Regulation

This post is a bit off-base from what I normally write about.

There is a regulatory battle currently going on in Washington pitting the (largely Wall Street-friendly) Treasury against the (largely FDIC-friendly) Democrats, led by the enigmatic Barney Frank. Much has been discussed elsewhere about the pros and cons of reviving the Depression-era Glass-Steagal Act, so I won't go into too much detail there. However, I will put forward a simple counter-argument to claims by those (such as Gordon Brown) that reviving the Act won't help, because Northern Rock was a retail bank and Lehman Brothers was an investment bank, yet they both failed. This argument neglects to consider the impact of the ability to use balance sheet: commercial banks could offer their balance sheets in securitisation and debt/equity issues, whereas investment banks could not. So investment banks were forced to move into ever-risky ventures, while in moving into the securities & derivatives business, commercial banks were putting their own balance sheet at significant risk. Furthermore, the march of financial innovation encouraged their retail arms to lend to more risky entities and the ability to sell these as ABS allowed them to feel much more comfortable with high LTVs and borrow more on the wholesale markets. It is blatantly obvious to anyone with a brain that abolishing Glass-Steagal digitally increased the aggregate risk the financial system was able to take, as well as increasing its interconnectedness.

But that is not the only problem. The increasing march into exotic derivatives as well as the exponential growth of dealer inventories of derivatives overtook the expenditure on internal infrastructure. As an example, several booking, settlement and payment systems for derivatives at some institutions are nearly 20yrs old! These creaking systems have been gradually updated by "bolt-ons" and "sticky-tape" solutions but they could not keep up with the ever-increasing back-log of trades. I would expect that the problem is even worse in the very large banks that have endured years of mergers. It does not help that morale in back-offices is usually very low. IT and infrastructure spending increases to modernise this archaic structure needs to be significantly increased.

Furthermore, there is no real industry standard for valuing even the most vanilla of OTC derivatives - an issue that becomes exceptionally complex when taking into account counterparty risk and Mark-to-Market collateralisation. Listing vanilla derivatives on exchanges removes this complexity, increases price transparancy as well as significantly reducing interconnectedness in financial markets. I have witnessed several attempts by the exchanges to introduce contracts that very closely replicate such OTC instruments, but the banks have repeatedly stonewalled. If we are attempting to change the regulatory structure in order to reduce systemic risk, there is simple no excuse for not doing this.

Exotic derivatives, and more custom derivatives, are of course a different story. However, moves such as JPMorgan's release of its CDS model into the public domain should help to gradually establish some valuation standard. Regulators should aim to insist full collateralisation of mid-point valuations of the two counterparties, and for uncollateralised transactions insist that capital charges are adequate. I note that many banks have now set up Credit Valuation Adjustment (CVA) desks - these attempt to try to hedge firm-wide credit risk on uncollateralised MTMs in the interdealer derivative market. Some banks have also introduced P&L accrual rules on longer-dated trades. These are steps in the right direction.

The Frank proposal (which is heavily influenced by the FDIC) is to set up a systemic institution resolution fund, and Geithner's argument that having it there will merely increase moral hazard does not really stand up. The Frank proposal aims to discourage firms from being Too Big To Fail - surely this is a good thing? There are plenty of examples of the "financial supermarket" model failing: American Express, Travellers, Citi, RBS etc. As Mervyn King once said (and I am far from his biggest fan), "Too big to fail is too big to exist". It really is that simple.

The leverage issue is far more complex. There are far too many examples in history of financial systems becoming over-leveraged and becoming the epicentre of financial crises - if you haven't already read it, Kindleberger's "Manias, Panics & Crashes" will supply those examples. The key issue is that individual banks exhibit no control over systemwide credit creation - they only care about maximising their own profits, so it natural that they will lend as much as they can in order to make more money. In absense of competitors, their lending decisions will be "prudent", but the introduction of competition encourages lending to riskier ventures. There is nothing wrong with that per se, but notice that the overall amount of credit creation is larger in this case. There is plenty of evidence that government allocation of resources is suboptimal, however, government control of aggregate credit creation could be one sensible means of preventing overleveraging and asset bubbles. In such a scheme, the Fed could target credit growth in aggregate use Window Guidance to divide this up between banks, who would then use their individual expertise to decide which entities to lend to. This leaves lending decisions to the free market and macroeconomic policy in the hands of the (supposedly) independent central bank. Of course, the dividing up of growth targets is an issue here as banks are incentivised to go for market share, which is the main problem with the strategy. An alternative suggestion has been for counter-cyclical capital requirements and leverage ratios which is similar to the above in that it tries to indirectly control credit creation by by "leaning against the wind". This, too, is a no-brainer.

Changing topic slightly, it is striking how much legislation has been proposed globally over the past few weeks on the regulation/bonus/banker-bashing front. I can't help but think that recent stories of bankers calling up estate agents and scooping houses up, and a seeming determination to pay bonuses "come what may" in the face of such outrage has brought this on. Governments in their bailouts were generally hands-off in the face of popular demands for bonus curbs, relying on merely capping bank Boards' pay. But the "business as usual" attitude of the past few months has embarrassed politicians into action, and for that, we all will suffer. It never ceases to amaze me why bank employees were not issued large amounts of equity capital in place of cash bonuses, aimed at replacing depleted capital, allowing cleansing of balance sheets and ultimately a break of ties with their State owners. In such a situation, pre-provision earnings would result in these bank share prices flying, reaping rewards for all stakeholders: employees, management and taxpayers. Sigh. I digress...

The Belgian windfall tax on bailed-out bank profits was swiftly adopted by the French - a country with a significant market share of global banking - and now there is no longer a worry that "he who regulates first loses market share". The latest incarnation of bailouts of RBS and Lloyds appear purely designed to kill their investment banking arms. Whether or not they find loopholes allowing them to pay bonuses, these are likely to find their way into the press and create political firestorms. Such institutions will not be able to fight for talent and they will go back to being "boring utility banks" following the 3-4-3 model. This seems to be "de facto" Glass-Steagal. Coming on the back of the break-up of ING, it is clear that there is now no real obstacle to breaking up large institutions in the US either. The Frank legislation comes on top of these.

Regulators are getting serious.