The Bankwatch

Tracking the consumer evolution of financial services

Posts Tagged ‘regulation

Real banking innovation requires separation of basic banking from the rest of financial services

Reading Competition creates a Race to the TOP: The EU should seek Liberalisation not Harmonisation over at the thoughtful “The Extended Society” blog, and some of the other links there such as this at the Economist, got me to thinking more about regulation of financial services.

The Dodd-Frank act | Economist  [emphasis mine]

The law that set up America’s banking system in 1864 ran to 29 pages; the Federal Reserve Act of 1913 went to 32 pages; the Banking Act that transformed American finance after the Wall Street Crash, commonly known as the Glass-Steagall act, spread out to 37 pages. Dodd-Frank is 848 pages long. Voracious Chinese officials, who pay close attention to regulatory developments elsewhere, have remarked that the mammoth law, let alone its appended rules, seems to have been fully read by no one outside Beijing (your correspondent is a tired-eyed exception to this rule). And the size is only the beginning. The scope and structure of Dodd-Frank are fundamentally different to those of its precursor laws, notes Jonathan Macey of Yale Law School: “Laws classically provide people with rules. Dodd-Frank is not directed at people. It is an outline directed at bureaucrats and it instructs them to make still more regulations and to create more bureaucracies.” Like the Hydra of Greek myth, Dodd-Frank can grow new heads as needed.

At Extended, Henry makes the point that we need less regulation, not more.  This will he argues, prepare financial markets for life in the wild and we will be the better for it because

“Competition creates a Race to the TOP”.  This is an admirable argument, and in a green field situation when designing markets from scratch, as in the Amsterdam 1602  example provided, makes eminent sense.  That is not the case today.

That said, I would not advocate strong deterministic regulation that is politically nor socially motivated.  That is for smarter and folks, and not for this blog.  What is for this blog is a closer look at what financial services has learned and actually needs based on experience of the last 4 years in particular and how we got here.

What is regulation, and what is expected of regulation?

The purpose of regulation is presumably at its core is to provide control and protection of citizens.  At least that would be the basic belief of free market advocates.  Where regulation becomes shakey and on much thinner ground is when it is used to reshape society, business or groups of people.  This is the realm of social democrats whose desire is to make life better for certain segments.

This is where Dodd-Frank and EU Financial Directives are straying into dangerous territory that is fed by news headlines.  They are designing regulation in the name protection, yet there is an almost emotional aspect;  the one that focusses on bonuses as the largest example, but including prima donna chief executives, and general corporate greed.

Yet despite the relatively light 118 pages that made up the US banking system and which reduced by 37 when Glass-Steagall was repealed, we still had the 2008 crash.  Where the thinking falls off the rails, is that by adding 10 times more pages that the problem will be solved.

One of the largest fears exhibited by smart thinkers at the 2009 Davos meeting was that new regulation cannot be designed to solve problems that are in the past.  They should be, the argument went, be designed to solve future problems and provide stability.

This led to the entire Too Big to Fail discussion, and enormous bailouts and quantitative easing combined to kick the proverbial can down the road such that we are now dealing with a new problem.  We have the pre 2008 system with its global system of financial entangled products that far exceed commercial trade, now layered on with financial organisations that are so large that any one going down, would be so catastrophic in and of its self, even without the aforementioned global entanglement.

What regulation do we need, and what regulation are we getting?

At a high level, and having watched the events play out for the last 4 years, it seems quite clear, at a high level, that we need regulation that will accomplish 3 things:

  1. A soft landing break up of large financial institutions
  2. A soft landing unwinding of the consumer debt cycle, and (the 64 thousand $ question)
  3. A firewall between Government borrowing and the risks associated with points 1 & 2.

Instead the EU is looking at a myriad of rules that seem to be mirrored on Dodd-Frank.  The French are also pressing for a new tax on financial investment activity.  These are rules guaranteed to provoke unintended consequences that will have no bearing on the problems that need to be solved.

Why not do this:

  • Isolate a section of banking for consumers that seek it from financial risk. There was a time, and it was only 5 or 6 years ago depending on which country where deposits up to $60K – $100K had a government guarantee through the Federal Deposit Insurance Corp (or Canadian Deposit Insurance Corp, or UK £85,00 – wikipedia – deposit insurance).  While these legal limits remain, no-one believes it.  Everyone assumes entire banks and their deposits are protected.   The result is that trust is now focussed upward to Government and now the question is which government do we trust with our money?
  • Time to change that, and make it clear anything outside the deposit schemes are NOT protected.  This takes one line of regulation but has the largest potential impact.  If I was in government, I would insist on the Volker Rule/ Glass-Steagall to backstop this provision.
  • Keep regular consumer debt inside the utility banks.  The technocrats will figure it out with debt reductions, consumer proposals, debt re-arrangements.  Fancy words that will align real consumer debt with the allowances on the banks’ balance sheets.  Think 10 – 15 years; it can be done.
  • Fix Basle 3x to treat sovereign debt like any other debt.  Let analysts look at the debt servicing capacity of the nation, and determine the interest rate, or even whether to participate.  You will see the Eurozone rapidly decide who is in or who is out.
  • Peripheral point.  The Euro zone must be broken up.  This Euro currency is the dream of central European bureaucrats.  There is no basis in reality, nor popular expectation that aligns the bureaucrats dream with the average person.  There is too much mixing of disparate objectives (freedom of work, freedom of movement, social equality, none of which squares with the local pressures felt and political objectives required of the individual countries.

This would bring us to a period of utility banking.  Boring.  Just like buying water, and electricity.  But it is there for those that prefer the security of those basic services, which I would suggest are likely the majority of people.  When people go to the grocery store, or pay their phone bill they need to know the money that was there yesterday is still there.  This is the definition of utility banking, and even the richest person needs to know his debit card will work tomorrow.

Beyond utility banking, there are many with investments that seek additional return and they can look outside the utility banking framework.  Then there are another group with super investment needs.

Beyond utility banks let the remainder organisations create diverse and no doubt novel products that offer the services, returns and whatever else the customers desire.  They will succeed or fail; this is no matter for government.  Let these organisations design their products to attract utility bankers other needs beyond day to day payments, through novel design and products that provide a balance of risk and reward which fits with their customers risk profiles’.

A final point to note.  These risk-taker banks will be initially very attractive to governments (think London vs Paris) and governments will be motivated to design tax positive zones to attract them.  Let them.  Provided the three principles above are embedded it is their risk (and their citizens) to take on, but it is NOT the risk of other countries to support them.  (Euro-desingers take note.)

Relevance to Bankwatch:

Thank you Henry for focussing my thinking on the underlying problem with regulation.  Bureaucrats are making it at best too complicated and at worst wrongly directed.

There is no hope for banking innovation in my mind, until we first separate basic banking from the rest.  Only then can we have clarity of strategy and design on services that are either risky or risk free.  The amalgam we have today is more like a social safety net, that no-one believes nor trusts.

Written by Colin Henderson

February 20, 2012 at 16:23

Posted in Uncategorized

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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

Big banks might move to Hong Kong | FT

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.

Written by Colin Henderson

January 4, 2010 at 08:48

Plan for Sound Banking – Conservative White Paper | analysis

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.

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.


Written by Colin Henderson

July 20, 2009 at 16:01

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 , ,

Canada and India develop regulation proposals for G20

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

Written by Colin Henderson

March 31, 2009 at 22:43

Posted in Uncategorized

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G20 draft communiqué & FT interview with Obama indicate more regulation coming to Banks

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;

Written by Colin Henderson

March 29, 2009 at 20:29

Posted in regulation

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Two years on | Which banks understand the web lifestyle?

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.]

Written by Colin Henderson

March 30, 2008 at 17:16

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