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.”   

Wil Bernanke Policy "Destroy Credit Creation"? Bill Gross is Worried It Will--The Role of Financial Innovation

Yesterday I discussed the concern Bill Gross, founder and co-chief investment officer of PIMCO, has about the current Federal Reserve policy of keeping short-term interest rates low for the next two years.  The concern extends to the possibility that the Fed will attempt to “twist” the term structure of interest rates by buying more and more long-term government securities in an attempt to bring longer-term interest rates in line with the very low short-term interest rates.  Gross sees the efforts extending to the seven- and eight-year maturity range.

The concern Gross has is that a flat yield curve will cause banks and other financial organizations to de-leverage even further and faster than they would under conditions the of un-sustainable debt levels created by the previous fifty years of credit inflation.  Gross, in his Financial Times article (http://www.ft.com/intl/cms/s/0/04868cd6-d7b2-11e0-a06b-00144feabdc0.html#axzz1XGri4Us6), argued that the Federal Reserve consistently maintained a positive slope to the yield curve throughout this fifty year period (with the exception of periods of tight monetary policy) so that the banks and other financial institutions would continually provide “credit creation” so that the economy would continue to expand and create jobs. 

The positive slope to the yield curve provided the mechanism for this credit creation through three channels that I have written about on a regular basis.  First, the positive slope to the yield curve meant that banks and other financial institutions could borrow short at relatively low interest rates and lend long at higher interest rates.  The mis-matching of maturities increases interest-rate risk but then if the yield curve, on average, remains positive, the positive yield spread can be maintained over time.

Second, credit inflation “bails out” riskier loans so the banks and other financial institutions could lend money on riskier deals and thereby earn an even larger interest rate margin.  To paraphrase Warren Buffet…if credit inflation tide is rising, it is hard to tell bad assets from good assets.  Only when the credit inflation tide recedes and the water level drops do we discover who is not wearing a bathing suit.   Tell me about the sub-prime mortgage mess…

Third, narrow interest margins can be turned into substantial returns on equity by the use of financial leverage.  And, if competition brings net interest margin levels down, banks and other financial institutions can maintain the levels of return on equity they had previously earned by adding more and more financial leverage to their balance sheets. 

This third component of the growing risk exposure of a period of credit inflation can only succeed if the banks and other financial institutions are “liability managers”.  In terms of the last fifty years, financial institutions became liability managers through the process of financial innovation.  Most financial institutions were locked into their balance sheets before the 1960s because money and capital markets were not developed to the extent that banks and others could buy or sell all the funds they wanted a the going market interest rate.

Commercial banks, at this earlier time, could only obtain funds through “local” markets and these funds were not very interest sensitive.  Hence, these organizations were “asset managers” limited to what Leo Tilman calls “Balance Sheet Arbitrage”.  (See a review of Tilman’s book “Financial Darwinism” at http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman.) Balance sheet arbitrage is the “old” way of commercial banking where banks are “local” in nature and obtain funds from demand deposit accounts and savings accounts which pay very low interest rates and lend the funds out to borrowers, many of whom have no other sources of funding so that the interest on these loans are relatively high.  Thus, the banks worked with nice interest margins that were relatively stable and reliable. 

Liability management came into pay through the financial innovation of the 1960s.  Negotiable CDs and Eurodollar deposit along with holding company issue Bankers Acceptances became the innovation of choice in the larger banks and this freed up the balance sheets of banks so that they were no longer limited to “local” constraints on the choice of funding sources.  Funding sources became world wide and the understanding was that, at most times, banks could now buy or sell as many funds as they wanted at the going market interest rate. 

In essence, commercial banks could now “leverage up” as much as regulation…or accounting rules…would allow!

And, as regulation eased up, banks and other financial institutions got into other financial and organizational innovations.  Tilman lists these as moves into “Principal Investments” (private equity and venture capital, investments in hedge funds, or, capital allocations to internal proprietary trading desks) and “Systematic Risks” (which included interest rate risks, credit risks, currencies, commodities, and equity indices). This created an environment I have called the “New Liquidity.” (See http://seekingalpha.com/article/289579-let-s-move-on-from-keynes-and-accept-the-new-liquidity.)

The result? Bill Gross nails it in his article: “Thousands of billions of dollars were extended…” It seems as if capital requirements were non-existent.  Credit could expand almost without limit.

And, why are we interested in credit inflation and not price inflation?  Why do we focus on credit creation and not money? Focus, in the past, was placed on money because people were concerned about what was happening with consumer prices…”flow” prices.  “Flow” prices relate to the prices paid for goods and services that are consumed in a relatively short period of time.  “Flow” prices are to be differentiated from “asset” prices. 

“Flow” prices are in many ways “constructed” prices.  For example, in the construction of the Consumer Price Index, the price of a house is not included because that is the price of an asset.  The “flow” of housing services is what people consume and the “price” of this flow of services is called “rent”.  In the construction of the CPI, the “rental price” of housing services is, to a large extent, estimated.  And, as it turns out, since the consumption of housing services is such a large component of consumer expenditures, the “rent” component turns out to be the largest part of the CPI.

Theoretically, the price of an ‘asset” (the price of a house) should be equal to the discounted present value of the future cash flows relating to the purchase of the housing services provided by the house (the rent or rental value of the housing services).  In the world these two prices can differ from one another for a substantial amount of time as they did during the 2000s where housing prices were severely inflated and estimates of rental values lagged far behind. 

This is true of other asset categories like equity shares that are traded on the stock markets (take for example the Internet bubble of the 1990s).

Thus credit and credit inflation are of crucial interest to the behavior of prices…all prices…in the economy.  And this is why we must be interested in cumulative credit inflations that become unsustainable and turn into cumulative debt deflations that create a “formidable headwind” (thank you Mr. Bernanke) that must be overcome by any fiscal or monetary policy hoping to stimulate growth in the economy. 

The problem seen by Mr. Gross, however, is that the monetary policy now being followed by the Mr. Bernanke and the Federal Reserve that promotes a flat yield curve will just exacerbate the situation because it will accelerate the debt deflation taking place.  One could also argue (ala Mr. Gross) that the situation created by recent financial innovation, the “new liquidity”, will further add to the volatility of the whole situation. 

The "New" Liquidity

This is the age of the “New” liquidity.  This new liquidity is driven by two things: first, information technology; and second, by the free flow of capital throughout the world. 

Finance is nothing more than information.  A dollar bill can be exchanged for another dollar bill.  A demand deposit can be exchanged for dollars and is nothing more than 0s and 1s on some bank’s computer.  A bond provides you with a series of cash flows, which are nothing more than electronic blips, 0s and 1s.  Mortgage-backed securities are nothing more than different cash flows cut into streams that suit the needs of whoever buys them…0s and 1s.

Information can be “sliced and diced” any way that you want it and can be stored and transmitted instantaneously almost anywhere in the world.   This latter point is where the free flow of capital throughout the world enters the picture.

This free flow of capital throughout the world is where the “new” liquidity comes in.  Financial assets, in today’s world, are extremely liquid.

 That is, these assets are liquid…until they aren’t liquid!  They remain liquid until something changes, like the price of the real estate behind certain assets ceases to rise continuously. 

And, this is the new world that the Federal Reserve has to operate within. 

The financial innovation of the last fifty years has been truly exceptional.  Information technology has aided this advance.  There are derivative instruments everywhere.  International capital markets have meant that financial assets can be placed all over the world.  The finance industry has become a huge part of the global economy, both in terms of wealth produced and in terms of employment.  Even manufacturing firms like General Motors and General Electric have gotten into the game and in recent years their finance wings have produced a majority of their profits.

The volume of financial assets that have been produced in this environment has relied on the liquidity of international capital markets to facilitate and expand the flow of these assets into every corner of the world.  The ease of the flow has been truly remarkable.

But, it is the very ease of the flow that has created problems here and there.  The problems I am alluding to are called “bubbles.”  Because capital can flow so freely from market to market and this flow can take place almost immediately, capital can move rapidly from various segments of the capital markets into other segments as sentiment or information changes.  And, as long as the markets remain “liquid” the movements can continue until the situation is played out.

This is a different environment from the one that the current model of monetary policy is based upon.  That model, originally created through the Bretton Woods agreement in the 1940s, assumed that there would not be a free flow of capital internationally.  Thus, with a gold standard and fixed exchange rates, the economic policy of a government could be focused on maintaining high levels of employment, low levels of unemployment. 

Of course, the credit inflation of the 1960s destroyed the underlying assumptions of this international monetary agreement and this was institutionalized on August 15, 1971 as President Richard Nixon took the United States off the gold standard and floated the value of the dollar.

The subsequent period of credit inflation and the consequent explosion of financial innovation has taken us into another realm.  And, it is this new environment we are dealing with now.

Money can now flow almost anywhere at extremely rapid speeds.  Money can flow almost instantenously into different sectors of the financial market.  Thus a change in investor sentiment or the introduction of new information or a change in the stance of monetary policy can create “bubbles” in different sectors of the economy. 

We saw a growing occurrence of bubbles over the past 20 years.  We saw the dot,com bubble in the 1990s followed by its collapse in the early 2000s.  We saw the housing bubble in the early 2000s, followed by the collapse in the housing market in the latter part of the decade.  We seemed to have had stock market bubbles in both decades. 

Recently we seem to have had a bubble in international commodity markets due to the quantitative easing of the Federal Reserve system along with bubbles in certain emerging nation stock markets.  One can also make the argument that the recent behavior of the Treasury bond market represents a bubble.  How else can you explain the fact that the yield on Treasury Inflation Protected Securities (TIPS) has been negative.  Participants in the financial markets were not interested in TIPS for their yield but as a price play connected with the “rush to quality” in international financial markets.  (See Jeremy Siegal and Jeremy Schwartz, “The Bond Bubble and the Case for Stocks,” http://professional.wsj.com/article/SB10001424053111903639404576516862106441044.html?KEYWORDS=jeremy+siegel&mg=reno-wsj.)

Former Fed Chairman Alan Greenspan continues to claim that a bubble cannot be perceived before-the-fact, that is, before the bubble has burst.  Hence, the Federal Reserve could not fight off bubbles in financial (or commodity) markets because they could not be identified.  This seems to be the reigning philosophy of the current leadership at the Fed.   It is the old model of monetary policy.

Yet, the liquidity of international financial markets is a reality and the existence of bubbles is a fact of life.  I believe that these facts are being accepted by the people running our governments and central banks.   Yet, their thinking still has a ways to go and their model of how central banking should be conducted has not been completely formed. 

For one, these “leaders” seem to think that every problem they are facing is a liquidity problem.  I have addressed this earlier. (See http://seekingalpha.com/article/288610-the-debt-crisis-it-ain-t-over-until-it-s-over.) Thus, their solutions are systematically based on the maintenance of liquidity in international capital markets.

The fact that the market for an asset may be illiquid because it is related to cash flow problems, say as in real estate investment, and that no amount of liquidity will bring the value of the asset back to previous levels seems to escape these “leaders.”  That is, an asset is liquid, until it is no longer liquid.

Second, the model being used by these “leaders”, a model that places high economic growth to achieve low levels of unemployment, leads these “leaders” to adopt policies, like QE2, that are totally inappropriate for the current economic situation.  Providing liquidity in these cases may create further bubbles, as presented above, but may have little or no effect on economic growth or employment.

Fed Chairman Ben Bernanke is a very creative person.  He has been improvising monetary policy for the last three years.  The old model does not seem to fit any more.  Yet, a new model has not been created.  But, any new monetary policy must be based on the reality of today, a reality dominated by instantaneous flows of money to almost any where in the world.   

Keynes knew that you could not focus a nation’s economic policy on its own employment situation when capital flowed freely throughout the world.  That is why he created his macroeconomic model.  His followers, especially the fundamentalists Keynesians, don’t seem to understand this reality.   It is time to move on.  It is time to accept the reality of the “New” liquidity.

Response to "The Future of Banking" Comments

In response to two comments on my recent “Future of Banking” post (http://seekingalpha.com/article/287037-the-future-of-banking-looks-grim-again) I would like to make the following additions.

First, in terms of the number of employees in banks, I truly believe that the existing model of commercial banking is “legacy” and is in the process of changing.  The comment was made, for example, that “Until customers don't want to come into bank branches anymore, you will have to retain that model.”

In the past five years, I don’t believe that I have been in a bank branch in which there were more than three customers (including myself) at any one time.  And the branches are of similar size to the ones in which I was a teller back in the 1960s. 

I remember those days.  On a Saturday morning when the branch opened at 9:00 AM we would have eight tellers working eight tellers windows and lines of 10 to 15 people at each window constantly until 1:00 PM when the branch closed.  The weekdays were not so busy, but there was always a constant flow of customers through the banks.

I do not know exactly what the future of banking is going to be, but I am working on it as I write.  I have studied, written about, helped start up companies and worked with early stage companies in the area of information technology.  I am on the board of a newly formed bank and am in the process of starting up a credit union.  The use of information technology is constantly on my mind with respect to its application to the finance area. 

Everything I know and have experienced indicates that banking and finance is going through a quantum leap and, over the next ten years, will evolve into something we may not recognize as banking and finance, given the models we work with today.

In teaching classes in information science, I suggested two places for the students to look for ideas about what the future would be like.  First, I said, look at what the military is doing.  They must be ahead of everyone else in their ability to keep secrets and to fight wars (kill people).  They must have the most advanced technology.  Second, I said, look at what the young people are doing the kids in the 8 to 14 age bracket.  What is ubiquitous to them will be “standard” in five to eight years. 

If your business does not take these two things into account in your operations then you will probably not be around to enjoy this future.

I know young people that have not been inside a bank or the branch of a bank for at least five years.  I seriously doubt that my grandchildren will see the inside of a bank or the branch of a bank more that just a few times in their life. 

Finance is information…and nothing more.  Hence, how information is stored, processed, and used will dominate the practice of finance. 

I hope I find out what the future of banking is going to be before others do. 

Whatever it will be, it will not be as people intensive as it is now.

The second comment had to do with “mark to market” accounting.  The comment correctly indicates that many bank assets are probably over valued and this fact will come to light in the future indicating that many banks are in worse shape in terms of capital than we presented think they are.

The comment concludes: “I have seen very few people focus on this in what I have read over the past 3 years, yet I think what I have spelled out here is a potentially looming 'largely unrecognized' further problem. “

I agree with this analysis but would add that over the past three years I have constantly argued in my posts  (you can look them up on Seeking Alpha) that the commercial banking industry needs to go to a accounting system that does a better job of “marking “ assets to market.  This, to me, is essential for the finance industry to be “open” and “transparent”.

In terms of my recent post, I just did not have time to get into this issue.  Of course, adding this issues to the other two does not make the future of banking look any rosier.

The Future of Banking: Dodd-Frank at One Year

Well, we have suffered through one year of the new financial reform act passed in 2010.

“Some critics of the law contend that it skimped on the details, leaving regulatory agencies with too heavy a burden” having to write up the specific new rules and regulations.)  

Of the 400 new rules due from the reglators, only 12 percent have been finalized while 33 percent have missed the deadline set for their finalization.  There are still 55 percent of these rules that have a future deadline.

Barney Frank, co-author of the act, said Congress had no other choice.  “We didn’t punt anything.  It’s precisely because we knew we couldn’t get everything exactly right that we did leave room for the regulators.” (http://dealbook.nytimes.com/2011/07/20/barney-frank-financial-overhauls-defender-in-chief/?ref=todayspaper)

Part of this is because Frank…and others…didn’t really know what they were doing.  The article continues “Even he (Frank) concedes that arcane financial matters were never his strong point.” Frank jokes: “I know more now about repos and derivatives than I ever wanted to know.”

The result: we have a Congressional law, the Dodd-Frank Act, aimed at preventing 2008-2009 from happening again, written by people who knew little about banking and finance but had to do something to save the world from the people who ran Wall Street. 

The major concern of Congress was about institutions that were too big to fail.  These “large” banks were to create “living wills” that provided a blueprint of the organization’s operation that would allow regulators to dismantle the bank in an orderly fashion.  (These, of course, have not been written yet.)  And, there were other things about proprietary trading and derivatives and disclosure and so forth.

My conclusion from one year of Dodd-Frank is that the financial industry will survive…in some form…and will do very well over time although not in the way Congress will like.

I must admit, my awareness of the banking and finance industry began in the 1960s.  This was really the first decade that the laws and regulations coming out of the period of the Great Depression were really tested.  The 1940s was a period the United States was focused on war; and the 1950s were devoted toward the country getting back to some kind of normality following an era of world-wide depression and world war.

In the 1960s the fifty-year period of credit inflation got its start and this changed everything.

Since this period has spanned my professional career the evolution that took place is very real to me.  The period started out very calm and contained.  Banks were very limited in what they could do and they were especially constrained geographically.  There were unit banking states where a bank could only have one office; there were limited branching states where a bank could have multiple offices although the number were limited; and there were states that allowed state wide branching.  However, banks could not cross state lines and branch in other states!

There was a definite line between different types of financial institutions.  There were, of course, the commercial banks…and the savings and loan associations…and the mutual savings banks…and the investment banks…and so on and so forth.

The products and services offered by each type of institution were severly limited and closely regulated.  Interest rate ceilings were present to protect depository institutions engaging in “destructive” competition that would weaken the banking system. 

In my mind, two major things occurred as a result of the initiation of credit inflation in the early 1960s.  First, United States corporations grew bigger and bigger.  Second, international flows of capital were freed up from earlier constraints in order to support the growth of world trade. 

The consequence of this was that financial institutions, especially commercial banks, had to break out of their constraints so that they could serve there larger customers, both within the United States and in the world. 

Financial innovation began to roll.  The four biggest financial innovations that took place in the 1960s, I believe, were the formation of bank holding companies, the creation of the negotiable CD, the allowance of bank holding companies to issue banker’s acceptances, and the invention of the Eurodollar deposit.  These innovations basically over came state laws and allowed American commercial banks to become world bankers. 

By the start of the 1970s, state banking restrictions were effectively dead and the freed-up international flow of capital doomed the gold standard which was officially buried by President Richard Nixon on August 15, 1971 when the floated the United States dollar. 

As the credit inflation continued through the last half of the century financial engineering and financial innovation dominated just about everything else other than the growth of information technology.  Perhaps the final nail in the coffin of the 1930s financial regulation was delivered in 1999 as the United States Congress repealed the Glass-Steagall Act of 1933.  This was the act that separated commercial banking from investment banking into separate organizations.

My point in reviewing this history is to make the claim, again, that “economics works.”  If there is an economic reason for an individual or institution to “get around” laws and regulations, then that individual or institution will “get around” those laws and regulations.  Some laws and regulations will fall earlier than others but these latter laws and regulations will be circumvented over time as there develops more and more reason to do so.

In other posts I have argued that the banks that were too big to fail before are now bigger and more prominent than before the recent crash.  Also, financial institutions have already moved way beyond the “intent” of the Dodd-Frank Act in the areas that have the most economic promise, have “cooled it” in other areas, and in some areas where it has not really been worthwhile for them to fight they have relinquished those minor facilities. 

Especially in this “Information Age” finance and financial arrangements are going to be harder than ever to regulate and police.  Finance is nothing more than information, nothing more than 0s and 1s (see many of my posts in the past) and information can be “sliced and diced” almost any way one wants to slice and dice it and can flow, almost instantaneously, throughout the world.

The only thing of benefit that has come out of the new financial reform act has been some increases in transparency but this has not come anywhere close to the level I would like to see happen. 

These are some of the reasons for my conclusion of one year of Dodd-Frank that the financial system will survive.  However, the system that is evolving will be a lot different than what we see now and a lot different from what the Congress and the regulators would like to see.  Also, I am still predicting that the number of financial institutions in the system will drop below 4,000 (from a little less than 8,000 now) over the next five years. 

Let’s just hope that Congress and the regulators don’t chase most of the finance offshore.    

Debt and Accounting Gimmicks

Isn’t it interesting that highly leveraged institutions and organizations seem to bring out very innovative accounting strategies?

It is in times like these that were learn just how creative accountants can be. 

“Weekend elections that threaten to drive Spain’s ruling Socialist party from power in several regions and cities also promise a potentially nasty surprise: the revelation of piles of undisclosed debt in local governments that could undercut the country’s drive to avoid an international bailout.” (See “Spain Vote Threatens to Uncover Debt,” http://professional.wsj.com/article/SB10001424052748704281504576331280001740702.html?mod=ITP_pageone_2&mg=reno-wsj.)

“Five months ago, a government change in Spain’s Catalonia region revealed a budget deficit more than twice as big as previously reported.  Now a growing chorus of economists, local politicians and business leaders say that new governments are likely to discover, as Catalonia did, piles of ‘hidden debt’ owed to health clinics and other suppliers.”  It is suggested that “there is widespread, unrecorded debt among once-free-spending local governments.  Some companies are complaining that fiscally frail administrations are pressuring them to do business off the books and not immediately bill for goods and services…”   

“Such bills could add tens of billions of euros to the official debt figures reported by local and regional governments.  If such skeletons come out of the closet in coming weeks, Spain’s cost of funding could continue to rise—throwing the country back into the limelight after it has struggled to demonstrate it doesn’t need to be bailed out like Greece, Ireland, and Portugal.”

Wait a minute…didn’t the renewal of concern over the debt situation in Greece come about because it was discovered that the amount of debt owed by the Greek government was worse than had been previously accounted for. 

We don’t need to just keep picking on European states.  What about state and local governments in the United States?  Pension funds grossly underfunded?  Off-balance sheet financing?  And more?

But, why stick with governments?  What about Lehman Brothers?  What about AIG?  What about Citigroup?  The amounts of off-balance sheet tricks used by these organizations fill the current library of books about the recent financial crisis.  The story is about CDOs and SUVs and so forth.  Trying to disguise liabilities is not just a gimmick of the public sector. 

To me, however, this mis-accounting goes even further.  The question really is one about where do you draw the line.  That is, what types of accounting efforts are meant to evade discovery and hence are not exactly kosher…and which ones are of little or no harm? 

For example, how do you value an asset on the balance sheets of financial institutions?  If you hold a marketable security you must be concerned with the liquidity of that security when valuing the asset.  If interest rates rise and the market price of the security goes down, do you mark-to-market the value of the security on your balance sheet?  If the security is a part of the trading portfolio of the institution then the general answer is that the value of the security on the balance sheet should be marked down.

But, if the institution bought the security to hold then the question becomes more difficult for some people to answer because the intention is to hold the security to maturity at which time the full amount of the principal would be repaid to the institution.

Now, what if the credit quality of the security comes into question?  There are really two questions here: the first has to do with the credit quality of the security; the second has to do with the liquidity of the security?  If the credit quality of the security declines, then, given the value of the asset should decline…its price should fall.  Thus, the market price of the security should decline.  However, if the market is uncertain about how to price the asset, given the decline in its quality, the market for the security may “dry up” and the security may not be able to be sold immediately.

Thus, the value of the asset on the balance sheet should be adjusted downward, but without any market judgment about what the price of the security should be…how do you determine the amount the asset should be written down?

Here we have a problem that was addressed by the US government’s Troubled Asset Recovery Program (TARP) during the financial crisis.

Many in the financial industry have argued that the assets should not be marked-to-market in such cases because there is really no market for the asset.  Hence, these securities should be retained on the balance sheet at book value.

Now, what about the direct loans a financial institution makes?  Almost all of these do not have markets in which they can be sold.  So, the loans are totally “illiquid”.  Furthermore, bankers consider that most of the problems the borrowers face are “cyclical” and all that is needed when economic times are not good is for the economy to improve and the loans will work themselves out.  That is, the financial institutions must hold the loans “to maturity” and, thus, they can be held on the balance sheet at book value. 

The question is…what should be the accounting treatment of these assets of financial institutions?

Of course, this problem only occurs during bad times after most of the economy has become excessively leveraged and loan value are under attack.  For example, currently, in terms of residential real estate loans, mortgages, we see that seriously delinquent loans (90 days or more delinquent) are declining but still near historic highs, the number of borrowers in foreclosure remain near record highs, and the sale of houses and housing prices continue to decline. (http://professional.wsj.com/article/SB10001424052748704816604576333222700445278.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj) The commercial real estate area remains depressed.  The loans of these two kinds of loans continue to plummet. (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)  But, has the status of these loans been changed on the books of the banks?

The concern, in these cases, is not with the liquidity of the asset.  The concern is with the solvency of the financial institutions.  Have accounting practices not given investors…and others…a true picture of the financial condition of the institutions under review? 

My concern in all these cases is that we really don’t find out the truth until too late…until it is “after-the-fact.”   Then we blame speculators or others, who take advantage of the situation, of preying on the innocent, of creating the crisis, and, of course, we don’t want to reward speculators. (http://professional.wsj.com/article/SB10001424052748704904604576333393150700686.html?mod=ITP_pageone_2&mg=reno-wsj)  

The bottom line: the pressure to use accounting gimmicks to cover up the “real picture” grows as high degrees of leverage come to dominate an economy.  This is because debt requires contractual payments.  Debt requires an obligation and a responsibility. 

And, so we see a pattern.  Just as credit inflation is the foundation for greater risk-taking, higher degrees of leverage, and more financial innovation, we see that greater risk-taking, higher degrees of leverage, and more financial innovation is the foundation for more creative accounting practices. 

In both cases, we all ultimately lose in the end!