Sunday, February 15, 2009

Stree Testing the Banks, Bank Regulation, and Bank Failures

It is obvious from my recent posts that the amount of debt in the economy is my biggest concern right now. Of course, the focus of current concern is the banking industry. Bankers got caught up in the euphoria of the stock market bubble of the 1990s and the credit market (housing) bubble of the 2000s and showed the way to others about how to take on riskier and riskier assets and finance these assets with more and more debt. Off-balance sheet financing and virtual deals added to the fragile structure of the banking system as innovation built upon innovation.

I will not place all the responsibility for not catching everything that was going on, on the shoulders of the regulators because one of the things that a market system is very good at is finding ways to get around regulations and regulators. This is one of the reasons why regulation will always fail in the end…it just cannot keep up with what private institutions can find to do…and so regulation is always lagging behind in its ability to know what is going on in financial institutions and financial markets.

Let me just say that I have served in the Federal Reserve System and I have been the CEO of two publically traded financial institutions and CFO of a third, and, although the banks I worked with did not have the resources to be innovative in this way…my knowledge of the banking industry leads me to applaud the ingenuity and creativity of bankers to come up with new instruments, new markets, and new ways to do things. Innovative behavior is the pride of a market economy.

The law of economics in irrefutable…if incentives exist within a given market situation…economic units will make an effort to take advantage of them. Thus, if rules and regulations are placed on a market or on institutions and incentives exist to get around these rules and regulations…people will get around them!

The effort is not to break laws…but rules and regulations are never complete in and of themselves…hence there will always be wiggle room for an organization to maneuver and take advantage of the incentives available to them. This is why regulation will never…read me again…never…be able to gain complete control. The only way to gain complete control over institutions and markets is…to totally take over and own the institutions and markets, themselves.

We must remember this as people in Washington, D. C. attempt to build up the new regulatory system.

That said…I think a lot of responsibility does fall on the shoulders of the regulators for falling so far behind the banking system in their examination and oversight of individual banks. There is a need for rules and regulations to be imposed on the banking system because of the problem…not of one or two banks failing…but the fear that there could be a contagion within the banking system that could severely damage the financial and economic system…either in terms of a liquidity crisis…which took place in December 2007…or a solvency crisis which we are going through right now.

A liquidity crisis and a solvency crisis are not the same and should not be compared with one another. A liquidity crisis the Federal Reserve System can do something about. A solvency crisis is beyond the ability of the Fed to resolve. However, the Federal Reserve and other regulatory bodies, through their responsibility for the examination and oversight of the banking system, can help to prevent a liquidity crisis by doing a deep and thorough review of the books of financial institutions and hold these financial institutions to the standards of “good” banking practice. This effort is a first line defense against a failure of banks that could lead to a contagion amongst financial institutions.

Now, Tim Geithner, Secretary of the Treasury, has informed us that a “stress test” will be performed upon banks to determine whether or not specific banks will be eligible for financial aid from the United States government. The “stress test” is to be broad enough and deep enough to discern if a bank is still breathing or not…and if it is breathing…it can be eligible to receive capital from the government in order to help it work out its asset problems.

My question is…shouldn’t the government already know this? Wasn’t this their job!

If we have to go through an additional examination process on a large number of banks to find out whether or not they are solvent…what have we been paying for over the past 20 years or so?

And, I hear the cry for “regulatory forbearance”…that the regulators should ease up on the bad assets of the banks…and give the banks a chance to “work things out over time.” I think this is crap!

I like “mark to market”! If banks know that they are going to be responsible for marking their assets to market then one should not feel sorry for them when they have underwater assets…and want “regulatory forbearance”. To me this situation has arisen because bankers never felt that regulators were going to hold them responsible for this procedure and so they went along believing full well that they would never have to mark their assts to market. Now, they are ticked off! Now, they believe that the regulators have double-crossed them! I say…too bad!

Finally, let me say that I believe that banks that are insolvent should be allowed to fail. The stock holders have lost everything. Others may have lost large chunks of wealth…but, the banks have been badly mismanaged. The banks took on too much risk and they assumed too much leverage. The executive at the larger ones took it for granted that they would be considered to be too big to fail…and their jobs would be safe.

I know that I have not run a bank with a trillion dollars or more in assets…or even hundreds of billions. Yet, in those I did run, I never wanted to have the regulators or central bankers or Treasury officials tell me what to do. My rule of thumb was to always maintain operating procedures that were more conservative than those that the regulators required. I wanted to be in control of the bank…I did not want someone else imposing their standards on me!

When you push yourself right up to the edge…and even over the edge…with financial innovations and creative accounting…you run the risk of losing control of your organization. If this is the way you want to lead and manage your organization…then you are exposing yourself to the possibility that you will lose control of the future of your organization. Don’t cry when the government comes and takes away your goodies. It was a choice that you made.

There are going to be more bank failures. We have only had 13 failures so far this year…possibility 18 or so by the end of this month. At this rate we would have about 110 failures during the year. Most of these will be small ones, although the probability of two or three or more large failures taking place is increasing every day. However, this is far below the 200 or so bank failures that took place during the S & L crises.

In the present case, there is a good chance that several banks will be “nationalized” in some form or another. In my mind, the worst thing that Secretary Geithner can do is to try and soften the situation. Debt is our problem right now…see my blog “The Three Problems We Face: Debt, Debt, and Debt” posted on February 11, 2009, …and debt is going to be our problem for some time into the future. We need to be honest about the problem, transparent about what is being done about the problem, and we must be courageous in addressing the problem. To me this is the only hope we have in shortening the present downturn.

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