The Bankwatch

Tracking the consumer evolution of financial services

When will it all end? | the answer has to begin with smart banking regulation

I just finished a conversation with a colleague on the West Coast of the US who it turns out is a reader of this blog, so thank you for that.

The topic was the dire nature of the news, and in particular the emails from RBE (Nouriel Roubini) which are consistently bearish, and with the timing of those emails coming in late at night, this can contribute to sleep deprivation from worry.

Aside from the potential for re-scheduling the emails, it made me reflect on what is missing in all this economic crisis, and how it is different than what the memories of the majority have in their experience. 

When will it all end?  That is probably the best summary of the question on the minds of most, so a continual flow of negative information does not bode well in offering answers to that question.  At best some glimmer of good news such as an uptick in month over month car sales such as we saw in Canada today.  Of course that is meaningless, since the month in comparison was so low, it was hard to go lower.

Then I saw this leader in the Financial Times over lunch wherein Angela Merkel continues with her consistent refrain that we ought to focus on regulation.  It is notable that she said this the day after the US government announced a $1.2 trillion liquidity boost, which just sent investors scurrying for commodities, due to renewed concerns about inflation.

Merkels point is that the unintended consequences of government stimuli are worse than the problem that needs to be addressed.

“What we need is for [the April 2 G20 summit in London] to send a strong psychological signal. We should not be competing for the most unrealistic fiscal stimulus,” Ms Merkel told parliament before she travelled to Brussels for a European Union summit.

I believe she is right.  The missing element in all this is certainty.  Absolute certainty will never be achieved within financial markets but the current mess is getting worse, not better.  As Niall Ferguson points out repeatedly, this is a crisis of debt that we are experiencing.  That includes consumer debt, corporate debt, and financial institutional debt, the latter reflected in their unspeakably high debt to equity levels of 20 or 30 : 1. 

If we follow the logic flow those highly levered banks cannot deal with write downs on the highly levered consumers and corporates.  That stalemate produces inaction within the private sector, so the government jumps in.  However the government has jumped with both feet into the wrong swimming pool.  The current track of investment in financial markets to impose liquidity will simply be absorbed by the banks, and meantime, there is still no action on the debt problem.  And so in an attempt to restore confidence in markets, the government resorts to investment in bank equity, with no restrictions on the current bank management.  Again there is no clear apparent benefit to this and the only outcome expected now is that the banks will become wholly government owned, at least the large banks.

This underlying concern and worry can be characterised by questions about how the government will operate banks better than bankers will.  Nothing to date suggests and improvement, and in fact the concerns about bankers is systemic and global.  If everyone is running around stealing things, more police won’t fix it – firest people must know that stealing is wrong and brings penalties.

Returning to Merkel – her focus along with her lone colleague on this, Sarkoszy, is designed to provide a framework for certainty within the financial services industry.  For example (my example, not hers) …  the new regulation could require banks maintaining target leverage at no higher than say 4 : 1, with steps required each year to get there.  Incidentally would still be far higher than the Merchant Banks of the 1700’s but just say that was the target. 

First of all, every bank in the world today would be in contravention of that target, and some so far off that they cannot meet the steps.  You might see Governments stepping in with 100% administrative control of those banks to ensure stability and while they rework their balance sheets. 

After leverage regulation, next, derivatives should be made illegal.  The banks could either take on the asset associated with the derivative but only if those with liabilities take it on as debt.  Otherwise they just disappear and are ordered to be written off.  This would eliminate nearly $ 1 quadrillion (1,000 trillion) in world debt all of which is off balance sheet, and remains the smoking gun of this depression.  The result would be greater certainty and in theory limited impact on balance sheets, although their would be other consequences.

These two simple regulations would produce a dramatic shift and singular focus on strategy designed to break up large banks, sale and write-down of assets to develop a new base line from which to create a credible and believable capital base.  We would see a return to calm step by step back to basics banking.

Relevance to Bankwatch:

The point remains that regulation does not have to be burdensome – it has to be smart, clear and understandable, unlike the Basle Accords, which should be torn up.  The development of new regulation would produce rational business outcomes, instill confidence in those banks that get to target first, and generally produce a clear way ahead with a framework for others (consumers, corporate and governments) to understand how to plan.   Banks would also know how to plan and their strategies would be immediately measureable.

Then and only then would business certainty begin to return to the economy – it has to begin with the banks.  Then and only then the question, “when will it end” might have some answer, and allow my west coast friend to sleep at nights.

Written by Colin Henderson

March 20, 2009 at 14:11

Posted in Uncategorized

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