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First Look – UK Independent Commission on Banking report has a focus on new competition, but implementation will have practical difficulties

Executive Summary pdf 8 pages 0.4MB


Full Report pdf 214 pages 2.2 MB

The report begins by summarising the impacts of the financial crisis on the UK banks.

Table of Contents here

The overall impact is summarised here:

Despite recent de-leveraging, the total balance sheet of UK banks is more than four times annual GDP. More than 80% of RBS and more than 40% of Lloyds are in state ownership. Competition in UK banking has been seriously weakened as rivals to the largest retail banks have left the market or been absorbed into others.

The general approach has three objectives

Making the banking system safer requires a combined approach that:

  • makes banks better able to absorb losses;
  • makes it easier and less costly to sort out banks that still get into trouble; and
  • curbs incentives for excessive risk taking.

Too big to fail:

Banks ought to face market disciplines without any prospect of taxpayer support, but systemically important banks have had and still enjoy some degree of implicit government guarantee. This is the ‘too big to fail’ problem. Unless contained, it gives the banks concerned an unwarranted competitive advantage over other institutions, and will encourage too much risk taking once market conditions normalise. It also puts the UK’s public finances at further risk, especially given the size of the banks in relation to the UK economy.

On the ability to withstand shocks:

Banks must have greater loss-absorbing capacity and/or simpler and safer structures. … The Commission, however, believes that the most effective approach is likely to be a complementary combination of more moderate measures towards loss-absorbency and structure.

While Basel 3 suggests a minimum capital ratio of 7% the Commission suggests 10%.

In the Commission’s view, the available evidence and analysis suggests that all such banks should hold equity of at least 10%, together with genuinely loss-absorbent debt. That would strike a better balance between increasing the cost of lending and reducing the frequency and/or impact of financial crises.

And on the topic of international banks the Commission is sympathetic to the need to remain competitive;

Subject to that safeguard for UK retail banking, and recognising that wholesale and investment banking markets are international, the Commission believes that the capital standards applying to the wholesale and investment banking businesses of UK banks need not exceed international standards provided that those businesses have credible resolution plans (including effective loss-absorbing debt) so that they can fail without risk to the UK taxpayer.

And the first novel suggestion to rank depositors ahead of other unsecured creditors in a wind-down situation.

Loss-absorbency and stability might also be improved by ranking the claims of ordinary depositors higher than those of other unsecured creditors.

But the key question was how they would treat investment vs retail banking, and indeed as predicted they will not propose break ups, rather ‘ringfencing’  those parts of large banks.  This is an important paragraph, which leaves questions as to how it might work in reality.  (emphasis mine)

Ring-fencing a bank’s UK retail banking activities could have several advantages. It would make it easier and less costly to sort out banks if they got into trouble, by allowing different parts of the bank to be treated in different ways. Vital retail operations could be kept running while commercial solutions – reorganisation or wind-down – were found for other operations. It would help shield UK retail activities from risks arising elsewhere within the bank or wider system, while preserving the possibility that they could be saved by the rest of the bank. And in combination with higher capital standards it could curtail taxpayer exposure and thereby sharpen commercial disciplines on risk taking.

The report notes that retail and wholesale/investment banking can be distinguished, which is interested, since Martin Wolf who is on the Commission has been quoted as noting this is not feasible.

Separation between retail banking and wholesale and investment banking could take various forms, depending on where and how sharply the line is drawn. While mindful of regulatory arbitrage possibilities at the boundary, the Commission believes that there are practicable ways of distinguishing between retail banking and wholesale and investment banking.

For the most part, retail customers have no effective alternatives to their banks for vital financial services; hence the imperative to avert disruption to the system for their continuous provision. Customers of wholesale and investment banking services, on the other hand, generally have greater choice and capacity to look after themselves.

The Commission recognises the ultimate firewall would be to separate the types of banking into separate structures, however it notes the benefits of universal banking would be lost.  It is not clear what that means, and I will leave that for later analysis.  However it will require overall capital and loss-absorbing debt rules for universal banks, as well as for the sub division retail bank.  This will make for interesting reporting and also for definition of the rules between reporting periods.

The Commission is therefore considering forms of retail ring-fencing under which retail banking operations would be carried out by a separate subsidiary within a wider group. This would require universal banks to maintain minimum capital ratios and loss-absorbing debt (as indicated above) for their UK retail banking operations, as well as for their businesses as a whole. Subject to that, the banks could transfer capital between their UK retail and other banking activities.

The report then goes on to discuss improvements to competition.  One proposal in particular will drive bankers nuts.  They note that Lloyds has 30% of all UK current accounts.  So they are proposing a ‘quick switch’ methodology be provided within a reasonable timescale.

This Interim Report suggests that it may be possible to introduce greatly improved means of switching at reasonable cost, in which case the industry should be required to do this within a short timescale, and that barriers to entry may be able to be reduced.

Relevance to Bankwatch:

I got this summary from their length Executive Summary which reads more like a report, because I wanted to get an overview.  Now I have a better idea of what they are suggesting, I will dig into the main report, and have a better idea what I am looking for.

Meantime a couple of items to note;

  1. Ringfencing will be a bureaucratic reporting nightmare
  2. The quick switch idea to move accounts to a different institution is a non-starter in my view
  3. UK banks will be safer as a result of the increased capital requirements but so what – they are already nationalised.  Where is the direction to un-nationalise them.  That is what I am looking for.




Written by Colin Henderson

April 11, 2011 at 09:39

Posted in regulation, UK

Basel 3 (Basel III) details released

For the record here is the detail on Basel 3 (Basel III).  It is a positive step but it still means banks have a debt to equity level of 8.5 :1

BIS Press release and pdf.

High level taken from the pdf.

basel 3 1

Detailed schedule taken from the pdf.

basel 3 detail

Written by Colin Henderson

September 13, 2010 at 16:00

Posted in regulation

The fragility of the banking system – the final 2 days in the life of Wachovia in 2008

There is a statement today …

Statement of John Corston, Acting Deputy Director, Complex Financial Institution Branch, Division of Supervision and Consumer Protection, Federal Deposit Insurance Corporation on Systemically Important Institutions and the Issue of "Too Big To Fail"

that contains some very interesting facts, and side from he bureaucratic commentary there is a real sense of incredulity that this is how big banks are managed.

The overall message is excruciating detail is one of rationalising insufficient regulatory oversight existed to permit the FDIC to adequately monitor the situation.  It describes the nature of onsite examiners at FI’s with greater that $10 Bn in assets (news to me) and how they were able to determine in 2008 with limited information that Wachovia was deteriorating do to increased bad debts but also doubts about derivatives which were being traded not as a hedge but for house benefit.

No surprises so far, and sounds like a regulator.  Then despite the bureaucracy no sooner than 11 + days before the demise of Wachovia, FDIC got excited that there was a problem despite earlier warnings.

In early September 2008, the FDIC became increasingly concerned with the liquidity condition of Wachovia. During the week of September 15th, following the Lehman bankruptcy, Wachovia experienced significant deposit outflows totaling approximately $8.3 billion, representing a mix of deposit types, but primarily large commercial accounts. On September 23rd, senior executives and staff of the FDIC met to discuss our elevated concerns with the institution, specifically noting liquidity concerns including considerable contingent funding risk and increasingly negative market views on the firm. The institution’s marginal and weakening financial condition made it vulnerable to this negative market perception.

This is the point where the detective work goes from years to minutes in detail.  Early September 2008, FDIC met with Wachovia executive regarding ‘elevated concerns’.

Liquidity pressures on Wachovia increased the evening of September 25th when two regular Wachovia counterparties declined to lend to the firm.2 Since the institution was a net seller of Federal Funds this signal was not viewed by the OCC as a catastrophic development. As discussed in the next section, the failure of WaMu was announced late in the evening on September 25th. As of the morning of Friday, September 26, the OCC indicated to the FDIC that Wachovia’s liquidity position remained manageable. During the day, however, market acceptance of Wachovia’s liabilities ceased as the company’s stock plunged, credit default swap spreads widened sharply, and many counterparties advised that they would require collateralization on any transactions with the bank.

So now over a 2 day period from Sept 23rd to Sept 25th Wachovia encounters counterparties to their commercial paper that will no longer lend to Wachovia, yet the OCC (Treasury) signaled all remains well.

Wachovia’s situation worsened as deposit outflows on Friday (26th) accelerated to approximately $5.7 billion, $1.1 billion in asset-back commercial paper and tri-party repurchase agreements could not be rolled over, and $3.2 billion in contingent funding was required on Variable Rate Demand Notes.

Then the final kicker.

On the morning of September 26th, before U.S. financial markets opened for the day, the FDIC Board approved both the systemic risk exception and the acquisition of Wachovia by Citigroup. This proposed acquisition included government assistance in the form of an asset guaranty on a portion of Wachovia’s assets in exchange for $12 billion in Citigroup preferred stock and warrants. The terms of the asset guaranty called for Citigroup to absorb the first $42 billion in losses on a $312 billion segment of Wachovia’s assets with the FDIC covering any additional losses above that amount.

… …

In the end, the Citigroup transaction was superseded by an unassisted bid by Wells Fargo to acquire Wachovia that was announced on Friday, October 3rd.

Relevance to Bankwatch:

The moral of this saga is the speed that a bank can disappear.  On September 23rd FDIC determined Wachovia was in serious trouble and September 26th Wachovia’s fate was sealed.  The speed of this is astounding and certainly speaks to the inability of the system to determine earlier that a problem was brewing.  But the FDIC already ranked Wachovia as being in trouble earlier in September (“FDIC became increasingly concerned with the liquidity condition”).  Surely some earlier activity could have occurred, especially since even this blog knew there was a systemic mortgage problem 18 months before Sept 2008!

For me this really speaks to the fragility of the banking system and the banks.  It also speaks to the lack of teeth that the regulators have, or are willing to exercise.  Its an obvious fact that banks operate at the convenience of government.  No legitimate enterprise could otherwise operate with debt to equity of 20 :1 +/- and survive. This occurs by virtue of the money markets and direct connection with the central bank who effectively manage the liquidity positions of banks. 

So long as that is the system there must be better co-ordination of information with the regulator so that banks are kept honest and do not get into the kind of house trading that made Wachovia a high risk market maker rather than a market participant.  This participation is high risk market activity not associated with basic banking is why Wachovia deserved to disappear.  The flip side is that banks create sufficient capital depth that they can operate independently.

Written by Colin Henderson

September 1, 2010 at 21:40

The Magnetar Trade – otherwise known as ‘The Black Hole”

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)

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.

Written by Colin Henderson

April 17, 2010 at 20:46

The need for genuine transparency in security risk assessment | peer-to-peer lending as an alternative

This little nugget from Gillian Tett at the Financial Times last week brought a few thoughts into sharp focus.

Is this the lull before the storm for US mortgages?  |

For this spring, something of a paradox is hanging over the mortgage-backed securities world. At the end of this month, the US Federal Reserve is due to freeze its programme to purchase Fannie and Freddie agency MBS that it implemented in the wake of the financial crisis.

However, before anyone is tempted to crack open the champagne, they should think – once again – about that “displacement” effect. During the past two years, the full impact of the collapse of the securitisation market has been largely concealed from most investors – let alone American politicians – because of the sheer scale of government assistance on offer. In a sense, investors have been lulled into something of a false sense of security, because so much of the support has been highly complex – and thus hard to understand.

A simple question for investors.  How do you evaluate risk?  When the government stops backstopping mortgages, the entire risk onus lies on Funds and Banks.  Till now they have been operating under the assumption that the government was always there as lender of last resort.  There have been two recent outcomes of the banking crisis:

  1. interest rate returns have been driven to almost zero from unlimited Government liquidity
  2. risk management has had government participation as its central focus

So how does a portfolio manager assess the risk on mortgage backed securities on their merits?  This lost art has been traditionally based on assessment of economic indicators, unemployment rates, inflation rates, purchasing power, and historic assessment of ones own portfolio.

We have the interesting situation where most of those indicators have been and remain negative or at best in serious doubt.  Stock market performance is irrelevant in considering consumer debt repayment.  So how will portfolio managers assess the risk of those MBS when they come on the market following withdrawal of the Fannies.  Will they ignore them because they have to ability to assess the risk?

There has to be a better way to assess risk, that is based on the consumers’ underlying data.


The problem with MBS (Mortgage Backed Securities) and any other ABCP (Asset Backed Commercial Paper) lies in the design.  It is a black box of consumer debt that is only has good as the bank which bundled it.  Bank A may have had a good record of MBS, so you choose to invest.  But really you are investing in the underlying promises from Bank A such as first loss, or making good on defaults beyond x%.  All this despite the fact that these securities are off Bank A balance sheet, but that’s a whole other post.

So really the risk is assessed based on gut feel for promises from Bank A and the economy.  There is not direct assessment of what matters – the borrowers contained in the MBS.

Enter peer-to-peer lending.  A set of loans in peer-to-peer lending services are not bundled.  Rather investments are made directly in the loans with platform capabilities enabling bulk purchases based on lender criteria.  But that criteria is assessed directly on the missing element from MBS – the borrower characteristics.  Lenders can see individual and aggregate debt service ratio’s debt levels, income levels, and stability indicators such as marriage status, home ownership, time on job etc.

Internet technology allows rapid assessment of many characteristics, with real-time updates.  Further the risk assessment is ongoing and while watching the evolution of the portfolio of borrowers.  What would have made this impossibly inefficient pre internet pervasiveness is now possible.

When we speak of transparency with peer-to-peer lending, this is in complete opposition to the ultra opaqueness of the MBS referred to earlier.

Going back to the dilemma confronting portfolio managers this spring – how will they assess risk?

Written by Colin Henderson

March 14, 2010 at 19:14

Posted in regulation

Securitization is nothing more than unrecorded leverage

I could not agree more with this quote from Niall Ferguson.  The problem is leverage, and securitization is nothing more than leverage that is not appropriately recorded on the balance sheet.  There is no amount of regulation, bank taxes or bonus taxes that will decrease the propensity for the next crisis until that simple recognition is agreed.

Niall Ferguson: This Crisis Didn’t Happen Because Banks Were Too Big | Clusterstock

"I don’t think it was really the banks’ involvement in hedge funds that were nearly as much of a problem as banks involvement in securitized MBS collateralized debt obligations."

Written by Colin Henderson

January 30, 2010 at 13:59

Real Time Solutions for US Financial Reform | NYU Stern Working Group on Financial Reform

On Vox, the authors noted have a new ebook (pdf) that paints a quite complete picture of the elements for consideration in financial services regulatory reform.

Real Time Solutions for US Financial Reform

Viral Acharya Thomas F. Cooley Matthew Richardson Ingo Walter
15 December 2009

The NYU Stern group – authors of the influential book Restoring Financial Stability: How to Repair a Failed System – have completed a new ebook that assesses the strengths and weaknesses of the US financial reform legislation. This column introduces the new ebook.

FYI, here is the ToC.  Click through for the book in pdf.


Chapter 1. Summaries
Section 1 – U.S. Financial Architecture
2. The Architecture of Financial Regulation
3. Central Bank Independence and the Role of the Fed
Section 2 – Systemic Risk
4. Measuring Systemic Risk
5. Managing Systemic Risk
6. Taxing Too-Big-to-Fail Institutions
7. Capital and Liquidity Requirements
8. Is Breaking Up the Big Financial Companies a Good Idea?
9. Contingent Capital
10. Financial Institutions Subject to the Bankruptcy Code
Section 3 – Institutions
11. Money Market Funds: How to Avoid “Breaking the Buck”
12. Hedge Funds and Mutual Funds
13. Toward a New Architecture for U.S. Mortgage Markets: The Future of the
Government-Sponsored Enterprises
14. Insurance Industry
15. Regulation of Rating Agencies
Section 4 – Markets
16. Regulating OTC Derivatives
17. Securitization Reforms
Section 5 –Governance and Consumer Protection
18. Consumer Finance Protection Agency: Is There a Need?
19. Regulation of Compensation and Corporate Governance at Financial Institutions
Section 6 – Accounting Issues
20. Bank Regulators Should Not Meddle in GAAP
21. Banks’ Loan Loss Reserving
22. Market Illiquidity and Fair Value Measurement

Written by Colin Henderson

January 24, 2010 at 20:33

On Bank Systemic Risk, International Integration and Capital Requirement | Turner Discussion Paper

There has been much talk of systemic risk since the financial crisis hit. I see it more as a crisis of banking and banking confidence, and the debate on systemic risk is critical because it exists because of Government intervention and protections, implicit and explicit. The latest from Lord Turner of the FSA is a discussion paper, that reviews systemic risk and provides as good a discussion on that topic as I have seen.

What it particularly interesting is how the insights raise the prospect of penalising globally integrated banks over nationally independent organizations with higher capital requirements. Things just got more complex for decisions on integration.

DP09/4: Turner Review Conference Discussion Paper | FSA

3.18 In general terms, a firm is systemic when its collapse would impair the provision of credit and financial services to the market with significant negative consequences for the real economy. The factors which make firms systemically important fall into three categories (although firms may combine elements of these factors):

  1. systemic by size. This can be a function of the firm’s absolute size or in relation to a specific financial market or product in which a firm is particularly dominant. The channels through which systemic risks would crystallise as a result of the failure of such a firm include: losses to uninsured creditors and depositors through high bankruptcy costs and reduced recoveries; disruption to financial services (such as to payments, clearing and settlement, extension of credit); and losses to insured depositors because the DGS could not pay out sufficiently quickly or because the aggregate payout imposes unsustainable costs on those who fund the DGS. In addition and crucially, systemic risks can take a macroeconomic form, with the loss of credit extension capacity leading to, or exacerbating, a downturn in economic activity which then has consequences for the rest of the financial system.
  2. systemic by inter-connectedness. Links and inter-connections can include, inter alia, inter-bank lending, cross holdings of bank capital instruments, membership of payment systems, and being a significant counterparty in a crucial market. The channels through which such problems manifest themselves include:
  • interbank exposures. The domino effect where the collapse of one firm leads to
    major losses at others, and then in turn leads to their collapse. This can then
    trigger a chain reaction;
  • the confidence channel. The collapse of a systemically important firm leads to a
    crisis of confidence in financial markets. The confidence channel is particularly
    important to the ‘systemic as a herd’ category (see below), given the perceptions
    by the market that a number of firms are exposed to the same set of risks;
  • the asset margin spiral channel. Firms increasingly finance themselves through repo
    and reverse repo arrangements. The haircuts charged on the collateral underlying
    these contracts dictate the extent to which firms can leverage themselves. In a crisis,
    both funding conditions and credit concerns will lead counterparties to increase
    haircuts, triggering a deleveraging process. This will in turn be disruptive, through a
    self-reinforcing spiral between lower market liquidity and funding liquidity.
  1. systemic as a herd. The market can perceive a group of firms as part of a common group (for example, because they have a similar business model, such as building societies in the UK and the savings and loans banks in the US), or common exposures to the same sector or type of instrument. A single firm in this group may not be systemic in its own right, but the group as a whole may be.

turner discussion paper oct 09 dp09_04.pdf

Written by Colin Henderson

November 2, 2009 at 20:15

Posted in regulation, UK

Tagged with , ,

US releases draft regulatory framework for Financial Institutions

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

Written by Colin Henderson

June 17, 2009 at 09:05

Posted in regulation

Tagged with , ,

Bank capital levels around the world are low and sufferring

The IMF report had a spreadsheet in the appendix with bank capital levels around the world.

While it has individual countries, I summarised into this chart.  The data shows Capital as a percentage of Assets so higher is good, lower is bad.

Note the negative trends in most except Canada, and this is based on the latest data to end of 2008.  Use the thumbnail for a larger version that is clearer.



Written by Colin Henderson

April 21, 2009 at 11:46

Posted in regulation

Tagged with , ,

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