The Bankwatch

I have been following the matter of bank leverage, and the improvements that are required to deal with current bad debts and more importantly future bad debts that will arise from credit card and mortgage defaults. Sadly no lessons have been learnet judging by the reaction from the investment analyst community to the small improvement in capital ratio at Goldman Sachs.

Banks still need bigger cushions | Reuters – Rolfe Winkler

It was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Clearly the relationship to recent TCE (Tangible Common Equity) levels is hardly the point. What ought the TCE level be now based on the expectations for the next few years?

Yes, leverage is down, but only relative to the obscene levels reached a year ago. Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.

In fact this little tidbit is interesting.

A nickel of equity for every dollar of assets is a pathetically small capital cushion. When the Federal Reserve system was founded, the required cushion was 18 cents. Ever since, we’ve been marching toward zero, pumping more credit into the marketplace than can be prudently managed.

At 18 cents leverage would be 4.6 :1 … that is still excessively high relative to coorporate leverage but perhaps it could be argued based on strong profit margins of banks. In any event it is hard to argue for anything less. Then we must layer on the continued practise of off-balance sheet debts which are not incluuded in TCE calculations, and which of course mean leverage is actually worse than shown.

In the meantime, banks are using various accounting gimmicks to hide leverage. For instance, Citigroup and JP Morgan Chase have $165 billion and $145 billion of off-balance sheet assets, respectively, that will have to come back on their balance sheets next year. Taking account of them now would reduce their TCE ratios by 8 percent and 7 percent, respectively. Bank of America has $470 billion of off-balance sheet assets, though they haven’t disclosed what will end up on the balance sheet.

This is fun and a good cause.

Linux Foundation launches branded credit card | finextra

The Linux Foundation is set to launch a Visa credit card featuring its Tux mascot for people who want to contribute to the operating system’s development.

There is an enormous intelligence in this paragraph from Dave. It centres on the reality that with each transaction, a consumer is making a decision about their banking service. That service may be merely a payment card, or it may be a BarclaysBofALloyds Card. it doesn’t matter.

What has really happened is that the product experience has transferred from the old view of product, the bank account, to the new view, which is the experience. The experience occurs at the ATM, the POS terminal, the online banking session, the iphone app (oops you haven’t got that!). The customer experience is in the use of the account, not in the interest rate. That rate stuff is relegated to another mind space that is related to return and investment quality. That other mind space is critical, but not at the point of transactional experience.

United we fall | Digital Money Forum

Retailers don’t want to stop taking cards and go back to cash, but neither would they expect the product to be provided for free. So what is the real dynamic? Many people might sympathise with the retailers’ central complaint, that interchange has not evolved to reflect the modern retail payment environment, while being sceptical that a regulatory transfer of resources from one group (banks) to another group (retailers) will result in any benefit to the consumer. But there is a dynamic, so we cannot be static in response. We as an industry (by which I mean the electronic payments industry) need to demonstrate to retailers that our products are worth paying for. As I’m learning from the Innovation in Payments work over at the CSFI, if we restrict the value proposition to the payment transaction, this is difficult. It’s the value-added services around the payment transaction that create our future proposition.

This is essential stuff to consider in building new services. The traditional view of biulding a bank account goes like this:

• how many free ATM transactions
• how many free debit transactions
• at which balance will interest kick in

These assumptions are negative in nature in a consumers view. How about a value proposition that says ..

• monthly fee = $ XX
• ATM – free
• debit – free
• interest – zero
• savings account – no debit and high rates

Relevance to Bankwatch:
Of course I am simlifying here, but the point is to address the features of the account towards the requirements of the customer. Customers want simplicity, and understandabilty [I know that is not a word]. Take a look at any telco site and do the opposite. Allow customers to understand on the first page, what they are going to get.

In the ‘how is the world doing’ category, this take (from the chairman of Morgan Stanley Asia and author of ‘The Next Asia’ (Wiley), due out in September) on China is consequential for us all. The west imported cheap labour from there for the 15 years preceding 2007, and the after effect is coming home to roost. What will matter to us all, and to banks, is the relative impacts on currency values as the historic imbalances are rebalanced to a different metric.

I have to keep going back to how banks in the west redesign their products and services. The old approach will not apply. Consumers problems reflected in high personal debt were the output of the crisis, and consumer reaction in the west and in China (where they are being laid off by the millions) will be a significant part of the nature of the recovery.

I’ve been an optimist on China. But I’m starting to worry | FT

This outsized bank-directed investment stimulus leaves little doubt as to how bad it was in China in late 2008 and early 2009. An unprecedented external demand shock, stemming from rare synchronous recessions in the developed world, devastated the export-led Chinese growth machine. That triggered sackings of more than 20m migrant workers in export-intensive Guangdong province. Long fixated on social stability, Beijing moved to arrest this deterioration. The government was determined to do whatever it took to restore rapid growth.

This is a theme that is gathering steam. It is based on the reality that customers are using internet for their banking, and there is a high level of redundancy in offerring similar capabilities in physical locations. The counterbalance is of course the need to attract customers, new accounts and deposits which has traditionally been a branch activity.

That balance is shifting now and the tension between those two opposing forces will be ineresting to watch, as banks exectute strategies and consider their cost base.

BofA could eventually cut 10 pct of branches SF Chronicle

Bank of America Corp. could eventually shrink its 6,100-branch network by about 10 percent as consumers utilize other methods of banking, a company spokesman said Tuesday.

The move would be a pullback from the bank’s two-decade expansion, most recently under Lewis’ command, which expanded the bank from coast to coast.

[update] A quick look at Online Banking Report reminded me of an attribution I should have made, of Jims far sighted report in 2006.  In that report he rightly took a 40 year view.  Which Chairman at a bank is taking a 40 year view today ?

Online Banking Report: The Demise of the Branch (April 2006), for more on the long-term trends in the mix of branch and alternative delivery.

Umair zeros in on a real point that is precisely correct.  The point here is not what you may or may not think about prezi … the point is what prezi’s users think. Then relate that to what customers think of your bank’s products.

The best business model in the world is also the simplest: make stuff that’s insanely great

Everybody’s searching desperately for business model innovation: Detroit, newspapers, record labels, banks. No market is left untouched, no value proposition sacrosanct.

Yet, the best business model in the world is also the simplest: make stuff that’s insanely great. Stuff that’s insanely great does what Prezi does — amazes, enriches, and inspires. That kind of stuff doesn’t need a hard sell, a new market, or a convoluted product range. It just needs to be.

This is an interesting article over at Foreign Policy. It is interesting because it fits in the meme of what recovery looks like. Regular readers will by know by now I am firmly in the space that recovery will be framed by a smaller economy, and slower growth of that smaller economy.

This piece compares the Chinese economy to Lucent during the dot com bubble. Lucent were selling to dot com company’s which disappeared. China was selling to US and to a lessor extent European consumers who have … disappeared. The minor distinction is that the consumers actually still exist, but the $64K question is what we can expect from their spending patterns. So the context for the article is whether China has a manufacturing infrastrucuture that is overbuilt for what the world requires?

Of course the articles point is the impact of a China crash on the world economy. My concerns are a bit more prosaic. I assume smaller economies and lower velocity of money.

How banks should orchestrate their product design and marketing stratagy. In a chat this week with a retired senior executive from a Canadian bank Thursday, he noted an increase of 200 basis points that banks were achieving in lending to prime corporate customers. These are multi million dollar loans. Lending and liquidity are not the issue anymore. The issues are risk and attractiveness of market segments. We have seen a dramatic explosion of growth in the consumer market over the last 17 years. That bubble is gone. How should banks design their approach going forward now?

My focus here is 100% consumer, and I will leave the corporate stuff to the experts. I remain convinced costs will have to be squeezed out of the Banks’ consumer delivery model, and that means in simplistic terms, less branches and more internet.

Interesting stuff.

[UPDATE:]

From the FT this morning …

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The privatisation of a state steel company has been scrapped after an executive was beaten to death by workers angry at the threat to their jobs from a takeover of their firm, according to a Hong Kong rights group.

The violent riot in north-east China late last week involved up to 30,000 workers, a reminder of the ongoing sensitivity about lay-offs from state firms in industries targeted for consolidation.

The headline "How to Steer Clear of Money Scams" on a Google blog caught my attention. It turns out it is incredibly useful information for people to think about while on the web.

How to identify scams and other schemes

Here is more on the Tory plan for banking outlined in the attached White Paper [57 pages]. Politics aside, lets take a look at the merits of this proposal and how it aligns with the problems I have perceived within banking and that are exacerbated over the last 2 years.

The core issues I have seen are these:

• banks have become high dividend paying conduits due to protective regulation and tight association with Central Banks
• the regulatory protection produced a ‘cannot fail’ mentality about banks’ and ..
• this in turn resulted in no perceived need for a strong capital base, which …
• gave us excessive leverage on all bank balance sheets, and that ….
• leaves banks unable to withstand any economic hiccups, requiring …
• government to in effect nationalise the large banks, in order to…
• protect the economies of G8 countries from failing

Result: We are moving to an era of zombie banks otherwise known as financial utilities, leaving the question of which banks will rise above that and promote genuine innovation and better quality financial services for consumers. There are basic flaws I see in the banking business model, and observing the banking crisis has simply added validity to those – more to come on that. Meantime one of those flaws is a lack of capital retention in banks.

Banking 101 looks at retaining money for a rainy day. Banks have no money for a rainy day. Everything earned is re-invested in growth (new leverage) or paid out in dividends. Its a brilliant model in a perfect market – enough said.

Now that we have that out of the way, lets go to the Tory paper.

In the foreward we are off to a good start with this tidbit:

The crisis has also revealed that large parts of the financial sector had a free option at taxpayers’ expense. Profits were privatised during the good times, but because we cannot allow the banking system to fail, losses were socialised when things went wrong.

… and the crux of their solution

We will give the Bank of England the power to regulate the pay structures, riskiness, complexity and size of financial institutions, and require those with structures that put financial stability at risk to hold large amounts of capital as an insurance policy to protect the taxpayer. We will abolish the Financial Services Authority, and will create instead a strong new Consumer Protection Agency.

But then some things have a reek of political motivation and untintended consequences in this statement  ..

We will empower the Bank of England to use capital requirements to crack down on risky bonus structures. From the banks’ point of view this will effectively introduce a ‘tax’ on risky bonus structures that incentivise employees to seek short term profits at the expense of longer term stability.

It is really hard to see how that kind of regulation could be managed without government being owners of the bank and embedded in the governance structure.  But there is real support for Basle initiatives such as ..

We will introduce a “backstop” leverage ratio limiting how much banks can lend for a given amount of capital.

This one is awesome!

We cannot continue with a system where banks make huge profits in the good times but benefit from an implicit taxpayer guarantee when things go wrong.

And the punchline …..

If we are to minimise the chances and scale of future crises we need a policy framework that has both the analytical capacity to bring together these different factors and the corresponding powers to act decisively when risks are identified. In contrast Britain’s existing tripartite framework is confused and fragmented, with responsibilities, powers and capabilities split awkwardly between competing institutions.

This figure surprised even me … I know we have become accustomed to the word trillion, but do we really know how much money is involved here … our money!

The crisis has resulted in taxpayer support for financial institutions on an unprecedented scale. According to the IMF’s latest Global Financial Stability Report, central banks in the US, UK and eurozone have provided $9 trillion of support to the financial sector.

According to the Bank of England “total losses in financial wealth toward the end of 2009 Q1 were equivalent to around 50 per cent of the world’s GDP”.

And bearing in mind that US banks are not in good shape this comment on British banks is sobering ..

The end result was that British banks became amongst the most indebted, most leveraged in the world, with tangible assets 39 times tangible equity compared to only 17 times even in US banks.

What went wrong in our banks was therefore a reflection of fundamental imbalances that were allowed to build up throughout our economy over a decade. As George Osborne said earlier this year, “Our banking system is not separate from our economy; it is a reflection of it. Our banks hold a mirror up to the worst excesses of our society. And the unsustainable debts in our banks are a reflection of unsustainable debts in our households, our companies and our Government.”

This sentence summarises the context of the White Paper, and needs to be memorised imho:

The end result was a banking sector that was undercapitalised, dependent on unsustainable funding strategies, low on liquid assets, poorly governed by weak boards and driven by dangerously short term incentives.

The fundamental conclusion of the White Paper is that the problem is systemic and not personally accountable to the FSA staff. It is systemic because it was not physically possible for the FSA (or any of the other regulators) to aggregate and act on the range of risks that were appearing.

The senior management of the FSA have been commendably open about the failures of the tripartite structure in their own review of what went wrong. The FSA’s own report on Northern Rock stated that “some of the fundamentals of work on assessing risks in firms (notably some of the core elements related to prudential supervision, such as liquidity) have been squeezed out”.12 The problem with the existing arrangements is not the people at the FSA, many of whom are very good, but the inherent problems created by the current structure. Despite their efforts to improve the FSA’s operations since the beginning of the crisis, the FSA’s management remain limited in what can be achieved as long as the flawed tripartite structure remains in place.

In summary, Gordon Brown made five crucial errors in macroeconomic policy and financial policy as Chancellor: creating the flawed tripartite structure; removing the Bank of England’s historic role of calling time on the levels of credit and debt in the economy; removing housing costs from the inflation target; running an increasingly unsustainable fiscal policy; and consistently ignoring warnings on the risks building up throughout the financial system.

Solutions:
Moving ahead to solutions, these principles are outlined ..

There is an emerging international consensus on many of the solutions that are required to prevent a crisiof this magnitude happening again. These include:
• Increasing the quality and quantity of bank capital
• Increasing capital requirements for risky trading activities
• Introducing limits on banks’ leverage
• Improving the regulatory focus on liquidity
• Regulating risky remuneration structures

There is an interesting discussion on the “Too Big to Fail” problem. RBS is singled out with liabilities of £2.06 trillion which places it at 142% of UK GDP. This cries out systemic risk (remember Iceland)

The White Paper solution:

We will abolish the FSA and the failed tripartite system and create a strong and powerful Bank of England with the authority and powers to protect financial stability.

• The Bank of England will be responsible for macro-prudential regulation, judging and controlling risks to the financial system as a whole. This will restore the Bank’s historic role in monitoring the overall level of credit and debt in the economy, and builds on existing Conservative proposals for a Debt Responsibility Mechanism.
• This macro-prudential role will be carried out by a new Financial Policy Committee within the Bank, working alongside the Monetary Policy Committee, which will monitor systemic risks, operate macro-prudential regulatory tools and execute the special resolution regime for failing banks.
• The Financial Policy Committee will include independent members in order to bring external expertise to bear on the problem of maintaining financial stability. It will include the Governor and the existing Deputy Governor for Financial Stability, who also sit on the Monetary Policy Committee, in order to ensure close coordination between monetary and financial policy.
• The Bank will also be responsible for the micro-prudential regulation of all banks, building societies and other significant institutions, including insurance companies.
• This micro-prudential role will be carried out by a new Financial Regulation Division of the Bank, headed by a new Deputy Governor for Financial Regulation, who will also be a member of the Financial Policy Committee.
• The work of the Financial Regulation Division will be overseen by the Financial Policy Committee to ensure close coordination between macro-prudential and micro-prudential regulation.
• We will create a strong new Consumer Protection Agency with responsibility for protecting consumers. This will create a new framework and culture for financial services consumer protection regulation.
• We will simplify the system by moving responsibility for consumer credit regulation from the Office of Fair Trading to the Consumer Protection Agency, reducing the number of overlapping regulators responsible for consumer protection.

The remaining pages go into much discussion on derivatives, other countrys’ approaches and consumer protection. Thinking of innovation, there is an interesting section on new banks …

While it is obviously imperative to ensure that any new banks are sound and run by fit and proper individuals, we should look at how it might be possible to streamline the approval process in order to encourage new entrants.

Relevance to Bankwatch:
All in all, this is a thoughtful paper, with only occasional lapses into politics, but generally one that focusses on problems and solutions. There will be a hue and cry that it deals with yesterdays problems and that future crises will be different. I would argue that notwithstanding future problem types, there are obvious problems with the banking business model that requires attention while we sort out the nature of new problems we have not yet encountered.

The issue of unintended consequences is something I worry about, but this paper genuinely aims at known issues of bank leverage, regulatory fragmentation, and inadequate consumer protection. This is not a bad framework to begin.

PlanforSoundBanking.pdf

Every banker and security expert must read this. The flow here is common knowledge to security experts already but it really drives home to users how they must be careful about how they approach their password strategies.

The key here is to note how the interconnection takes place between, in this case, gmail and the secondary address, hotmail. The former can be secure yet through innovative ‘social enginering’ the second can open all sorts of doors.

Worthwhile to take the time .. read through and think about your approach.

The Anatomy Of The Twitter Attack | Techcrunch

Unfortunately for Twitter, Hacker Croll found such a weak point. An employee who has online habits that are probably no different than those of 98% of other web users. It began with the personal Gmail account of this employee. As with most other web applications, the personal edition of Gmail has a password recovery feature that presents a user with a number of challenges to prove their identity so that their password can be reset. It likely wasn’t the first account from a Twitter employee that Hacker Croll had attempted to access – but in the case of this particular account he discovered a kink in the armor that gave him the big first step. On requesting to recover the password, Gmail informed him that an email had been sent to the user’s secondary email account. In an effort to balance usability with security, Gmail offered a hint as to which account the email to reset the password was being sent to, in case the user required a gentle reminder. In this case the obfuscated pointer to the location of the secondary email account was ******@h******.com. The natural best guess was that the secondary email account was hosted at hotmail.com.

At Hotmail, Hacker Croll again attempted the password recovery procedure – making an educated guess of what the username would be based on what he already knew. This is the point where the chain of trust broke down, as the attacker discovered that the account specified as a secondary for Gmail, and hosted at Hotmail was no longer active. This is due to a policy at Hotmail where old and dormant accounts are removed and recycled. He registered the account, re-requested the password recovery feature at Gmail and within a few moments had access to the personal Gmail account of a Twitter employee. The first domino had fallen.