Thursday, November 10, 2011

European Banks Getting Around Capital Rules

Bloomberg posted an article yesterday titled “Financial Alchemy Foils Capital Rules in Europe.” ( Commercial banks are up to their old tricks again.

“Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.”

The issue has to do with “risk-weightings”, “the probability of default lenders assign to loans, mortgages and derivatives.”  The technical label: risk-weighted asset optimization.”

The issue has to do with how banks define how risky an asset is. 

Whoops, the whole problem depends on what the definition of is, is!

Regulators have a very tough job…and they always have had a very tough job.  Rules and regulations are put in place.  And, financial institutions have the time and the incentive to find ways to get around them.  So, financial institutions take the time and spend the resources to get around the rules and regulations.

This is just Economics 101: if there is an incentive for someone to do something to “get around” the rules…someone will find a way to “get around” the rules. 

I had direct experience of this when I was working in the Federal Reserve System around the time that a wonderful financial innovation came into existence…the Eurodollar deposit. 

The Eurodollar deposit was one of the inventions that allowed commercial banks to become “liability managers” rather than just “asset managers”.  These financial innovations allowed commercial banks, especially the larger ones, to get around the geographic restrictions faced by American banks at the time, and become fully competitive with their less restricted global competition. 

The word inside the Fed at this time was that the Fed was six months behind the banks.  That is, the Federal Reserve would institute some rules or regulations to constrain the use of these Eurodollar deposits and the commercial banks would then find ways to get around them.  However, it would take the Fed about six months to find out what the commercial banks were doing and institute some new rules or regulations to close the escape hatch.  And, the “cat and mouse” game would be played once more.

In that “primitive” time, I gained an appreciation of the inventiveness of the private sector and the frustration faced by the regulators.  The only time the rules and regulations really were strictly adhered to was in the case that the incentives for circumventing the rules and regulations were small enough so that the banks would not put out the time or resources to innovate.

Today, the sophistication and complexity of the banking system is such that regulators are at an even greater disadvantage than they were back in the “good old days.”  And, the primary reason that the bankers are some much further ahead is information technology. 

Over the last decade, I have constantly put forward the idea that finance is nothing more than information.  The whole basis for the field of financial engineering is that finance is information…and information can be cut up and re-arranged just about any way a person might find it useful to cut it up and re-arrange it.  In other words, “slicing and dicing” in a natural characteristic of information technology…that is, of financial practice.

Thus, I have been arguing for more than two years that any efforts to put new rules and regulations on financial institutions to prevent the financial crisis of 2008-2009 from occurring again are just an exercise in futility.  The Dodd-Frank financial reform act was “Dead On Arrival”…especially since most of the rules and regulations contained in the act were not even written at the time.

In fact, I would call the efforts of the legislatures and regulators in the eurozone and in the United States to control the financial industry more closely as the “regulatory employment effort of 2011”…or whatever.  In order to have any chance to know what is going on in the banking system the eurozone and the United States has had to hire hundreds if not thousands of new employees to write the rules and regulations, to interpret the rules and regulations, to enforce the rules and regulations, and to re-write the rules and regulations as it is observed that the rules and regulations are not working as expected.

And, financial institutions will still be out ahead of the politicians and the regulators.

The financial industry is going to be what it is going to be.  One thing that needs to be avoided, in my mind, is the environment of credit inflation that has existed for the last fifty years.  The environment of credit inflation just exacerbates the speed at which financial innovation takes place putting even more pressure on the government and the regulators to “keep up” and stay on top of events. 

And, what can be done?  I have been a constant advocate for increased openness and transparency in financial reporting.  Stop this hiding of assets.  Stop the switching of assets from one class to another.  Mark-to-market assets.  And so on and so on. 

Furthermore, incorporate market information into the early warning system of financial institutions. I have written about this many times before.  One such market-based early warning idea proposed by Oliver Hart of Harvard University and Luigi Zingales of the University of Chicago is based on Credit Default Swaps.  (See 

In my view, finance has gotten so complex and sophisticated that government regulation of the financial industry, as it is done today, is something of a lost cause.  The fact that politicians pass bills and acts to regulate the financial industry and can’t even initially write up the specific provisions of the rules and regulations and then when they do get written up it takes 3,000 pages to define the rule or regulation, is evidence of the futility of the exercise. 

Greater disclosure and market-based early warning systems seem to me to be the only real chance we have to monitor these financial institutions and then have some influence over the course of events. 

Until the politicians change their tune, however, we are going to continue to work in a financial world that is opaque and “out-ot-control.”   

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