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.”   

Is the Future of Finance "Post-Human"?

Thursday, February 17, I put up a post titled “The Future of Finance is Getting Closer” (http://seekingalpha.com/article/253645-the-future-of-finance-is-getting-closer). In this post I discussed the changing world of finance and how it is being impacted by changes in information processing and the spread of information. I write on this subject fairly frequently because I believe that the continued improvement in information processing and the continued spread of information are going to dominate the future of finance…and everything else.

A reader of this post expressed concern over this assessment: derryl, stated that “John seems to be describing, not a post-industrial world, but a post-human world. Disembodied minds trading in information.”

I don’t believe that I am describing a “post-human world.” Information processing and the spread of information has been going on for a long, long time. Let me put this in context. Freeman Dyson, Physics Professor Emeritus at the Institute for Advanced Study in Princeton wrote in review (New York Review of Books, March 10. 2011) of the new book by James Gleick, “The Information: A History, A Theory, A Flood” that “Everywhere around us, wherever we look, we see increasing order and increasing information.” This is true both in the living world as well as the non-living world.

Dyson goes on to qualify this statement. This “unending supply of information is a glorious vision for scientists. Scientists find the vision attractive, since it gives them a purpose for their existence and an unending supply of jobs.” Scientists work with the increasing amount of information to identify and work with the increasing amount of order.

The concern by derryl only becomes real if the amount of information that exists is finite. Then the advancements of information technology can conceivably capture and model all that is and we evolve into “post-human world”.

The world being described by Dyson is a world in which the questions never end because the amount of information in this world is growing and will continue to grow. Thus, there will always need to be humans because there will always be questions to ask and inferences to be made.
This world Dyson sees is continually requires humans to be around to gather the new information being produced and incorporate into new concepts and models.

This is even more true of “human” activities like finance and investing. All the studies of complexity theory argue that the behavior of humans is much more “complex” than the behavior of non-living things. The reason for this is that modeling humans requires more information and more sophisticated models than is required to model non-living things. Thus, building models relating to investment behavior in a world where the total amount of information is increasing is something that cannot become “post-human.”

Dyson captures this reality by writing that “The vision is less attractive to artists and writers and ordinary people…Ordinary people may not welcome a future spent swimming in an unending flood of information.”

We see the problems in modeling human behavior in the book “The Quants” (See review: http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.) In this book, the author describes what has been called a quant-led collapse: specifically the August 2007 market meltdown. “This meltdown came in what is known as the “shadow banking system” and not the true banking system (for) the Federal Reserve really didn’t seem to know what was going on. The first catastrophe came when the Bear Stearns hedge funds were instructed to file for bankruptcy on July 30, 2007. The melt-down started in earnest on Monday August 6.” Quant firms suffered large losses on “toxic” assets.

But, the “Quants” are still in business. And, the “Quants” are still using sophisticated mathematical models to invest. As with all human problem solving activity, the humans have learned from the 2007 experience. They have modified or re-built their models to take into account the new information that has been gathered and processed. And, they now have more robust models than they did before the financial collapse.

This is a highly quantitative world, yet it is not post-human and in my view will never be post-human. Humans are problem solvers and in playing this role they must build models, test models, modify models and use models to make decisions or explain things. Humans are information users. And, in the world we are moving into will be even more information and information processing driven. It will be “smaller and faster.” (See http://seekingalpha.com/article/225773-the-new-world-order-smaller-and-faster-part-2.)

This world, however, is going to be a more volatile world, it is going to be a world that changes faster, and it is going to be a world that requires people to adapt to the changes that they see going on around them. One cannot “lock” themselves into the world of the past.

History has shown that the spread of information and information technology cannot be stopped. It’s spread may be postponed for a while, but it eventually will succeed in spreading.
Laws and regulations must take account of this. Congresses and regulators must take account of this. Dictators and autocrats must take account of this. Presidents and Prime Ministers must take account of this.

A danger is that this world bifurcates…divides into two…those that can work within the new paradigm and those that adjust, for whatever reason, to the new paradigm. We are seeing some of the consequences of such division. The income distribution is being determined more and more by the amount of education a person has. Jobs are splitting more and more between service jobs and manufacturing jobs. But, even this is not all. Even clerk-like service jobs are being replaced by new technology. Jobs are more plentiful in information technology and finance than in jobs connected with “making things.” Health care is going to be an employment magnet but even there the clerk-like jobs are going to be replaced by new technology.

As a consequence of these developments, under-employment has grown substantially and will not decline much in upcoming years. Capacity utilization in the manufacturing industries will remain at historical lows. A substantial re-structuring is going to have to occur in the economies of the developed nations.

The point I am trying to make is that the world is going through a period of major transitions…economically, politically, and culturally. This is a once-in-a-century thing. As with major transitions in the past, the human element has not been eliminated, but the structure of human involvement in the world has changed dramatically.

Such change can be disturbing. I know that I am feeling the effects of this change in my life…and it is not just because I am getting older!

The Pace of Financial Overhaul

The writing of new financial regulations required by the Dodd-Frank financial reform act passed last summer seems to be dragging. “Regulators have missed or postponed several deadlines to write rules needed to implement the financial overhaul…” (http://professional.wsj.com/article/SB10001424052748704029704576087890419559076.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The writing of such regulations in the world of modern finance is a very difficult and messy task at best and one that is even harder given the speed at which that world is changing. In some cases, definitions need to be revised such as who is an “accredited investor”; hearings are taking longer than expected; and disagreements need to be worked out. Furthermore, the regulation-writers are being careful because they “want to get it right.”

“In the next 18 months, U. S. regulators are supposed to issue more than 100 rules or studies in response to the Dodd-Frank law.” And, “The political deadlock in Congress over spending has left the SEC and CFTC without budget increases needed for the task.”

All this means to me, however, is that Congress and the regulators are just falling further and further behind which just makes what they are doing more and more irrelevant!

I have written many posts over the last two years or so about financial regulation and regulatory reform. Most of them have not been very encouraging concerning the positive benefits of the effort now going on to re-regulate the United States (and the world) banking system. The most comprehensive comment that I have made is that the re-regulation that is going on is already “out-of-date.” The reasons I give for this comment is that politicians and regulators are always fighting the last war and so start out behind and the bankers have already moved on into the future making the things being done even further “out-of-date.”

But, just notice three more bits of news that have been in the news in recent days, weeks, or months. First there is the phenomenon known as WikiLeaks. Not only has WikiLeaks “outed” the United States diplomatic system and threatened to disclose internal information said to be very embarrassing to certain United States banks, there is now the threat to expose 2,000 prominent individuals and companies that have been engaged in tax evasion and other possible criminal activity. This latter information was supposedly contained in two computer disks given on Monday to the founder of WikiLeaks by a former senior Swiss bank executive.

This “leaking” of information gets at one of the basic problems connected with information and information storage: security. The issue has to do with who has what information and who should be excluded from having certain information.

One of the fundamental ideas related to information theory is that “information spreads”. People try to control information and contain its spread, but this only slows down the speed at which information spreads…it doesn’t stop the spread.

Just ask the governments and religions that have tried to control information and thinking.

Just think of all the hackers out there. I very firmly believe in the “efficient markets” theory of hacking. That is, if someone can benefit in some way from hacking into a system, even to just embarass someone, they will find a way to successfully hack into that system.

Some information governments would not like others to have, like secrets related to national security. It was proven in the 1990s that all current “code” systems used to protect secrets are useless if someone has a Quantum Computer. Thus, a government like the United States believes that it needs to be “first” in creating a Quantum Computer so that it can keep these very important secrets. (http://seekingalpha.com/article/225773-the-new-world-order-smaller-and-faster-part-2)

My point is that in the world of information technology in the 21st century where information, even secret information, is so accessible, shouldn’t the government and the regulators show a little more interest in the openness and transparency of the financial institutions and the financial markets than it is showing.

The politicians and the regulators are looking for very specific outcomes. History shows that governments that try to force “outcomes” on a system NEVER SUCCEED!

It is remarkable how systems and markets are more able to regulate themselves if information is open and transparent to all. Maybe this is what Congress and the regulators should be emphasizing.

Second, there is the Goldman Sachs/Facebook transaction. Rather than have a public offering of shares in Facebook, Inc., where a substantial amount of information on the company would have to be forthcoming, Goldman decided that a private offering was better for the company at this time. Now, with concern that the focus on the private offering could be deemed “public” because of the intense attention given to the deal in the media could be considered a violation of U. S. securities laws, Goldman has decided to only offer the shares to non-United States investors.

My point here is that something is wrong with the regulations for such a “mess” to exist. First of all, what is “private” information and what is “public” information? Secondly, if others, like the media, can get sufficient information and publish it so that a “private” offering becomes a “public” offering even if the bank conducting the offering does not actively violate the law, what really is the definition of a “private offering”?

Third, in this global world, an offering such as the Facebook shares, can be taken “off-shore” as easily as sending an email out to potential investors. Should our laws and regulations be set up so as to “force” companies to go elsewhere in the world and escape onerous” regs” or “out-of-date” restrictions?

Fourth, in the information technology world we are moving into how can any financial offering be considered “private.” The possibilities that the “private” offering might become “public” are almost infinite.

Just one final tidbit: the Wall Street Journal article “Battle for Techies: Wall Street vs. Silicon Valley.” (http://professional.wsj.com/article/SB10001424052748704637704576082512439373244-lMyQjAxMTAxMDEwODExNDgyWj.html?mg=ep-wsj&mg=reno-wsj) The subtitle to this article is “Trading Companies Roll Out the Perks to Lure Top Talent; Shuffleboard, Paintball and, Yes, Higher pay; Outside the Bubble.” Wall Street believes it needs the best “techies” to compete in the modern world.

The point: information technology is very present in finance, after all, finance is just about information. Information technology is playing a bigger and bigger role in finance. See my book review of “The Quants”: (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.) And, information technology is going to play an even bigger role in finance in the future.

Obviously, my belief is that the current efforts to write new rules and regulations for the financial area are on the wrong track and wasting a lot of money. But, these efforts are creating jobs and that is helping the economy. Maybe the financial reform bill was really just a stimulus bill in disguise

The "Sound and Fury" of Banking Reform

Well, the Senate finally passed a banking reform bill. It is said that President Obama wants to sign the final bill around July 4.

All I can really say about the bill is that it represents a lot of “sound and fury signifying nothing.”

The bill will be costly. The bill will result in a lot of inconvenience.

But, banking and finance will recover and will continue on their merry old way!

The reason that I say this is that finance is just information and with the accelerating pace of information technology in the United States and the world, finance will continue to expand and prosper. The regulators cannot control how information is used or transformed!

History has shown that information spreads and although the pace of its spread can be slowed down, it has never been stopped. Just ask all the religious medievalists in our world today that are fighting a losing battle and are defensively striking out at everyone else.

I have stated some of the reasons for my position in a series of posts beginning January 25, 2010: see “Financial Regulation in the Information Age”; http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.

I have also highlighted the place of information in the practice of modern finance in my review of the book “The Quants”: see http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson.

Furthermore, attempts to reform and re-regulate the banking system will ultimately do more damage to banks that are not among the 25 largest banks in the country than it will do to those banks that the administration and Congress are really after. And remember, the largest 25 domestically chartered commercial banks in the United States control about two-thirds of the banking assets in the country.

Another factor that I have tried to stress over the past year is that the largest banks have already moved on. The legislation in front of the Congress is aimed at preventing the last financial crisis from occurring again. In my estimation, the largest banks are beyond this feeble effort and are moving into areas we will learn about in the next round of “popular” books explaining what has happened to our financial system.

An example of this was a recent report in the press about how Congress is trying to alter the status of how hedge funds reward their managements so that more of this income is taxable. The response of the industry was to have already hired scores of lawyers to “get around” any legislation about hedge fund fees.

Can you imagine any other kind of response from the financial industry…or, for that matter, any industry?

Reform and re-regulation face a moving target and, consequently, they are aiming their efforts at the past, not the future.

The financial reform package will change the playing field for a limited amount of time. However, in this age of information you can bet that the lag between what “the Feds” do now and how the financial system reacts to these actions will be shorter than ever before.

NOTE: we now have 775 commercial banks on the list of “problem banks” put out by the FDIC, up from 702 banks at the end of 2009. When this latter list was presented, I argued that the FDIC would close between three and four banks a week for the next 12 to 18 months. We have been averaging 3.8 banks closed every week this year through May 14. Using a rough “rule of thumb” my estimate now is that at least four banks will be closed every week through the end of 2011.

I still have grave concerns about the solvency of the 8,000 “smaller banks” in the United States. I define the “smaller banks” as any bank below the top 25 largest banks in the country. These 8,000 “smaller banks” control only one-third of bank assets in the United States. I derive this concern from the actions of the Federal Reserve who continues to subsidize the banking system with extremely low interest rates, and the FDIC. Although the Fed and the FDIC are not “owning up” to this problem, everything they are doing raises questions about how solvent these smaller 8,000 banks really are. I guess the big issue concerns what would happen to the value of bank assets IF interest rates were to rise. Would this result in a “cascade” of “small” bank failures?

Washington Still Doesn't Get It!

The President and Congress just don’t get it!

Financial reform is in the air! The bad guys did it and they need to be brought to account! Protect Main Street and go after those that are on Wall Street!

Unfortunately, this is not going to produce the results that the President and Congress want.

Unfortunately, we are not going to get helpful results until the President and Congress develop an understanding about finance and what their current philosophies about economic policy are doing.

Unfortunately, I don’t see this happening in the near term.

Just two points this morning, but points that I have made before.

The first point pertains to the understanding…or misunderstanding…of what finance is all about. This misunderstanding is captured in the lead editorial in the New York Times this morning titled “After Goldman” (http://www.nytimes.com/2010/04/22/opinion/22thu1.html?hp). In this editorial we read: “The Goldman deal was nothing more than a bet on the mortgage market…WITHOUT ‘INVESTING’ ANYTHING IN THE REAL ECONOMY.”

Guess what? That is what finance ultimately is. Finance is nothing more than information and millions and millions of people operate with this kind of information every day.

What is your dollar bill? A piece of paper…a piece of information.

Well, but it is legal tender!

Right, according to the government you have to accept a dollar bill in payment for debt. What has this got to do with THE REAL ECONOMY?

And, what about the demand deposit account you have at your commercial bank? It is just 0s and 1s in some computer. What has this got to do with THE REAL ECONOMY?

By the way, you are betting that you will be able to access that money when you need it? Is it safe?

Well, you say, the deposit account has insurance on it, doesn’t it? The Federal Government has guaranteed that you will not lose these funds and will not be inconvenienced by a delay in access to them. You have a promise! But, what has that got to do with THE REAL ECONOMY?

What are loans? Well, they are cash flows. Say, an initial cash outflow to the borrower and then a series of cash inflows back to the lender. Just 0s and 1s through bank accounts.

But, I put up a house to back the loan, didn’t I? The house is a real asset.

Yes, but the loan agreement is in terms of cash flows and the house is there for security in case you don’t pay the returning cash flow. Furthermore, that house is 25% underwater now, another piece of information, so how does this impact the cash flows?

Furthermore, it was the government that showed us how to “slice and dice” cash flows in order to tailor cash flows so that potential purchasers would find those “new” cash flows more attractive and purchase them. The first mortgage-backed security was issued by the Federal Government in 1970. The mortgage market went from playing a zero role in world capital markets to becoming, by the middle of the 1980s, the largest component of world capital markets. (See Michael Lewis’ “Liar’s Poker”.)

Thank you Washington for teaching us that cash flows are just bits of information! No real world
here.

Now Washington wants to bring the herd of cats it has unleashed under control. Good luck!

The second point has to do with government policy and how it creates the environment for all else that goes on in the economy. Some of this discussion can be related to the David Wessel’s column in the Wall Street Journal this morning, “Mapping Fault Lines of Crises,” (http://online.wsj.com/article/SB20001424052748704133804575198080507492968.html#mod=todays_us_page_one). Wessel, in his column, discusses the work of Raghuram Rajan, a professor at the University of Chicago and former chief economist at the International Monetary Fund.

Rajan argues that “The U. S. approach to recession-fighting and its social safety net are geared for fast recoveries of the past, not jobless recoveries now the norm. That puts pressure on Washington to do something: tax cuts, spending increases and very low interest rates. This leads big finance to assume that the government will keep money flowing and will step in if catastrophe occurs.”

This philosophy of government was first incorporated into government policymaking in the early sixties and has continued as the foundation for economic policy ever since. A consequence of this has been that the purchasing power of the dollar has gone from $1.00 in January 1961 to $0.15 in 2010. And, as we know, a sustained inflationary environment is one that produces massive debt creation and increasing financial leverage along with extensive amounts of financial innovation.

This leads us to another part of Rajan’s argument: “As incomes at the top soared (in the last half of the 20th century), politicians responded to middle-class angst about stagnant wages and insecurity over jobs and health insurance. Since they couldn’t easily raise incomes, politicians of both parties gave constituents more to spend by fostering an explosion of credit, especially for housing.” And, Wessel states, Rajan goes back in history to support the fact that this is not an atypical reaction.

The latter move not only contributed to general inflation, but eventually led to asset price bubbles in specific sectors of the market which could not be sustained. Hence the financial crisis!

Finance has never really been connected to THE REAL ECONOMY. Take a look at Niall Ferguson’s book “The Ascent of Money.” (See my review, http://seekingalpha.com/article/120595-a-financial-history-of-the-world.) This is especially true since the growth in finance and financial innovation, historically, has been connected with government’s financing of wars and, in the 20th century, the social system.

Furthermore, finance, in the future, is going to be even more connected with the idea of information and the exchange of information. For example, see the book “The Quants” (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson). And, this concept is spreading beyond financial markets. An amazing amount of research efforts and publications are connected with “Information Markets” which are not related to financial markets. Bob Shiller of “Irrational Exuberance” has produced a lot in this area: see his books “Macro Markets” and “The New Financial Order.”

The point is, again, that the President and Congress are fighting the last war. But, the last war is history!