What's to Like About the United States Banking System?

I really don’t see much to like in the United States banking system. 

With interest rates so low across the board, commercial banks have very little interest rate spread to work with.

With Congress and the regulators so screwed up and yet so anxious to pass laws and regulate, the “regulatory risk” and the “complexity risk” facing the industry is enormous.

There is still plenty of evidence that commercial banks have a lot of unrecognized overvalued assets on their balance sheets. (http://seekingalpha.com/article/320370-bank-stress-tests-a-substitute-for-mark-to-market-accounting)

There seems to be growing interest in suing banks that are alleged of “making misleading public statements as the property market crumbled in 2007 to hide internal downgrades of loans from investors” (http://professional.wsj.com/article/SB10001424052970203735304577169360314402158.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj) or for other reasons that banks failed to appropriately disclose their financial condition.  There are also other settlements coming related to bank lending practices in the 2000s.

Bank earnings are a mixed bag, at best.  The larger banks are not performing well because trading profits and profits on many non-traditional banking operations are off.  (See JPMorgan and Citigroup)  The returns to trust banks (BNY Mellon, State Street Corp. and Northern Trust Corp.) are sagging because these institutions have taken a “defensive position” with respect to the financial markets and shifted a substantial amount of funds into cash and ultra-safe assets. (http://www.ft.com/intl/cms/s/0/140b9e70-41da-11e1-a586-00144feab49a.html#axzz1jqA4rKTp)

Only the banks that have stayed pretty much as traditional banks (like Wells Fargo, U. S. Bankcorp, and PNC Financial Services Group) have held up, profit-wise, in recent periods. This performance seems to be connected with some minor pickup in loan growth. 

Even in the case of loan growth, analysts are relatively pessimistic about the future.  “It appears that much of the commercial loan growth we have seen at the large cap banks is coming from large corporate syndicated lending.  Not all banks are players in this market.” This from Christopher Mutascio at Stifel, Nicolaus & Co.  Note that Mutascio is expecting “total loan growth and commercial loan growth” to slow in 2012.  No bounce here. (http://professional.wsj.com/article/SB10001424052970204555904577168510658669178.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

In my most recent blog I discussed the effort of BankUnited, a Florida-based bank, to sell itself because of the condition of the banking industry, especially in Florida.  BankUnited wanted to grow and yet could find no other banks to acquire…and they had looked at about 50 banks in the Florida region and elsewhere.  Because of the state of the banks available to acquire, BankUnited decided to sell.

Well, yesterday, BankUnited pulled itself “off the market”.  The bank had attempted to set up an auction for itself but only Toronto-Dominion Bank and BB&T Corp. submitted preliminary offers.  These offers did not come up to the price of that BankUnited received when it went public last year.  Thus, the bank withdrew its offer to sell. (http://professional.wsj.com/article/SB10001424052970203735304577169400198108514.html?mod=ITP_moneyandinvesting_1&mg=reno-secaucus-wsj)

Some of the banking statistics reflect the stagnant nature of the banking system as a whole.  For example, total commercial banking assets in the United States rose by about $700 billion last year. 

Note, however, that cash assets at commercial banks rose by about $515 billion!  That is, almost 75 percent of the growth in bank assets came from an increase in the cash holdings of the banks. 

Also, note that about 80 percent of this increase in cash assets at commercial banks in the United States occurred at foreign-related financial institutions. 

Furthermore, these foreign-related financial institutions increased their commitment to Net Deposits Due to Foreign-related offices by almost $650 billion.  Thus, these foreign related institutions took U. S. dollars and shipped them off-shore!  Thank you Federal Reserve System!

In all, the share of United States banking assets going to foreign-related financial institutions rose from about 11 percent to almost 15 percent from December 2010 to December 2012.  The largest twenty-five domestically chartered banks in the United States continue to account for almost 60 percent of the banking assets in the country.  The smallest domestically chartered banks (about 6,300 of them) continue to shrink as a proportion of banking assets. 

The American banking system is welcoming more foreign-related financial institutions to the ownership of its assets…note that one of the two bidders for BankUnited was Toronto-Dominion Bank…and is also seeing more and more of its assets being held by larger banks.

Right now, the commercial banking system seems to be going nowhere, just restructuring. 

This is just a very, very tough time for the banking system.  It is a time of transition.  The whole industry is changing. (http://seekingalpha.com/article/319449-the-banks-they-are-a-changing) But, then, the whole world seems to be going through a period of transition.  

The Banks, They Are A Changin'

The banking system is going through massive changes.  The morning papers are filled with stories about what is happening in the banking area, although they cover only a minor portion of what is going on in the industry.

The Wall Street Journal trumpets, “Bank of America Ponders Retreat.” (http://professional.wsj.com/article/SB10001424052970204409004577156881098606546.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj) The current Bank of America represents, perhaps as well as any organization the excesses of the financial institutions over the past twenty years or so.  Currently selling at 33 percent of book value, the Bank of America can be potentially classified as one of the “Zombie” banks that now meander through the environment. (http://seekingalpha.com/article/319205-there-are-still-zombie-banks-around)

The Journal article does not give us much faith that management has a firm grasp on the situation…or, at least, is not revealing to us the reality that they face.  “Bank of America Corp. has told U. S. regulators that it is willing to retreat from some parts of the country if its financial problems deepen…”

The crucial hedge word is “if”.

Commercial banks have to recover from the binge that has taken place in the banking industry over the past fifty years.  This binge has seen commercial banks grow to enormous size and many have become “too big to fail.”  It has resulted in a massive shift in employment in the United States as the proportion of people working in the manufacturing trades has declined substantially relative to those working in the financial industry.  It has resulted in a huge shift in risk-taking in the industry, a move to more and more financial innovation, and a substantial increase in the amount of financial leverage used in the industry. 

Several of the articles in the morning paper discuss the reductions that are taking place employment.  For example, yesterday the Royal Bank of Scotland Group PLC announced that it will be laying off 3,500 people.  Cutbacks have also been announced by UBS AG and UniCredit SpA and well as Credit Suisse Group AG and many other major players.  The reductions in staff of the smaller institutions do not get as much publicity and play in the press. 

Some have argued that the industry is going through a cyclical shift that generally happens after a downturn in the economy but more and more industry analysts are claiming that they see a more permanent shift taking place.  And this is true of other parts of the financial industry than just the commercial banks.  “It isn’t just the lackluster business environment that is prompting banks to rein in their lofty investment-banking ambitions.  A realization is sinking in among securities-industry executives that because of the huge potential losses they are exposed to in bear markets, the business just isn’t as attractive as it once seemed.” (http://professional.wsj.com/article/SB10001424052970204409004577156833880721736.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The fifty year period of credit inflation bought out over time many of the bad decisions and allowed the banks to go merrily on their way.  As “Chuck” Prince, former CEO of Citigroup expressed it…”As long as the music continued to play, people had to keep dancing.”

But, this continual pressure to grow and expand and take on more risk resulted in a massive change in the banking industry itself.  Going from around 14,000 commercial banks in the 1960s the commercial banking industry now contains less than 7,000 banks.  My forecast is for this number to drop below 4,000 in the next several years. 

And, the banking industry is bifurcating: almost two-thirds of the assets in the banking system are owned by the largest 25 banks in the country.  That leaves just one-third of the assets in the hands of about 6,300 banks.  More and more wealthier personal banking relationships are being handled by firms that cannot be considered to be community banks.  The products and services in these banks are many and the electronic interchange and access between financial assets and transactions are seamless and almost instantaneous.  

One could imagine a banking system in which the wealthier people worked with institutions like these and the less wealthy “banked” at non-profit credit unions, the non-profit institutions being the only ones that could provide the products and services needed without having to achieve a competitive return on shareholder’s equity.

The last factor producing major changes in the banking industry is the advances taking place in information technology.  Finance is nothing more than information.  That is, finance can ultimately be just a recording of 0s and 1s.  Thus, as information technology advances, so does the innovation in the financial industry. 

And, don’t think of how you use banking services right now…think about the electronic gadgets that your children or your grandchildren are using.  This is where you will see what financial institutions are going to need to provide for in the coming years.  What goes on in “electronic stuff” is real to these children and will become a part of the financial system as electronic finance becomes ubiquitous in the future. 

Furthermore, as advances in information technology has allowed “finance” to become more innovative, my guess is that for the future…we haven’t really seen what financial innovation can do.

This has tremendous implications for the regulatory efforts going on in the United States and the world.  I have argued for three years now that the efforts of the United States Congress and others throughout the world have been to create a regulatory system that will prevent a 2007-2008 financial collapse.  To me, the commercial banks in the United States are way beyond this system already.  Oh, the banks fight Congress and the regulators all along the way.  But, how much of this is real and how much of this is a smokescreen. 

Throughout my professional career…and I have run three banks…the banks have always been ahead of the legislators and the regulators in terms of what is going on in the banking system.  I am no less confident now that the banks are still far ahead of legislation and regulation and will continue to be so into the future. 

I can’t imagine what banking will be like in five years…but, it will be something substantially different than it is now.  It will be more electronic, it will be more innovative, and it will be harder to control.  The only way we can hope to keep up with what is going on is to increase the openness and transparency with which the banking system operates.   

European Banks Getting Around Capital Rules

Bloomberg posted an article yesterday titled “Financial Alchemy Foils Capital Rules in Europe.” (http://www.bloomberg.com/news/2011-11-09/financial-alchemy-undercuts-capital-regime-as-european-banks-redefine-risk.html) 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 http://seekingalpha.com/article/207293-banks-disclosure-and-reform.) 

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.”   

Can Anyone Manage the "Too Big To Fail" Banks

An interesting article: “Once Unthinkable, Breakup of Big Banks Now Seems Feasible,” (http://dealbook.nytimes.com/2011/07/27/once-unthinkable-breakup-of-big-banks-now-seems-feasible/?pagemode=print) appeared in the New York Times on Thursday.

The basic question posed in the article: “Lawmakers and regulators have failed to remake our system with smaller, safer institutions.  What about investors?”

Our largest banks are not performing that well.  Shouldn’t stockholders demand better performances?

In terms of Return on Shareholder’s Equity (ROE), Wells Fargo has been at the top of the list of the Big Four.  With the exception of 2008, Wells has earned an ROE of around 10 percent, give or take a little. 

JPMorganChase has not done as well since it was attempting to play “catch up” with the others in the Big Four in the middle 2000s.  Other than in 2008, it has consistently improved its performance with some analysts arguing that it will earn around an 11 percent ROE in 2011.

Citigroup and Bank of America are lagging substantially behind these two.  Citi seems to be recovering from the disasters of 2007, 2008, and 2009, but its performance is still far from stellar.  Bank of America is…terrible.  Both companies will probably not see a 10 percent ROE for many years. 

The point the author of the above article, Jesse Eisinger, is trying to make is that such terrible performances should be met with shareholder demands to restructure in order to improve performance.  Of the four, Citigroup has made the greatest effort to do this but it is an indication of how badly the bank was managed that even this effort has left a lot of work still to be done. 

Bank of America seems to be in a daze.  I don’t think anyone there knows what they are doing.

JPMorganChase, having survived the financial collapse as well as anyone, is trying to expand into areas round the world in which it has not previously been competitive. 

The question proposed by Eisinger is a good one.  Given the performances of these organizations, shouldn’t the shareholders demand some leadership that would rationalize these organizations and get them back on the track to earning competitive returns, which in my mind is an ROE, after taxes, that exceeds 15 percent?

How has the market reacted?  Well, the only bank whose stock price trades above book value has been Wells Fargo trading at about 1 ¼ times book.  JPMorganChase trades at book; Citigroup trades at about ¾ book; and Bank of America trades at around ½ book.

The banking industry, led by these four banks, spent the latter part of the twentieth century building up financial conglomerates through mergers and acquisitions.  The push was to build, build, build.  Financial performance came from financial engineering and financial innovation.  Increased risk taking and greater and greater financial leverage were the games to be played.  Off-balance sheet accounting became a way to hide risk and to “jack up” returns.

As former Citigroup chairman and CEO “Chuck” Prince is famous for saying, “If the music is still playing, you must keep on dancing.”

The problems that accumulated due to the merger and acquisition binge that took place before the financial crisis hit was exacerbated from actions taken after the financial crisis hit by the acquisitions these organizations made in cooperation with the federal government.  Need one mention the acquisitions of Merrill Lynch, Washington Mutual, and Bear Stearns, among others?

Conglomerates, generally, have never had a history of being great financial performance.  Just putting together different kinds of businesses without any reason, without the possibility of achieving any synergies, has not produced exceptional results.  In most cases the resulting performance of such combination is abysmal.

Given this belief, one really needs to ask a question about the “quality” of the performances recorded before 2007.  The amount of accounting tricks, off-balance sheet “slight of hand”, failure to mark-to-market underwater or bad assets and so on sure made some of these banks look like they were really something.

Yet, when things got tough all this “magic” went away.  Banks even stated that some of the calls for accounting “sanity” caused them all the troubles they ran into.

Again, “If you say the problem is out there, that is the problem.”

In my view, the regulators are never really going to get these organizations under control, make them economically sound.  The pressure to do this must come from the owners, the shareholders.

Eisinger presents three reasons why this is unlikely.  First, a large number of bank owners (institutions) tend to be “passive and conflicted.”  Second, top managers get paid for running larger institutions.  If the banks became smaller, top executive salaries would decline.  Third, the growth in world trade requires large banks to support the large, multinational corporations. 

To me, the only true test is performance.  Can large, multinational banks earn a return that justifies people and institutions investing in them?  Can they earn a 15 percent ROE after taxes through achieving sustainable competitive advantage?  Or, do they need to take on excessive business and financial risk accompanied by accounting “gimmicks” to earn such a return?

I have three immediate responses to this.  First, financial regulators and legislators can never do the job we would like to think they might do.  For one, they are always fighting the last war.  They are still trying to prevent a 2008-2009 crisis from happening again.  In addition, given the changes taking place in information technology, it will be extremely difficult to keep up with everything that is going on in the banking system thereby making these institutions even harder to regulate.

Second, the number of “banks” in the banking system is going to continue to decline.  Small- and medium-sized banks are going to find it harder and harder to find niches that are not being eroded by the Internet, mobile devices, and non-banking organizations.  My prediction has been that America will have less than 4,000 banks in five years and this trend will continue. 

Finally, the best thing that Congress and the regulators can do is to require more openness and transparency in the banking system.  We have seen what accounting tricks, lack of disclosure, and failure to record realistic asset values can do to “pumping” up the banking system.  Required greater disclosure can go a long way toward investor understanding what a bank and its management are doing. 

Also, other tools can be used to bring market instruments into the picture as an early-warning system like the one recently proposed by Oliver Hart and Luigi Zingales in the journal National Affairs, and “To Regulate Finance, Try the Market” in Foreign Policy.

The regulators are not going to correct the “Too Big To Fail” problem.  Maybe the owners of the “Big” Banks should correct the problem.

Greece and Dimon and Bernanke

Standard & Poor’s rating services have just given Greece sovereign debt the lowest rating it has.  The Greek leadership is upset.  “We have a very tight fiscal package coming” the leaders say.  Yet the downgrades continue. 

The timing of the reduction in the debt rating, according to some pundits, is not coming at a very good time.

But, these things never happen “at a very good time”.  Building up excessive amounts of debt reduce options (http://seekingalpha.com/article/271651-debt-ultimately-leaves-you-with-no-good-options) and they leave you in a state where there is no “good time” to deal with the debt. 

Yet, people and governments, over the past fifty years, acted as if the amount of debt outstanding did not matter to their economy and that any fiscal difficulty a country might find itself in could be overcome by increasing the spending of the government and increasing the amount of government debt.

The amount of debt a government issued did not matter because the economic models the governments used did not include government debt.  Thus, a government could increase debt as much as it wanted and their economic models would be unaffected.

One of the primary reasons that debt, both public and private, was not included in the models was because there was not sufficient historical evidence on the levels of debt outstanding before, during, and after a financial crisis to justify inclusion in the models.  Kenneth Rogoff and Carmen Reinhart have attempted to eliminate this reason with their study of eight centuries of financial data presented in their book, “This Time is Different.”

Another reason why it is hard to study the burden of debt on a country is that the analysis of the risk associated with any given amount of debt is to a large extent psychological.  There seems to be little if any “tight” relationship between when the market determines that the amount of debt being carried by a country is excessive.  There seems to be no unique “trigger” to determine a sovereign debt crisis.

The bottom line is that the role of debt in the precipitation of a debt crisis is very, very complicated and the quantitative tools that exist are just not sufficient to fully capture any one specific situation.

As a consequence, the amount of debt a country carries is a judgment call, but the more debt a country accumulates the more it limits its future options and the more it loses control over the timing of any “crisis” that might occur.    

There seems to be other cases currently in the news pertaining to governmental decisions in areas that are very complicated and cannot be modeled in any satisfactory way. 

This is brought out very clearly is the column by Andrew Ross Sorkin in the New York Times this morning, “Two Views on Bank Rules: Salvation and Job Killers.” (http://dealbook.nytimes.com/2011/06/13/two-views-on-the-value-of-tough-bank-rules/?ref=business)

In this article, Mr. Sorkin re-plays the recent verbal exchange between Jamie Dimon of JPMorgan, Chase, and Ben Bernanke of the Board of Governors of the Federal Reserve System.  Mr. Dimon, among other things, questioned the ability of the Federal Reserve (of regulators) to understand the consequences of their regulatory actions.

Sorkin remarks, “it’s an uncomfortable truth that Mr. Dimon should be taken seriously, at least his suggestion that policy makers can’t predict the full impact of the coming regulation.”

Sorkin reports that when Mr. Bernanke answered Mr. Dimon’s question, he said, “Has anybody done a comprehensive analysis of the impact on credit? I can’t pretend that anybody really has. You know, it’s just too complicated. We don’t really have the quantitative tools to do that.”

Mr. Bernanke’s answer captures something that the economist Friedrich Hayek stated many years ago, that a central organization or one individual body can never possess sufficient information to make decisions that are dependent upon information that is dispersed widely throughout the economy and is relevant for “local” decision making.

With this statement, Mr. Bernanke loses more of the credibility that he had been trying to hang onto over the past eighteen months. 

The economic models that people and governments have been using over the past fifty years are inadequate, at best, and misleading in practice.  They work best when the economy is smoothly growing.  They just do not have sufficient data to handle the very complex situations that happen when things are not going smoothly.

As Hayek taught us, there is just too much relevant information for us to collect, store, and process and even if we could store it all, most of the information pertains to “local” situations that are way beyond our ability to model. 

Hayek also taught us that one of the major roles of the economist is to demonstrate to decision makers how little they really know about what they imagine they can design. 

In this respect, governments need to create the processes though which decisions are made and should not focus on the outcomes.  Outcomes are a result of those things a decision maker thinks he/she can “design” and this applies to bank regulation, unemployment targets, and so forth. 

 

To me the process of openness and disclosure is still the most important thing that a government can require…of itself…or of the organizations it is regulating.  When the government begins to determine what decisions should be made and what outcomes are to be attained, it begins to exceed its ability to succeed. 

And, as the government fails to attain the outcomes it wants, it asks for more control to gain those outcomes…and then more control…and then more control…

Regulation and Information--Part B

In my previous post, “Regulation and Information—Part A” I argued that banking and finance has become nothing more than information, and in this Age of Information, money and finance have just become the movement of 0s and 1s. As a consequence, finance has gotten away from people and physical assets and paper money and other forms of wealth, like gold, and just become bits of information that can be “diced and sliced” every which way and that can be bought and sold worldwide.

This post, as promised, has to do with my ideas about the possibilities for the regulation of banking and financial institutions. I will post a Part C tomorrow.

First, I need to explain a little bit about where I am coming from. I call myself an “Information Libertarian”. I believe that history shows that information spreads and cannot be contained. Its spread can be slowed down for a while, by governments or religious bodies for example, but eventually the spread of information wins out. As an Information Libertarian, I believe that it is my responsibility to help speed along the spread of information and, where this spread is being contested or resisted, help to unlock the doors that is keeping information bottled up.

To me, information must see the light of day so that it can be tested, used, and lead to the discovery of more information. In this way false information, information not allowed to change, and other constraints on the problem solving and decision making capabilities of humans can be seen for what they are and transcended.

Rules and regulations in the past have tended to rely too much on what I would call “the achievement of outcomes” and not enough on the “process of how things are being done.”

Reliance on “outcomes” focuses upon the wrong things and is very expensive for those being regulated as well as for those that are doing the regulating. The reason: if there is sufficient incentive for the regulated to do the thing being regulated, it will get done in one way or another, in spite of the regulation. This was the essence of the quote by John Bogle, the founder and former chief executive officer of the Vanguard Group, in my post of January 19 (see http://seekingalpha.com/article/183203-bracing-for-new-banking-regulations). Bogle stated that “There are few regulations that smart, motivated, targets cannot evade.” This was a part of what I was attempting to say in Part A of my discussion of regulation and information: the means of evading regulations has become sophisticated and easier in this Age of Information.

Also the cost of regulating in such an environment has increased substantially. The talent and skill required, along with the necessary patience and persistence of the regulator has gone up exponentially. In my experience, the regulator is ALWAYS behind the industry in knowing and understanding what is going on. How far behind they are varies from situation to situation and is a constant concern. But, you can rest assured that the regulators are behind the regulated.

As I have written in previous posts, the big banks have once more jumped ahead of the regulators in the past year as these banking giants have gained strength. Nothing has helped them more than the subsidy the Federal Reserve has given them by maintaining short term interest rates at such low levels: the Fed has given them “the gift that keeps on giving.” Not only have these banks regained health, they have moved way ahead of the regulators who have been dealing with all the problem small- and medium-sized banks and the squabbles takikng place in Washington, D. C. over how the banks and other financial institutions should be regulated.

This is the problem of focusing on “outcomes.”

I have argued over and over in earlier posts that banks and other financial institutions need to be subject to greater openness and transparency. This is consistent with my views on the need for information to spread and is consistent with my views on what kind of regulation can achieve some degree of success. It is also consistent with the idea that laws and regulations should focus on “process” and not “outcomes.”

Making banks and other financial institutions open up their books and causing their operations to be more transparent is the only way that I can see, in this Age of Information, to effectively have some impact on the behavior of these organizations. Having to report accurately and often to not only the regulators but also to shareholders as well as the public in general is the only way to be able to have some impact on them over time. The idea is that if they can’t hide what they are doing they will be a little more careful about what actions they take.

I cannot buy the argument that financial institutions need to keep their information on customers or what they are doing proprietary for if they don’t their spreads will go away. We saw what a disaster this was in terms of Long Term Capital Management. To me, the running of a financial institution is like coaching a football team: everyone knows the plays; the winning team is usually the one that executes the best or is the luckiest. Everyone knew what Long Term Capital Management was doing and others mimicked them. When things went the wrong way everyone tried to exit at the same time. Sounds like the subprime mortgage market doesn’t it?

I have also been a constant proponent of “mark-to-market” accounting. Let me describe to you how I see this tool. Banks, and other financial institutions, take risks. In order to achieve a few more basis points return over competitors, executives have either taken on assets that are a little riskier than they did before, or, mismatch the maturities of assets and liabilities a little more than they did. Shouldn’t we the regulators, the investors, the depositors, the analysts know this?

They, the bankers, have taken the interest rate risk and the credit risk and should be held accountable. To me it is childish for the bankers to “cry foul” when the market goes against them saying that it is unfair to force them to recognize the mismatched position they have taken. They are the ones that took the risk, they should be held accountable for doing so. They get the credit when things go well. Shouldn’t they be called on the carpet when things go the other way? If you know you might get caught, should you go ahead and do something?

In this case, maybe the bankers need to present two sets of books. One set to show what the value of the assets are if they (the assets) are held to maturity. Another set of books to reflect actual market values. The crucial thing is that the current real position of the bank needs to be “owned” by those running the bank.

The point is that if a management doesn’t want the public and the regulators to know that they have taken excessive risks, then they shouldn’t take the excessive risks.

In the Age of Information, the probability that people will find out what you are doing, particularly if you have some prominence, is higher than before and is increasing every day. We have just seen what can happen when some prominent person lives a life all out of character with who people thought he was. And, the fall has been pretty substantial.

Again, if this person didn’t want us to find out about his extra-curricular activities, he shouldn’t have pursued them. Simple as that!

The objective in requiring openness and transparency in reporting financial data is to say to people “before the fact”: if you take on too much risk or run your business in a careless manner, we will call you out on it. The “we” stands for investors, depositors, or regulators. The financial position of a bank or a financial institution should be “out-in-the-open” in great detail and the analysis of investors and regulators should be shared. If the bankers know they may be exposed then maybe the banks will attack their problems sooner rather than later.