The Bankwatch

This is a complex article at ProPublica that in simple terms illuminates all that was wrong with CDO’s and synthetic CDO’s. These instruments allowed investment bankers like Magnetar to circumvent insider trading rules.  The story of Goldman Sachs being charged by the SEC for fraud is only the beginning.  Financial reform is the last thing many financiers and bankers will have to worry about as this story takes hold.

Magnetar involved all the big names and most are listed here.  You will see many recognisable names, eg. Citi, Wachovia, Deutsche, Lehmans, UBS, Mizuho, JP Morgan.  At this point it appears to be only guilt by association, however there is nothing good or right in this tale.  Propublica quote this participant.  “The deal was a disaster. He shook his head at being reminded of the details and said: “After looking at this, I deserved to lose my job.”

The Magnetar Trade

Magnetar’s approach had the opposite effect — by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Magentar founder Alec Litowitz speaks at a private equity conference held at Kellogg School of Management at Northwestern University in February 2007. (Nathan Mandell)

What Magnetar were able to do was fund the housing bubble and bet against it bursting all at the same time.  They were able to do this using CDO’s and building them all the while knowing the bubble would burst.  The beauty of what they did was to create cash flow to fund their short selling of their own CDO.

Magnetar’s (Nearly) Perpetual Money Machine

By buying the risky bottom slices of CDOs, Magnetar didn’t just help create more CDOs it could bet against. Since it owned a small slice of the CDO, Magnetar also received regular payments as its investments threw off income.

I was listening to all the pundits making predictions for 2010 over the weekend and one struck me in particular. It was Chrystia Friedland US Managing Director of Financial Times on Fareed Zakaria GPS, and she predicted big banks moving their headquarters to Hong Kong, in response to regulation and taxes. It was a one liner comment, with no follow through, but there is no reason for an investment bank which can operate virtually not o optimise its HQ location. Interesting. One more point for the rise of emerging economies.

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

The US administration released a draft of their proposed regulatory framework today, putting the Federal Reserve front and centre.

The big theme is to promote broader control of any institution involved in banking, and to specifically eliminate exemptions such as the Thrift Charter.

Draft Fed report on Financial Institution Regulation pdf – 85 pages

Deep in the Harper transcript this little gem indicating Canada and India have been working on the framework of a proposal for the G20 to consider on financial regulation.

Transcript: Stephen Harper interview

As you know, Canada has co-chaired with India the working group on future financial regulatory reform. We have a very good report which I think will gain consensus. Essentially, we did come down on that one in kind of a middle-ground position we hope will get the support of both the United States and Europeans and others. And that is, that we actually think it is important that you have strengthened system of national regulation as opposed to an international system of regulation. Canada’s own case is proof that a strong system of national regulation can in fact work.

A quick search uncovered this from Reuters that pointedly makes no mention of Canada but appears to fit the bill of being a recommendation outline.  It is very sappy and toothless though, e.g.

• The financial stability forum and International Monetary Fund should create a way for key national financial authorities to meet foreign counterparts regularly to assess systemic risks to the global system.
• All systemically important financial institutions, markets and instruments should be subject to an appropriate degree of regulation and oversight. Large complex financial institutions require particularly robust oversight.

Anyhow I finally located the full doc here is the in very draft form.  Here is the Table of Contents.

The conclusion is not complete, however the commentary and lead up are very relevant.  More later once I get through it.

Local copy – pdf. g20-enhancing-sound-regulation-and-enhancing-transparency

Lionel Barber at the FT interviews US President Obama in advance of the G20 meeting Thursday.  Despite the broad sweeping answers it seems unlikely that we will see much tangible outcome from the session, but the G20 draft communiqué (below) is clear about stronger regulation.

Obama interview: Full text | Financial Times

FT: Let’s talk about the G-20. What will be your benchmarks for success?

Obama: The most important task for all of us is to deliver a strong message of unity in the face of crisis. There’s some constituent parts to that. Number one, all the participating countries recognise that in the face a severe global contraction we have to each take steps to promote economic growth and trade; that means a robust approach to stimulus, fighting off protectionism.

Next, we have to make sure that we are all taking serious steps to deal with the problems in the banking sector and the financial markets and that means having a series of steps to deal with toxic assets and to ensure adequate capital in the banking sector.

Third, a regulatory reform agenda that prevents these kinds of systemic risks from occurring again and that requires each country to take initiative but it also requires coordination across borders because we have a global, we have global capital markets, and that will include a wide range of steps, additional monitoring authority coordination of supervisors and various countries dealing with offshore tax havens.

The G20 draft communiqué has been leaked to the FT and some directional clues are there.  While the debate on stimulus and protectionism are less clear there seems little doubt we will see more regulation and regulation that is sweeping in nature across countries, Banks and economies … some snippets here, but worth reading if interested to get full context in the 2 or 3 pages.

Reforming financial systems for the future

14. We recognise that weaknesses in the financial sector and in financial regulation and supervision were fundamental causes of the crisis. …

• to work closely and systematically, in accordance with the Financial Stability Forum framework, to supervise cross-border institutions and to complete the establishment of colleges of supervisors for all significant cross-border financial firms;

• to improve over time the quality, quantity, and international consistency of capital in the banking system. Capital requirements should not be strengthened until a significant and sustained economic recovery is assured and the transition managed to ensure that the extension of credit is not constrained. Regulation should limit leverage and require buffers of resources to be built up in good times which banks can draw down when conditions deteriorate;

• each of us commits to candid, even-handed, and independent IMF surveillance of our economies and financial sectors, of the impact of our policies on others, and of risks facing the global economy;

When I started this particular blog, my impetus was the lack of creativity amongst Banks in getting beyond automation of traditional transactions, and sticking them online [online banking].

Introduction « The Bankwatch

Introduction Saturday, 28 January 2006

Welcome to Bankwatch. The purpose of this blog is to monitor banks around the world for their online capabilities, and the strategies they are adopting with online. Consumers are web savvy now, and most banks aren’t, so I will point those out, and I will also recognise best practices too.

It might be useful to just take a look and see what progress has been made in just over two years. My general sense is not much progress amongst Banks, but enormous progress amongst non banks challenging the status quo.

Whatever progress, is now laid against the backdrop of threatened new regulation in UK, North America and others to place a cost on the political consequnces of bailing out Banks, and in particular investment banks who until now have been largely left to live and die on their own sword.

Disruption within financial services will not happen simply. The topic of regulation is always controversial, being one that Governments immediately leap to because it offers the pretense that they are making things better, even though the current credit crisis that the Banks are sufferring is one that occurred despite existing regulation and accounting guidance on the topic of off-balance sheet lending.

Banks are running scared at the moment, lacking trust to lend to each other, and simultaneously being concerned about revenue and expense growth at precisely the time they need increases in the former, and decrease the latter.

Yet customers are evolving and will continue to expect more and better online self service from Banks. No amount of denial can alter that. More and better in quantity, and quality. Services and offers that are more engaging, and work the way customers want to work.

Nothing about this time offers promise for customers from Banks. There is much promise in new startups, and we have the regulation cloud right in the centre of this epic battle.

So which Banks [or Credit Unions] show signs of life, and look to break out of the pack? That’s my question de jour. As I develop this meme, what suggestions and examples of Banks that ‘get the web lifestyle’ can you offer? [In particular Europe & Asia where language makes it harder for me to source.]