to lend are still refusing to lend to banks looking to borrow because they cannot tell if the borrowing banks are solvent.
Not only this, but their appreciation of reputational risk was woeful. 
Business was done on the basis of short-term profits by bonus-hungry employees that has not only ultimately cost lenders far more than they ever made, but that is continuing to present them with a bill that is only getting larger....
Mr. Wilson makes a very important point.

The lack of appreciation of reputational risk was the result of all the opacity that the bankers created in the financial system.  With opacity to hide their bad behavior, there was no need to think about reputational risk.

For example, opacity allowed the banks to manipulate the Libor interest rate.  Had the banks been required to provide ultra transparency, the bankers could not have manipulated the rate.

However, banks were not required to provide ultra transparency and the bankers were able to manipulate Libor behind a veil of opacity.
The simple truth is that the costs facing Barclays and other major banks for what Santander UK mysteriously described last week as "historic customer conduct issues" are immense. 
Take swap mis-selling. The Telegraph has now written for several months about the growing scandal surrounding the mis-sale of interest rate swaps to SMEs. 
In the early stages of this campaign we were repeatedly told there was nothing to see here.
This is in fact a frequent refrain from bankers.  There are many examples including the mortgage foreclosure related robo-signing scandal.

Of course, there is something to see and what there is to see is always a major problem.
That what we were hearing was only the bleating of a small number of disgruntled businessmen upset at missing out on historically low interest rates. 
Eight months later, and Britain's major banks have so far set aside more than £600m to pay compensation to SMEs and the outcry over the scandal is growing rapidly. 
We are now told that swap mis-selling may be large, but will cost nothing like the more than £10bn bill to the banking industry from payment protection insurance. 
This again is likely to be wishful thinking when you consider the average size of a swap claim is somewhere in the region of £250,000 to £500,000. You don't have to make too many settlements like this to go to a pretty big number.
In the 1930s, the Pecora Commission showed the world bankers will exploit opacity to engage in an endless amount of bad behavior.  What the current financial crisis has shown is that nothing has changed in banker behavior.
And this is before you look at potentially the biggest of them all: Libor-rigging. 
Barclays is the only bank in the world to have admitted it attempted to manipulate the world's key borrowing rate. But with more than a dozen banks around the world under investigation, others will be drawn in. 
Already banks are facing claims from customers in relation to the alleged rigging. Earlier this week, Barclays was slammed by a UK High Court judge in a preliminary hearing of a swap mis-selling case in which lawyers for a care home operator are attempting to argue that because the bank was involved in Libor manipulation the company's contracts should be rescinded. 
If this case goes to court and the company wins then the impact on the industry would be enormous and would have the potential, according to the rumoured private utterances of one Cabinet minister, to bring down at least one major British bank.
The truth is, that when it comes to provisioning Barclays probably has a long way to go before it has accounted for the true cost of its past behaviour.
This could probably be said of all the banks.

Tuesday, October 30, 2012

Paul Krugman: Make economic policy based on overwhelming evidence not fantasy

In his column, Professor Paul Krugman calls for making economic policy based on overwhelming evidence and not fantasy.

If his advice were followed, we would never adopt the Japanese Model for handling a bank solvency led financial crisis, but rather would implement the Swedish Model.

The overwhelming evidence, with Iceland as the latest example, is that implementing the Swedish Model and requiring the banks to recognize upfront the losses that they would ultimately realize if the bad debt in the financial system worked its way through the long process of default and foreclosure results in a rapid recovery from the financial crisis.

There is also overwhelming evidence, with the EU, Japan, UK and US as the latest examples, that implementing the Japanese Model and protecting bank book capital levels and banker bonuses at all costs results in long periods of Japanese-style economic slump.

That the evidence supports the Swedish Model and rejects the Japanese Model is not surprising.

Under the Swedish Model, the banks absorbing the losses protects the real economy.  Under the Japanese Model, the burden of the excess debt is shifted onto the real economy.  Cash flow that would be used to support reinvestment and growth in the real economy is instead used to make debt service payments.

Given that Professor Krugman believes that economic policy should be based on overwhelming evidence, it is surprising that he doesn't discuss the need for adopting the Swedish Model.

Why is recovery from a financial crisis slow? 
Financial crises are preceded by credit bubbles; when those bubbles burst, many families and/or companies are left with high levels of debt, which force them to slash their spending. This slashed spending, in turn, depresses the economy as a whole. 
And the usual response to recession, cutting interest rates to encourage spending, isn’t adequate. Many families simply can’t spend more, and interest rates can be cut only so far – namely, to zero but not below.
Does this mean that nothing can be done to avoid a protracted slump after a financial crisis? No, it just means that you have to do more than just cut interest rates.
A recovery from a financial crisis doesn't have to be slow if the Swedish Model is adopted and the banks recognize the losses on the excess debt upfront.

When banks recognize the losses, families and companies have their debt levels adjusted to what they can afford to pay.  As a result, families and companies do not have to slash their spending and the real economy is protected.
In particular, what the economy really needs after a financial crisis is a temporary increase in government spending, to sustain employment while the private sector repairs its balance sheet. 
And Obama did some of that, blunting the severity of the financial crisis. Unfortunately, the stimulus was both too small and too short-lived, partly because of administration errors but mainly because of Republican obstruction.
Had the Obama administration required the banks to recognize the losses on the excess debt, the private sector's balance sheet would have been repaired.

Then, the fiscal stimulus would really have kicked the economy into high gear.
Over the past few months advisers to the Romney campaign have mounted a furious assault on the notion that financial-crisis recessions are different. 
In July former senator Phil Gramm and Columbia’s Republican Glenn Hubbard published an article claiming we should be having a recovery comparable to the bounce back from the 1981-82 recession, while a white paper from Romney advisers argues that the only thing preventing a rip-roaring boom is the uncertainty created by Obama.... 
The main point, however, is that the Romney team is wilfully, nakedly, distorting the record, leading Reinhart and Rogoff – who aren’t affiliated with either campaign – to protest against “gross misinterpretations of the facts.” And this should worry you. 
Look, economics isn’t as much of a science as we’d like. But when there’s overwhelming evidence for an economic proposition – as there is for the proposition that financial-crisis recessions are different – we have the right to expect politicians and their advisers to respect that evidence. Otherwise, they’ll end up making policy based on fantasies rather than grappling with reality.
The overwhelming evidence is that the correct response is to adopt the Swedish Model, require the banks to recognize the losses upfront, implement fiscal stimulus and bring transparency to all the opaque corners of the financial system so that a financial crisis doesn't happen again.

This response was first done by the FDR Administration and it broke the back of the Great Depression.

Probe of interest rate manipulation extends beyond Libor

Bloomberg reports that the probe into the manipulation of Libor has been expanded as it looks like rates on foreign exchange derivatives might have also been manipulated.

It comes as no surprise to regular readers that every place in the financial system where there was and still is opacity bankers engaged in bad behavior.  Opacity enables this bad behavior because it provides a cloak to hide what the bankers are doing.

The simple fact is that we have known since the Great Depression and the Pecora Commission that opacity in any part of the financial system is always bad.

This is why FDR and his administration rebuilt the global financial system on the combination of a philosophy of disclosure and the principal of caveat emptor.

Under this framework, financial regulators were given one and only one responsibility:  ensure that market participants had access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed investment decision.

As the manipulation of Libor showed, the financial regulators failed at their responsibility.

As the manipulation of foreign exchange derivatives is likely to show, the financial regulators failed here too in their responsibility.

Like Libor, the solution for ending manipulation of foreign exchange derivatives is to bring transparency to this opaque part of the financial system.

In the case of Libor, bringing transparency means requiring the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
UBS AG (UBSN) and Royal Bank of Scotland Group Plc suspended more than three traders in Singapore as regulators investigating Libor-rigging turn their attention to the rates used to set prices on foreign exchange derivatives. 
At least two foreign-exchange traders at UBS, Switzerland’s largest bank, have been put on leave as part of an internal probe into the manipulation of non-deliverable forwards, a derivative traders use to speculate on the movement of currencies that are subject to domestic foreign exchange restrictions, according to a person with direct knowledge of the operation. Edinburgh-based RBS also put Ken Choy, a director in its emerging markets foreign exchange trading unit, on leave, a person briefed on the matter said on Oct. 26. 
Regulators around the world are broadening the scope of their investigations beyond interbank offered rates such as the London interbank offered rate to encompass more benchmarks.... 
Unlike foreign exchange forward contracts, where two parties agree to physically exchange currencies at a set rate at a specific date in the future, NDF traders settle the net position in U.S. dollars. Who pays and how much at the end of the contract is determined by reference to a fixing rate which in some jurisdictions is set, like Libor, by a survey of banks.

Contracts that reference the Malaysian ringgit and the Indonesian rupiah against the dollar are among NDFs that are traded in Singapore. The spot rates for both currencies are fixed by the Association of Banks in Singapore based on data submitted by banks. If traders can move the spot rates, they could boost their profit, said a person familiar with the process who asked not to be identified.... 

Monday, October 29, 2012

BoE Andrew Haldane calls for a 'financial reformation'

In his speech on Socially Useful Banking to Occupy Economics, the Bank of England's Andrew Haldane called for a "financial reformation".  Unfortunately, he delivered reforms that are the equivalent of re-arranging the deck chairs on the Titanic.

In his speech, Mr. Haldane observes
For me, the crisis was instead the story of a system with in-built incentives for self-harm: in its structure, its leverage, its governance, the level and form of its remuneration, its (lack of) competition. 
Avoiding those self-destructive tendencies means changing the incentives and culture of finance, root and branch. This requires a systematic approach, a structural approach, a financial reformation.
I agree that we need a systematic approach, a structural approach, a financial reformation.

The question before you start to propose a systemic approach, a structural approach, a financial reformation is what was the necessary condition(s) that had to exist for all of these in-built incentives for self-harm to undermine the financial system?

The necessary condition was and still is that the global financial regulators allowed opacity to occur across wide swaths of the financial system.

Had there been transparency in all the currently opaque corners of the financial system, including banks and structured finance securities, would these in-built incentives for self-harm resulted in the financial crisis that we experienced?

Clearly, the answer is no.

It is important to identify the underlying cause of the financial crisis so that you know the financial reformation addresses it.  This is necessary so that you know the the reforms being implemented reverse the long regulatory race to the bottom and replace it with a race to the top.
I want to argue that we are in the early throes of such a financial reformation. And that this will help to deliver a more socially useful banking system. 
Let me mention some of the more important of these reform strands. These fall into five categories – the five “c”s: culture; capital; compensation; credit; and competition. 
It is easier to will the ends on these issues than it is to divine the means. How exactly do we change banking culture?
Make the banks provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

As Justice Brandeis observed, sunshine is the best disinfectant.  And nothing brings more sunshine to banking than ultra transparency.

Ultra transparency brings about instant culture changes as for example, no banker would think of manipulating Libor because everyone could see what they were doing.
So I want to give you some concrete, practical proposals for change. And I want to tell you not only that these should be delivered but that they will be delivered. 
Individually, none of these reforms may sound like a game-changer. A number lack the pizzazz of a “tar and feathers” strategy. But taken together, I think they amount to the most radical agenda of financial reform for 80 years. Importantly, I also think they will work.
First, saying these reforms amount to the most radical agenda of financial reform for 80 years is essentially setting the bar on the ground and stepping over it.  Prior to the current financial crisis, we hadn't had any need for financial reform since the Great Depression. [This argument didn't work for President Obama either when he talked about the Dodd-Frank Act.]

Second, all of these reforms are game changers in the way that rearranging the deck chairs on the Titanic was a game changer.

A true game changer is a reform that allows the governments to end all of the programs that were put in place to put the financial markets on life support since the start of the financial crisis.
First, and perhaps foremost, culture. We are about to undertake structural reform of the global banking system, perhaps the largest since the 1930s. In the US, this is the Volcker rule. In the UK, it is the Vickers proposals. Most recently in Europe, we have had the Liikanen plans. 
Though different in name, these structural reform proposals contain a common thread. They will seek a separation – or at least a ring-fencing - of retail and investment banking activities, legally, financially and operationally. 
Part of their motivation is to stop some of the riskier parts of investment banking, such as proprietary trading, infecting the indispensible parts, such as deposit-taking and loan-making. The crisis has provided ample evidence of the costs of such cross-contamination, with losses on risky trading portfolios imperilling bank depositors and borrowers. 
But at least as important is what such a separation might do ahead of crisis. Ahead of this time’s crisis, financial and human resources were diverted away from retail banking services and non-bank activities towards investment banking. At the same time, the culture and practices of investment banking infiltrated retail banking - a sales culture which culminated in harmful cross-selling and unlawful mis-selling. 
If they are successful, these structural reform efforts will reverse this pattern. They will seek a separation, not just legally, financially and operationally, but culturally too between the very distinctive sub-cultures of transactional investment banking and relationship retail banking. That cultural separation ought to be the acid test of the success of these structural reform proposals. 
There are those who doubt whether a ring-fence is sufficient to achieve that cultural separation in banking - can two separate sub-cultures really operate underneath a single roof? Time will tell. If it is not possible, then full separation would be the logical next step. Alternatively, banks themselves might of course voluntarily choose to divest and separate, as some are already doing.
Why undertake these complicated structural reforms which may or may not work when simply requiring the banks to provide ultra transparency produces the desired result?

With ultra transparency, you change the culture and risk taking by the banks in a fundamental way.
Second, capital. Much greater levels of protection are being put in place for banks generally and for big banks in particular. ... 
Regulation of this type might sound rather arid and technical. Welcome to my world. But it is also important. Higher financial buffers are not about protecting the banks – just like other firms, they can and should fail.They are there to protect the customers of banks, reducing the chances of them suffering panic or loss. And they are there to protect taxpayers too, reducing the chances of them footing the bill.....
In that world it is well known that bank capital ratios are meaningless.  As the OECD pointed out, the numerator, bank capital, is an easily manipulated accounting construct and the denominator, assets, whether on an as reported basis or a risk-weight adjusted basis are also easily manipulated.

It is intellectually dishonest to suggest that something as easily and highly manipulated as bank capital ratios have any role to play in a financial reformation.

If investors invested based on reported bank capital ratios, they would have lost a considerable amount of money investing in banks like Dexia which reported one of the highest bank capital ratios in Europe just prior to its nationalization.

Under the FDR Framework, it is the responsibility of the investors to independently assess the risk of each bank and to determine how much, if any, exposure they want to a bank based on their assessment of its risk and their capacity to absorb losses based on this risk.

Bank examiners demonstrate they understand the responsibility of investors (which they effectively are as they seek to protect the taxpayer from losses on the deposit guarantee).

Bank examiners do not rely on bank capital ratios, but rather look at 'capital adequacy'.  Where capital adequacy attempts to answer the question of does the bank have enough capital to absorb the losses that can be expected given the risk of its exposures.

The fact that many economists strongly endorse a meaningless capital ratio does not mean that investors who put real money at risk or bank examiners who look after the taxpayers' exposure should rely on this meaningless ratio.

Again, this is why we need ultra transparency.
Third, compensation. There is a deeply-rooted problem of short-termism in modern capital markets, with too great a focus on near-term versus longer-term, on spending over saving, on twisting rather than sticking....
Under the FDR Framework, regulators have absolutely no role in determining compensation.  While you and I might not like banker compensation packages, it is not up to us to mettle in the design of these packages.  Rather, we should focus on making sure that the bankers 'earn' their compensation.

With ultra transparency, the bankers who can deliver better earnings with lower risk deserve to be compensated better and they will be.

With ultra transparency, bankers who rely on more risk to generate their compensation will discover that their cost of funds increases and ends any benefit from increased risk taking.
Fourth, credit. The rising tide of inequality either side of the crisis was given impetus by first the boom and then the bust in credit and asset prices. We must in future do a much better job of moderating those credit booms and busts, to prevent them acting like a regressive tax on the poorest in society. 
That collateral damage is all too evident today in the chronically low levels of credit being extended on the high street – to first-time buyers wanting to put their foot on the first rung of the housing ladder, to business start-ups seeking to invest in assets, human and physical. Lending to UK households and companies has been contracting for 4 years and counting. 
In preventing a repetition, a first step is to recognise that taming the booms and busts in credit is a key public policy responsibility. Step two is charging someone with this task. And step three is getting on and doing just that. 
In the UK, we are already three steps along this road, with the introduction of a Financial Policy Committee (or FPC) housed at the Bank of England from last year. Its remit is to keep the system safe and sound while supporting lending and growth. 
Right now, the FPC is playing its part in trying to cushion the effects of the credit squeeze I mentioned, by freeing up banks’ capital and liquidity reserves to enable loans to be made to companies and households. 
If these sound like small steps for mankind, then they are giant ones for regulators. This is the first time in the Bank’s 318-year history that it has attempted such “macro-prudential” regulation. Of course, it is impossible for the FPC or anyone else to eliminate mini-booms and mini-busts in credit. But the FPC can legitimately aim to head-off the maxi-booms, such as the pre-crisis one, and the maxi-busts, the like of which we are currently experiencing....
What pure b***s***.

Isn't this exactly the role of Bank of England's monetary policy? (as I recall from my time working at the Fed, the central bank is suppose to take away the punch bowl just as the party gets going!)

Everyone knows that in the run-up to our current financial crisis, despite being charged with the task, the Bank of England did not take away the punch bowl.

There is zero reason to believe that the Financial Policy Committee will be more successful than the Monetary Policy Committee.
Fifth, we really must do a much better job of promoting competition in financial services. The most shocking statistic is that, up until 2010, no new bank had been set up in this country for a century. ... 
There is already some encouraging evidence of new entrants to the banking market. In weak moments, I think that we might even be on the cusp of a technological revolution in banking. Certainly, some new firms are bringing new technologies to banking – for example, through mobile payments. Others are mobilising pools of non-bank funds to finance lending directly – peer-to-peer lending, crowd-funding, invoice-financing. Others still are demonstrating that a clear focus on retail banking services, delivered locally by forging long-term relationships, can be a winning strategy. 
For example, take Handelsbanken. ...Their business model is fascinating, Quaker-even, in its orientation. They offer only basic banking services, mortgages and small business loans, to people in a tight, locally-defined catchment area. All credit decisions are taken locally by people, not centrally by a computer. No bonuses are paid and no-one has a sales-target. When the whole firm out-performs, a contribution is made to a pooled fund which is invested on employees’ behalf. 
The fruits of success are distributed equally and gratification is deferred. 
For banking, this is back to the future....
Requiring the banks to provide ultra transparency is also an example of back to the future for banking.

Back before the advent of deposit insurance in the 1930s, the sign of a bank that could stand on its own two feet was a bank that provided ultra transparency and allowed everyone to see all of its exposures.

Judge rules names of individuals who rigged Libor at Barclays can be disclosed

As reported by the Telegraph, a UK judge has ruled that Barclays will have to disclose the names of the individuals who rigged Libor.

Barclays will be forced to disclose the names of staff involved in Libor rigging, following a damning court judgment over claims it mis-sold interest rate swaps to a care home operator.
The bank was chastised on Monday at the High Court in London by Lord Justice Flaux, who claimed Barclays was intentionally trying to hide the true scale of the Libor scandal, which has already seen the lender fined £290m.
Up until now, the true scale of the Libor scandal has not only been hidden by banks like Barclays, but also by the global financial regulators.
The criticisms came as Barclays faced a preliminary hearing, ahead of a trial, over allegations it mis-sold to a care home group complex interest rate derivatives that were in turn based on false Libor rates. 
Issuing a damning judgment, Lord Justice Flaux said Barclays’ objections to the Libor-rigging claims brought against it by Guardian Care Homes were “wholly without merit” and accused the bank of “misleading” customers.
Would banks ever mislead their customers?

Of course they would and we didn't need the Libor rate manipulation or CDOs like Abacus to know it. It has been well known since the Great Depression.

This is why we have a financial system based on the FDR Framework and the combination of the philosophy of disclosure with the principal of caveat emptor.

It is assumed that if disclosure of all the useful, relevant information in an appropriate, timely manner is not required of the banks, they will not provide it and instead will mislead their customers.
Allowing the case to continue to trial, the judge described the bank’s attempts to dismiss the Libor aspects of the care home operator’s claim as “shadow boxing” and said they were “doomed to fail”. 
Guardian Care Homes’ lawsuit is seen as a test case for Libor-rigging claims and the court decision to allow the case to go to trial potentially opens the door to billions of pounds of legal actions against other banks involved in the rate-setting scandal. 
A level of exposure that calls into question the solvency of the banks involved.
Over a day-long hearing, Lord Justice Flaux repeatedly struck down Barclays’ objections and said the bank would be forced to disclose potentially embarrassing details, such as the identities of staff implicated in Libor manipulation. 
“[It] just seems perfectly obvious... that the people responsible for giving those instructions [manipulate Libor] must have known customers were being misled,” he said....
The judge has just provided an example of why transparency works so well.  By shining a bright light on bad behavior by bankers, it discourages them from engaging in bad behavior in the first place.
However, Lord Justice Flaux rejected the arguments and said Barclays would from next month have to begin providing the names of staff involved in Libor-rigging to Guardian Care Homes’ legal team.
“This is all shadow boxing. The real issue is they [Barclays] are trying to shut it down because they don’t like it,” he said.

Germany's Merkel urges more financial regulation when what is needed is transparency

One of the consistent themes since the financial crisis started has been the substitution of complex rules/regulations and supervisory oversight for transparency and market discipline.

Regular readers know that complex rules/regulations and supervisory oversight are favored by the Blob (aka, politicians, financial regulators, Wall Street and its lobbyists).

There are several reason that complex rules/regulations and regulatory oversight are favored by the Blob including:

  • First, it is good for the regulators as it expands the number of individuals who work for them to oversee compliance with the rules/regulations.

  • Second, and more importantly, Wall Street knows that all the loopholes in the complex rules and regulations will be expanded over time so that they are not binding.  Don't take my word for this, Paul Volcker made this point in testimony to the UK parliament.

Complex rules/regulations and supervisory oversight effectively preserve opacity in wide swaths of the financial markets.

For example, look at the complex rules for bank capital known as Basel III.  According to the Bank of England's Andrew Haldane, it takes millions of assumptions to calculate Basel III.  Not only does it take millions of assumptions, but bank capital itself is meaningless as it is an easily manipulated number.

Contrast this with ultra transparency and requiring the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  With this information, market participants could assess the risk of the banks directly.

Which do you think market participants trust, bank Basel III capital adequacy or their own independent risk assessment?

I bring this up because Germany's Chancellor, Angela Merkel, has called for more financial regulation.

The last thing we need is more financial regulation.  What is needed is to bring transparency to all the opaque corners of the financial system.

As reported by Reuters,

German Chancellor Angela Merkel urged the world's top economies to push ahead with further financial regulation, saying that not enough had been achieved so far.
Financial reforms that do not bring transparency in the form of disclosure of disclosure of all the useful, relevant information in an appropriate, timely manner do not achieve anything beyond ensuring opacity endures in the financial system.
The global financial crisis has prompted an overhaul of regulation in almost every part of the financial system from over-the-counter derivatives to bank capital requirements. 
But Merkel said in her weekly podcast that more was needed. 
"In my view, we are not where we ought to be yet," she said. 
"We had planned to regulate every financial centre, every financial actor and every financial market product. Significant progress has been made but the rules have not yet been implemented everywhere and we are still missing further areas."
What a singularly bad plan.  The plan should have been to bring transparency to every financial centre, every financial actor that the government implicitly or explicitly offers a guarantee to and every financial market product.
The chancellor pointed to "shadow banks", or non-bank financial institutions that are less regulated than banks, as an area where progress needed to be made. 
"For instance the regulation of shadow banks will hopefully be concluded at the next G20 meeting," Merkel said.
This should have been done already because all it takes is to require that structured finance securities provide observable event based reporting and that banks provide ultra transparency.
Leaders of the world's top economies (G20) made recommendations for regulation a year ago that also include hedge funds, special investment vehicles and repurchase agreements. 
Regulators worry that as traditional banks get more heavily regulated, risky credit activities will shift to shadow banks.
When it comes to regulation, as the Bank of England's Andrew Haldane has shown, less is more.

Specifically, banks should be required to provide ultra transparency and disclosing on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This disclosure solves a host of problems ranging from inability of market participants to assess the risk of the banks to stopping proprietary trading to preventing manipulation of Libor.
Merkel meets with the heads of the International Monetary Fund, World Bank, International Labour Organisation, the World Trade Organisation and the Organisation for Economic Cooperation and Development in Berlin on Tuesday.

Sell-side recommends that UK create equivalent of US housing agency to issue asset-backed securities

In its latest effort to sell opaque securities, the Association for Financial Markets in Europe, a sell-side lobbying organization, has proposed that the UK create the equivalent of the US housing agencies to issue asset-backed securities.

Under the AFME's blueprint, the UK would create a new agency for business lending that would guarantee securities backed by loans to businesses.

Why would the UK taxpayers want to take on credit risk when there is an easy way to restart the market for securities backed by loans?

Regular readers know that restarting this market requires that the securities provide observable event based reporting on all activities like a payment or delinquency that occur involving the underlying collateral before the beginning of the next business day.

With this information, investors could independently asses the securities and buyers would know what they own.

As reported by the Sunday Times,

A BLUEPRINT detailing how to kickstart lending to businesses by deploying the dark arts of casino banking has been handed to George Osborne and Vince Cable. 
Under the scheme, Britain’s 21,500 medium-sized companies would be given the tools to gain access to the international financial markets. 
Loans would be pooled by a new Agency for Business Lending, nicknamed ABLE, which would package them into different types of bonds and sell them to investors. The bonds would be backed by a government guarantee. 
The paper proposes using many of the financial engineering tactics blamed for causing the credit crunch. But it argues that the international markets would bring new sources of stable funding for UK firms and free up the balance sheets of domestic banks, allowing them to lend more.

Spain's bad bank underscores depth of Spain's bad loan problem

As I was reading the presentation from the Bank of Spain (hat tip Zero Hedge) on the bad bank to hold troubled real estate loans, it was clear that Spain's taxpayers and its real economy would be much better off if the Spanish banks were required to recognize upfront the losses on the bad debt that they would realize if the debt went through the long process of default and foreclosure.

One reason that bad banks do not work is the price that the bad assets are transferred to the bad bank at is not determined by the market.  Instead, it is determined by financial regulators.  This can lead to a host of problems.

For example, if the price for the bad assets is too high, it is effectively a subsidy of the bank by the taxpayer.  Private investors will not invest in the bad bank because the assets cannot generate the return necessary to compensate for their risk.

The primary reason that bad banks do not work is that unless the banks are required to provide ultra transparency and disclose their current global asset, liability and off-balance sheet exposure details nobody knows what other losses are hidden on or off their balance sheets.

The Spanish government, at the Troika's request, lays out this nice plan.  First, we stressed tested the banks to determine how much capital was needed.  Second, we take out the bad debt.  Third, we inject new capital.

Unfortunately, each step of the plan is fatally flawed.

  • First, the stress tested banks have far bigger losses than envisioned by the stress tests.

  • Second, the bad bank isn't taking all of the bad debt off the balance sheets of these banks.

  • Third, the amount of capital being injected doesn't make the banks solvent.  

If Spain wants to fix its banking system, it will follow Iceland's lead and require its banks to recognize all their losses upfront.

Next, it will implement ultra transparency so that market participants know that all the losses have been taken.

Then, banks that are capable of generating earnings and rebuilding their book capital levels will be allowed to continue operating.  Banks that cannot generate earnings will be resolved.

Bringing transparency to all the opaque corners of the financial system is a conservative project

MIT Professor Simon Johnson wrote yet another column calling for the break up of the Too Big to Fail banks (his other topic is calling for banks to hold more capital).  What makes this column of interest is that it really makes the case for bringing transparency to all the opaque corners of the financial system.
The columnist George F. Will recently shocked his fellow conservatives by endorsing Richard Fisher, president of the Federal Reserve Bank of Dallas, to be Treasury secretary in a Mitt Romney administration. 
Fisher’s appeal, in Will’s eyes, is that he wants to break up the largest U.S. banks, arguing that this is essential to re- establish a free market for financial services. Big banks get big implicit government subsidies and this should stop. 
Will’s endorsement was on target: The true conservative agenda should be to take government out of banking by making all financial institutions small enough and simple enough to fail. As Will asks, “Should the government be complicit in protecting -- and by doing so, enlarging -- huge economic interests?”
Regular readers know that by failing to fulfill its responsibilities under the FDR Framework government is complicit in protecting the banks.

First, the government fails to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner so the market participants can independently assess this information and make a fully informed investment decision.

Second, the government offers its own opinion as to the risk of the banks.  Prior to the crisis, financial regulators talked about how risk in the banking system was reduced because of financial innovation.  After the start of the financial crisis, financial regulators talked about how the results of a stress test the regulators ran showed the banks were adequately capitalized.
But Will could have gone further -- much of what Fisher recommends also is appealing to people on the left of the political spectrum. ...
As is transparency and the government fulfilling its responsibilities under the FDR Framework.
Unfortunately, Fisher’s views on “too big to fail” banks draw the ire of powerful people on Wall Street,
Transparency draws the ire not just of powerful people on Wall Street, but also powerful people in Washington (transparency doesn't draw the ire of economists as they assume that it exists).

Unlike the breaking up the Too Big to Fail or higher capital requirements, transparency is a threat to the Blob (aka, politicians, financial regulators, Wall Street and their lobbyists).

As FDR understood, with transparency, the Blob's power is limited.  As a result, policies like adopting the Japanese Model for handling a bank solvency led financial crisis and protecting bank book capital levels and banker bonuses at all costs would not be adopted.
Fisher and Harvey Rosenblum, executive vice president and director of research at the Dallas Fed, have laid the groundwork for a comprehensive reassessment of finance and banking -- and the effects on monetary policy
The closest parallel is the rethink that happened during the 1930s, as the gold standard broke down and the world descended into depression followed by chaos. 
But their approach is also reminiscent of the way that monetary policy was reoriented in the early 1980s, as Fed Chairman Paul Volcker and others brought down inflation. 
The world and the U.S. economy have changed profoundly. We need to alter the way we think about the financial system and monetary policy.
Actually, with the FDR Framework, your humble blogger laid the groundwork for thinking about the financial system and monetary policy.
Fisher and Rosenblum have expressed, separately and together, three deep ideas since the financial crisis erupted in 2008. 
First, very large banks are too complex to manage. “Not just for top bank executives, but too complex as well for creditors and shareholders to exert market discipline,” they wrote in a Wall Street Journal op-ed in April. “And too big and complex for bank supervisors to exert regulatory discipline when internal management discipline and market discipline are lacking.” 
Complexity, they say, magnifies “the opportunities for opacity, obfuscation and mismanaged risk.”....
And here is where Fisher, Rosenblum and Mr. Johnson make the case for bringing transparency to all the opaque corners of the financial system.  For banks, transparency requires that they disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Everyone knows that transparency is needed if market participants are to independently assess the risk of an investment and exert market discipline.

Without it, market participants have to rely on a third party for a risk assessment if they are going to invest.  For banks, the third party relied on prior to the financial crisis was the financial regulators.  For structured finance securities, the third party relied on prior to the financial crisis was the rating agencies.

Clearly, both of these were discredited at the start of the crisis as their risk assessments were shown to be wrong.  With their stress tests, the financial regulators have confirmed that their risk assessments have not improved.

As Fisher, Rosenblum and Johnson point out, without this disclosure bankers use complexity, a form of opacity, to magnify the opportunities to profit from opacity, obfuscation and mismanaged risk.  Which further confirms Yves Smith observation on Naked Capitalism that nobody on Wall Street is paid to create low margin transparent products.
Second, too-big-to-fail banks do actually fail, in the sense that they require bailouts and other forms of government support. This is exactly what happened in the U.S. in 2007 through 2009, and it is what is occurring in Europe today....
Regular readers know that a modern financial system is designed so that banks do not require bailouts.

Banks have deposit guarantees and access to central bank funding and as a result, they can continue operating and supporting the real economy when they have low or negative book capital levels.  The deposit guarantee effectively makes the taxpayer the silent equity partner while the bank has low or negative book capital levels.

The reason behind the bailout was the fear of contagion.  One bank would fail and it would bring down the entire banking system.  Contagion only exists when the the government fails to ensure adequate transparency.

Regular readers know that with ultra transparency not only can market participants assess the risk of each bank, but they can adjust their exposure to each bank based on its risk and what the market participant can afford to lose given this risk.

This ends contagion and any excuse for bailing out the banks.

Also, please note that Professor Johnson explicitly says that what we have is a bank solvency led financial crisis as the 'too-big-to-fail banks do actually fail'.
Third, monetary policy cannot function properly when a country’s biggest banks are allowed to become too complex to manage and prone to failure. 
In “The Blob That Ate Monetary Policy,” a Wall Street Journal op-ed published in September 2009, Fisher and Rosenblum pointed out that cutting interest rates doesn’t work when systemically important banks are close to insolvency. The funding costs for banks go up, not down, as a crisis develops....
The funding costs for the banks went up because of opacity.  Specifically, that the banks are 'black boxes' and nobody knows what is hiding on and off their balance sheets.

As the Financial Crisis Inquiry Commission documented, banks with money to lend could not assess the solvency of the banks looking to borrow and therefore they did not lend (aka, the interbank lending market froze).

There is no mystery why the cost of funding went up.  It was the result of opacity.
“Well-capitalized banks can expand credit to the private sector in concert with monetary policy easing,” Rosenblum wrote with his colleagues Jessica J. Renier and Richard Alm in the Dallas Fed’s “Economic Letter” of April 2010. “Undercapitalized banks are in no position to lend money to the private sector, sapping the effectiveness of monetary policy.”
This is a prime example of not understanding that the origination of loans is separate from the funding of loans.  The reason these are separate is that funding for the loan can come from the bank's balance sheet or by distributing the loan through a bank syndicate or by sale of the loan to pension funds, insurance companies, hedge funds or through an asset-backed security.

In our current financial crisis, the reason that lending has slowed dramatically is that the banks were not required to recognize upfront the losses they will ultimately realize on their bad debt exposures.  Instead, the financial regulators adopted forbearance that allowed the banks to engage in 'extend and pretend' techniques that turned bad debt into 'zombie' loans.

The collateral tied up as security for these 'zombie' loans undermines the ability of banks to lend.

Recall that banks are senior secured lenders.  The collateral tied up in the 'zombie' loans artificially increases the value of collateral on new loans (if the collateral were not tied up, the market value of all the collateral would be lower - an example of this is residential and commercial real estate).

The problem for lenders is they know the value of the collateral should be lower, but they just don't know how much lower.  As a result, they are reluctant to make loans.

Sunday, October 28, 2012

Baupost's Seth Klarman explains why pursuing Japanese Model is wrong

In his Q3 2012 letter to investors (hat tip Zero Hedge), Baupost's Seth Klarman goes through the various policies initiated under the Japanese Model for handling a bank solvency led financial crisis and explains why these policies are bad for the real economy in both the short and long run.

Under the Japanese Model, bank book capital levels and banker bonuses are protected at all costs.  This drives the burden of servicing the excess debt onto the real economy.  In turn, this cause the real economy to shrink.  This in turn is responded to with fiscal and monetary stimulus (like zero interest rates and quantitative easing).

However, embedded in the fiscal and monetary stimulus are headwinds to further economic growth.  As a result, pursuing the Japanese Model effectively condemns the real economy to a Japanese-style slump.

Regular readers are familiar with Mr. Klarman's argument as it repeats many of the same points your humble blogger has made.
Perhaps the oddest part of the ongoing QE scheme is that everyone can see in its fullness and boldness the attempted manipulation of Americans' behavior. (If people know they are being manipulated, do they behave exactly the same as if they don't know?) 
While anyone would be glad to have a cheaper mortgage as a result of QE3, would they really believe this would make their home worth more?  
It's more of a credit holiday, whereby the government offers you better terms than previously available. ... 
Also, artificially low interest rates have a cost to the government
As we know from the recent U.S. housing price collapse, mortgage lenders can indeed lose money. The guarantor of the U.S. housing market has a huge contingent liability. Moreover, the U. S. housing market was clearly overbuilt (by five million homes, according to some estimates) as of 2007, yet cheap financing may attract temporary incremental demand which home-builders might interpret to be permanent and thus overbuild all over again.  
This highlights the deleterious second and third order effects of well-intended but ill-conceived government programs. 
It is clear that someday the Fed will decide that the economy has strengthened sufficiently to end and then potentially reverse QE and zero-rate policies. Any possible sale of trillions of dollars of securities owned by the Fed, at such time would most likely be at a substantial loss given that interest rates would likely have risen and bond prices have fallen. 
Also, when people with a 30 year, 3.5% mortgage seek to move at a time when new mortgages now cost 5% to 6% or more, buyers will pause, reducing demand and driving house prices lower.  
QE3 may deliver a dose of helium to housing prices, but eventually helium leaks out of balloons, and gravity pulls them to earth.  
What kind of policy is this: untested; inflationary; eroding free market signals; diverting more of the country's resources toward housing at the expense of priorities such as infrastructure, technology, or science and medical research; and inevitably only a temporary fix with no enduring benefit?
Please re-read Mr. Klarman's question as it highlights just how destructive pursuing the Japanese Model and its related policies is to the real economy.
Finally, we must question the morality of Fed programs that trick people (as if they were Pavlov's dogs) into behaviors that are adverse to their own long-term best interest.  
What kind of government entity cajoles savers to spend, when years of under-saving and overspending have left the consumer in terrible shape? What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? What kind of entity drives the return on retirees' savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy.
Please re-read the highlight text as Mr. Klarman has made a clear case for adopting the Swedish Model with ultra transparency and making the banks absorb the losses on the excess debt in the financial system.

One of the benefits of adopting the Swedish Model is it eliminates the need for destructive policies.
Recently, a financial columnist wrote: "Four years after the fall of Lehman Brothers, and with-a presidential campaign in full swing, everyone can surely agree on one thing: we shouldn't risk another financial crisis." 
While I'm sure he is well-intentioned in this sentiment, this highlights a flawed notion held by too many of our country's commentators and regulators. What does it even mean to risk or not risk a financial crisis? You don't intentionally risk financial crises; they just happen. In fact, there is no way to not "risk them". And they don't usually provide fair warning. 
Financial crises are awful: they affect the lives of individuals and families; they can damage the economy, weakening it to the point of tearing the social fabric they often take years to overcome. It would be great if we could outlaw them, but unfortunately we cannot. 
Ironically, attempts to limit short-term pain, such as those in the four years did counting since the collapse of 2008, almost certainly make a future crisis much more, not less, likely. 
The seeds for financial crises typically grow undetected from a variety of excessive behaviors and assumptions, to where they become almost inevitable. 
Financial crises are rooted in over leverage and excessive levels of valuation. If society wants to prevent crisis, it must take measures well in advance, before the storm clouds gather, before excesses build in the system and before unbridled optimism dominates investor and business thinking
Efforts to constrain incipient crises in order to avoid feeling their full wrath, such as propping up bankrupt institutions and bankrupt countries, merely result in stagnation and a protracted period of subdued economic activity. 
Proper regulation might make some difference, if it had the effect of limiting leverage and containing speculative bubbles; but so much of regulation is naïve, ill-considered, and poorly enforced, thereby rendering it ineffective.
As Mr. Klarman points out, relying on regulation and regulatory oversight does not make the financial system stable.
Anyone who believes that government control and intervention will prevent problems of all sorts is living in a fantasy world where what we wish will happen always does
Go back to 2007 where the world was seemingly in a perpetual period of prosperity with low volatility while stock markets were hitting record highs. Few sniffed the possibility of any crisis on the horizon. Virtually no one imagined the magnitude of the crisis that erupted only one year later.  
Financial crises, sadly, will be with us forever. The idea that we can avoid one at our will only suggests both a dangerous naivete regarding how the world works and also the likelihood that when a crisis does arise, years of built up excesses will ensure that it will be far worse than it would otherwise have been. 
An environment where financial crises are seen to be a regular part of the landscape is one where people might actually take more precautions.  
People would maintain a margin of safety in all their decisions. investment and otherwise, regulations would be well thought out and diligently enforced, and the unscrupulous and the incompetent would quickly fail and disappear from the scene.
The bedrock for the market that Mr. Klarman discusses is transparency.  It is only with all the useful information in an appropriate, timely manner that investors can independently assess the risk and build a margin of safety into their decisions.

This is why I have argued for bringing transparency to all the opaque, corners of the financial system.
Modern day attempts to abolish failure only serve to ensure it, as moral hazard-- the likelihood that people's behavior changes in response to artificial supports or guarantees-- surges. Attempts to prevent or wish away future crises only make them more likely. Only by allowing, even welcoming, episodic failure do we have a chance of reducing the likelihood and magnitude' of future financial crises.

"conspiracy against public" requires Libor reform be based on banks providing ultra transparency

In his Guardian column, Larry Elliott looks at what has been proposed to reform Libor and concludes that much more needs to be done.

Regular readers know that what needs to be done is to reform Libor by requiring banks to provide ultra transparency and let the market use actual trade data to calculate the rate.

Your humble blogger submitted this suggestion to the Wheatley Review and their response was not only to ignore the suggestion, but to also exclude it from the responses on how to reform Libor that they published.

Mr. Elliott recognizes that the Libor reform solution proposed by Mr. Wheatley is woefully inadequate.

Adam Smith would be the perfect expert witness in the case being brought by Guardian Care Homes (nothing to do with this newspaper) against Barclays Bank, which has its first hearing in the high court on Monday. 
Way back in 1776, the sage of Kirkcaldy noted: "People of the same trade seldom meet together even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."...
Libor is a strange creature, but the way it has been operated fits Smith's dictum to the letter.  
It is not like bank rate, set once a month by the Bank of England's monetary policy committee and which stands at 0.5%. Nor is it akin to the interest rate paid on the gilts the government issues to finance its debt, which is fixed at auction and established by the myriad daily trades in the bond market. 
Instead, Libor is set by a small number of big banks, who submit every day a rate at which they think they might be able to borrow rather than the rates at which they can actually borrow. After the highest and lowest submissions are trimmed, an average of the rest of the quotes becomes that day's Libor rate. 
Getting the right Libor rate matters. Banks should not be able to fiddle the rate to screw their customers. Nor should they be able to submit misleading quotes in order to disguise just how bad their financial position they are in....
The only way to achieve these three goals is to require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, banks with deposits to lend can assess the risk of the banks looking to borrow.  This ensures that the interbank lending market stays open.

With this information, market participants can calculate Libor off of actual trades.
The question, therefore, is whether it is sensible to leave such an important interest rate in the hands of a cabal of banks. Is it sufficient to put down the scandals exposed this year to a handful of rogue traders, poor internal management and inadequately policed regulatory safeguards, or is there a deeper malaise?
Clearly, the answer to these questions is no.

Since our markets are based on disclosure, the only sensible solution is disclosure in the form of ultra transparency.  Compare this to the complex rules and regulatory oversight that was proposed instead.
Enter poacher-turned-gamekeeper Alexis Stenfors, who received a five-year ban from working in the City after costing his employer Merrill Lynch $100m by concealing losses on his trading account. Stenfors is now an academic at the London School for Oriental and African Studies where he has just published two papers on Libor fixing. 
There will be those who say that, as a rogue trader himself, anything Stenfors says has to be taken with a pinch of salt. Yet, Stenfors was a trader for 15 years before his fall and he knows first-hand how the markets operate. 
Put simply, the argument in the papers – available at – is that there is a systemic problem with Libor. Although the banks would like us to believe that the scandal is down to a few bad apples, that is not the case. 
Nobody buys the few bad apples, because we keep finding out about other opaque areas of the banks that were also populated by a few bad apples (think CDOs, mis-selling of interest rate swaps,...).
The first paper analyses how banks have the means, the opportunities and the incentives to rig Libor in a way that is beneficial to themselves. They have the means because they collectively set the Libor rate. They have the opportunities because the Libor rates they submit have little or no bearing on the rates at which they actually trade.
Which is why all and not some subset of their trades need to be disclosed.
And they have two big incentives to "game" the rate. The first is that they can enhance the value of their own derivatives portfolios by manipulating Libor. The second is that they can avoid being stigmatised as a "bank in trouble" by putting in a low Libor rate that bears no relation to what they are actually paying for their finance.
In addition, we know the banks did this because Barclays confessed to manipulating Libor for these reasons and paid a fine.
In his paper, Stenfors conducts a number of different games, in some of which the banks collude with one another and in some of which they don't. In all the different scenarios, the outcome is a Libor rate that differs from the true funding costs of the banks. He also notes that the trimming process for removing the highest and lowest bids is ineffective and that bringing in new rules and constraints to enhance transparency provides disappointing results. 
Rules and constraints do not enhance transparency.  They are a substitute for transparency.

What enhances transparency is disclosure.  Specifically, ultra transparency. 
"Banks are given the chance to influence the Libor in a direction that is beneficial to them – stemming from the exclusive privilege to be able to play the game, in other words to participate in the Libor fixing process," he concludes....
Clearly, Libor fixing is a case where self-regulation has proved to be useless. This might not matter much if the potential costs of getting Libor wrong were minor. But they are not: they are potentially astronomic, ....
the government has said it will accept the findings of Martin Wheatley's report into Libor, published last month, in full. These include statutory regulation, making misleading Libor quotations a criminal offence and giving the FSA powers to force participating banks to abide by a new code of conduct. 
But if Stenfors is right and Libor is structurally flawed, these reforms will not be enough. This "conspiracy against the public" requires ... an entirely new system.
A system based on requiring the banks to provide ultra transparency.  A system that the UK regulators already rejected in favor of complex rules and regulatory oversight.