Posts Tagged ‘Banking regulations’
Trust and leadership

It’s good to see the issue of trust and leadership being promulgated by a main street bank to its shareholders. If we are to change course before our societies experience the equivalent of an “alcoholic hitting bottom” we need more messages of the type sent by Robert G. Wilmers to his shareholders. Highlights include:

The economic crisis that began in the fall of 2007 implicated a wide range of institutions – not only bankers but their regulators, not only investors but those paid to advise them, not only private finance but its government-sponsored kin. The wide spectrum of the culpable has left the U.S. and the world with a problem which, although related to the financial crisis, transcends it and must be confronted: the decimation of public trust in once-respected institutions and their leaders. This has created a fear among those responsible for forming the rules and standards that shape the American financial services industry. And the outcome of this fear-driven rulemaking is likely to burden the efficiency of the American financial system for years to come and will potentially have broader implications for the overall economy.
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These trends all came together in 2008 with the sub-prime crisis, characterized by Wall Street banks betting on and borrowing against increasingly opaque financial instruments, built on algorithms rather than underwriting. Like the institutions of the ’80s, the major banks created investments they did not understand – and, indeed it seems nobody really understood. In the process, they contorted the overall American economy. The unnatural growth in the industry led the portion of GDP dedicated to insurance, finance and real estate to rise from 11.5 percent in 1950 to 20.6 percent during the decade that began in 2000. Page xv

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Since 2002, the six largest banks have been hit by at least 207 separate fines, sanctions or legal awards totaling $47.8 billion. None of these xvi banks had fewer than 22 infractions; in fact one had 39 across seven countries, on three different continents. The public, moreover, has been made well aware of such wrongdoing. According to a study done by M&T, over the past two years, the top six banks have been cited 1,150 times by The Wall Street Journal and The New York Times in articles about their improper activities….

Public cynicism about the major banks has been further reinforced by the salaries of their top executives, in large part fueled not by lending but by trading. At a time when the American economy is stuck in the doldrums and so many are unemployed or under-employed, the average compensation for the chief executives of four of the six largest banks in 2010 was $17.3 million – more than 262 times that of the average American worker. One bank with 33,000 employees earned a 3.7% return on common equity in 2011, yet its employees received an average compensation of $367,000 – more than five times that of the average U.S. worker. Thus, it is hardly surprising that the public would judge the banking industry harshly – and view Wall Street’s executives and their intentions with skepticism. Page xvi

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The Wall Street banks continue to fight against regulation that would limit their capacity to trade for their own accounts – while enjoying the backing of deposit insurance – and thus seek to keep in place a system which puts taxpayers at high risk. In 2011, the six largest banks spent $31.5 million on lobbying activities. All told, the six firms employed 234 registered lobbyists. Because the Wall Street juggernaut has tarnished the reputation of banking as a whole, it is difficult if not impossible for bankers – who once were viewed as thoughtful stewards of the overall economy – to plausibly play a leadership role today. Inevitably, their ideas and proposals to help right our financial system will be viewed as self-interested, not high-minded. As noted before, however, the major banks were not the only ones implicated in and tainted by the financial crisis. One can, sadly, go on in this vein to discuss a great many other institutions which have disappointed the American public in similar ways, in the process compromising their own leadership status. Page xvii

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The crisis was orchestrated by so many who should have, instead, been sounding the alarm – not only bankers but also regulators, rating firms, government agencies, private enterprises and investors. That a former U.S. Senator, Governor and CEO of a big six financial institution was at the helm of xix MF Global on the eve of its demise due to trading losses, or that the largest-ever Ponzi scheme was run by the former chairman of a major stock exchange will long be remembered by the public. The repercussions have stretched beyond banking, creating an atmosphere of fear affecting and inhibiting those who should be leading us toward a better post-crisis economy. Page xix.

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In designing regulations, the sort of informal conversations with private institutions and individuals, which were once routine, might now be viewed as suspect, leaving regulators to operate in isolation, without thoughtful guidance as to the overall impact of their actions. When all are suspect, no conversation can be viewed as benign. Ultimately, however, this is neither a recipe to improve public confidence nor a situation likely to facilitate the expeditious design of a regulatory structure which will not hobble the extension of credit. One must be concerned that a lack of leadership and trust, and an overreliance, instead, on the development of policies, procedures and protocols, has created a level of complexity that will decrease the efficiency of the U.S. financial system for years to come – and hamper the flow of trade and commerce for the foreseeable future.

The effects on a community bank such as M&T prove to be significant. The cost of compliance with the multiplicity of statutes, standards, and other government mandates under which a comparatively uncomplicated bank like xx M&T must operate has been tracked and discussed in these Messages for nearly a decade. The news, however, is not getting better. These costs have risen from roughly $50 million in 2003 to $95.1 million in 2011. Add to this, the insurance premium we pay to the FDIC, to maintain and replenish the Deposit Insurance Fund used to liquidate failed banks and repay insured depositors, which increased from just $4.5 million in 2006 to an annualized rate of $107.7 million at the end of 2011. New edicts, which limit our ability to pay overdrafts incurred by customers (Regulation E) and impose price controls on debit card interchange fees (the Durbin Amendment), will reduce our revenues by an estimated $139.8 million on an annualized basis. In total, our likely tally of annual compliance cost and revenue lost from these regulations is $342.6 million and would have represented 28% of pre-tax income in 2011. Page xix

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By virtue of having more than $50 billion in assets, a measure of size, with no consideration given to the activities in which we engage nor the merits of our actions, M&T has been deemed to be a “systemically important” financial institution and will be subject to higher capital standards as well as costly new liquidity requirements.

A common feature of many of these new directives is a higher order of complexity than had heretofore been typical, particularly for Main Street banks like M&T which do not engage in excessive risk-taking and rely on fundamental banking services as their primary source of income. Utilization of these opaque and intricate methods as a means to prevent a crisis is at best questionable. It is worth keeping in mind that prior to the financial crisis, the Basel Committee had introduced Basel II international banking standards, which among other things xxi endorsed the use of complex financial models to measure the risks associated with on and off-balance sheet exposures – so-called advanced measurement approaches. These standards proved wholly inadequate in the crucible of the financial crisis. Yet today, despite these failures, models have become more embedded into both regulation and basic accounting, a change which implies substantial increased cost.

It is no small irony – it is, dare I say, a bitter one – that these costly requirements have been visited on a company such as ours and hundreds, if not thousands, like us who did little or nothing to cause the financial crisis – and were, in fact, in many ways victims of it. And, of course, the higher costs along with higher capital and liquidity requirements will inevitably diminish the availability and increase the cost of credit to business owners, entrepreneurs and innovators of our community.Page xxi

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The proposed Basel III liquidity rules, for instance, call for banks to significantly increase their investments in government securities, leaving less capital for community-based loans which hold the most promise for potential economic progress. Such an unintended outcome is reminiscent of that which emerged from the 1992 Basel Accord, providing an incentive to invest in government debt, whether domestic or foreign, and in highly-rated derivative securities of all types including those backed by residential mortgages – all of which turned out to be more, not less, risky. The presumption that certain prescribed assets would inherently carry less risk, a thesis clearly disproved in the recent crisis, along with the new proposed minimum level of government bond holdings, would continue the trend of driving resources away from commercial lending – with negative ramifications for fulfilling legitimate credit needs.

New formulae from the FDIC are likely to have similar inadvertent consequences for the economy. Last spring, the FDIC began assessing insurance premiums based on assets rather than deposits, which it had done since its inception in 1933. As a result, a loan to finance the construction of a company’s new building, an activity that produces jobs, carries insurance premiums that are three to four times as high as for commercial loans extended for unspecified purposes with no need for employment creation – arguably the greatest necessity of the current economy. Even more troubling is the fact that, under this formula, the mere association with real estate deems construction lending more risky regardless of how sturdy one’s underwriting or how much “skin in the game” the entrepreneur is willing to commit. Page xxii

I can’t in good conscience paste more.  Read the whole thing from Reflections on the State of Banking and the Leadership Crisis on page x.  Don’t forget many of the community banks argued against TARP. They wanted capitalism to do its thing and punish those who made poor decisions and reward those who made correct ones. Silly them, in modern America wise decisions are those which capture the regulatory and legislative class, not those which efficiently deliver products in a free market. It’s so much more profitable to suckle on the taxpayer teat than earn your rewards in a free market. Manipulating structure in which you operate is just one more area of competition. But unlike competition in a market it often results in a consumer loss rather than a consumer surplus.

Wilmers analysis highlights a fundamental problem with both national and international banking regulatory frameworks. They centralize decision making. As such they suffer from the faults flagged by Hayek and manifested in the disasters of centralized socialist planners everywhere. In life there are inevitably unforeseen consequences. A centrally imposed solution means all make the same mistakes; while in a free market some will have done something different and will profit from the unforeseen state of the world. Devolved systems are inherently more robust than centralized ones. Global regulations like Basel of necessity create global systemic risks which inevitably manifest themselves in global catastrophes. It is just a matter of time. This failing is not limited to finance. It is generally applicable and provides one more reason to oppose moves toward one world government. Measures such as the embryonic global carbon dioxide emissions trading schemes and United Nations anti copyright measures will almost certainly be fundamentally flawed.

As for the current state of financial regulation, shame on our legislators and shame on the economists who gave them cover. Being the lackeys of bankrupt ideologies is nothing to be proud of. It certainly does not warrant comfortable sinecures. It’s time to clean out the academic and political Augean stables. When people realize what what we have lost there will be rivers of tears to divert to the task.

 
Uncovering covered bonds

The proposed government changes to the financial services are terrible policy. They will increase the weight of money going into housing compared to what would otherwise be the case. This effect may not manifest itself immediately, but it will when a bubble next gets going. Investment banks will get fees structuring products, some lucky people will exit the market at the right time (turning points are not predictable, so the best timing will result from luck). Most will find themselves in a similar spot to Americans, but without the option of sending in the keys. They will enter bankruptcy or spend much of the rest of their life with a crushing debt load. Nice.

Politically it could delay the Australian downturn. There is a lot of money in superannuation and it could replace Chinese demand for our housing. Because the super investments will be going into unproductive assets, the economy will not generate sufficient wealth for the retired people to live the life they are expecting, as per America. No matter what nominal balances may suggest in the interim. Super should go toward digging holes, growing or processing things. It would be nice if we could make something as well. We will not be a wealthy country on the back of flipping houses to each other, no matter how high a proportion of each flip is captured by the financial sector.

Of course on the political side, if they can’t inflate housing enough to counteract the effects of the Chinese purchase slow down, they are gone. It’s a bit like Bush kicking the can down the road. But at some point the debt burden gets too big. I’d rather our government learnt the lessons from around the world, rather than repeating them. Thus far we avoided covered bonds, no longer. When things get messy, they will be very messy. And they will get messy. Can’t predict exactly when, and how horrible it is partly depends on what we do between now and then. This is the opposite of what we should do. It is standing at the bottom of a hole and deciding to dig madly rather than climb.

The government solutions are destined to fail because they bring the wrong conceptual framework to the problem. They are too influenced by Keynesian economics. They discount the fact that we have endured a credit expansion induced bubble in multiple asset classes. The excess debt created has to be cleared, as does the mal-investment associated with the boom:

When there is a credit-inflated boom that results in your working at a job in which you produce goods that no one wants, needs, or can obtain financing to buy, and which your employer consequently cannot sell, it naturally follows that neither you nor your co-workers are going to be employed in the near future”. Source Vox Day cited in Why Keynesians and Krugman are Wrong

The Australian experience may yet come to reflect that of America:

(US 2005) Full employment was accompanied not only by an unsustainable external deficit, but also unsustainable asset prices, private debt levels and levels of consumption (and savings) relative to income as well as higher public debt levels. When the public’s willingness to increase its debt load waned as real estate prices fell, consumption, economic activity and employment fell along with it. We are now experiencing balance sheet recession and existing debt levels appear to be a barrier to increased private and public sector debt-financed demand.

Most troubling, but not surprising, the trade deficit is growing again and is unsustainable at about 3.7% of GDP. The external imbalance is not a temporary phenomenon. The simple and sad fact is that an unsustainable trade deficit implies that full employment levels of GDP are also unsustainable”. Source: Richard Alford cited in Why US stimulus can’t fix unemployment

Analysis demonstrating the beneficial effects of government stimulus’s are flawed. The models can’t fail but to attribute growth in GDP to them:

“If government spends a dollar; this will always be shown as contributing to GDP in the period it is spent. And, it would be shown this way even if the whole dollar were spent on imports and did not, in fact, contribute to GDP… If the government spends taxpayers’ money to build, say, a school library, at a reasonable cost, this will be shown dollar for dollar as contributing to GDP. If the same library were built at an inflated cost, this would be shown dollar for dollar as contributing to GDP. If the same library were then immediately demolished at government expense even more would be added to GDP. And this is not the end of the matter. If government takes resources away from the private sector to build a school library, this will be recorded, and probably written up, as the economy being saved from a decline in private sector activity by government spending” Source: Peter Smith cited in Keynesians are so wrong

Thanks to Chinese demand for Australian commodities Australia had the chance of a gentle landing. Almost everything economically significant that I can think of that the Government has done will make the economic downturn worse. Thank you Mr Rudd, Ms Gillard and the media sycophants who played a part in their election.

 
Buffett corrected

The Big Picture corrects Warren Buffett’s NY Times OpEd

I suddenly recalled who it was who allowed the banks to run wild in the first place: You. Your behavior before, during and after the crisis was the epitome of a corrupt and irresponsible government. You rewarded incompetency, created moral hazard, punished the prudent, and engaged in the single biggest transfer of wealth from the citizenry of the United States to the Wall Street insiders who created the mess in the first place.

Read the whole thing. This is coming to a paper near you:

hat tip FTAlphaville.