Author Archive

Very good piece in today’s “The Sheet” about the upcoming replacement of CBA’s core banking system. Correctly, it is entitled “Adventures with core systems: part I”. The belief that most banks in Australia need to replace their core systems reasonably soon is a strong one - and in most cases justified. The problem, of course, is also well known.

Core system replacement is expensive, risky and time-consuming. It is a huge change management task, with most of the bank’s staff well trained on the old one. For example - I dropped into my bank to close an account a few days ago. Sitting down with my “client adviser” she opened a web browser to check on my balances and see what I wanted to do. To do the bit she would need to show me she left it in the browser. However, as soon as she wanted to actually do anything she opened up a terminal emulator. I peered around and asked why she had not done it in the browser.

Her response was simple – the browser allowed her to do it but she was much faster on the terminal. Essentially, although the terminal emulator was lousy to look at it was effective and fast.

At that bank, and almost every one I have ever been into the story is the same – bank staff are comfortable with the old systems. Despite the fact they are built on technology that was outdated 20 years ago they still work. Staff are familiar with them. Anyone seeking to replace the system not only has to make it work from a technological viewpoint – but it also has to work in the organisation.

In comments, feel free to add in your favourite banking core system replacement story. Ones from Westpac are particularly invited – the one that was particularly successful a few years ago sounds good. Operational risk events can also be pretty funny - if you are not in the middle of one.

Give “The Sheet” a read too. if you are interested in banking activity in Australia it is worth it.

Today’s piece in the Herald Sun was interesting. HBOS have put a lot of time and effort into their international expansion over the last decade, so I would have to be skeptical that they would be looking to sell. That said, if they were looking to raise a fair amount of fresh capital, selling all, or only part, of BWA would make some sense.

If we assume that St. George will be sold to one of the big 4 (whether Westpac or not is irrelevant) then BankWest would be the fifth biggest bank in the country - and the only way for one of the others of the big four to increase scale without actually having to do the hard work of increasing business gradually - through processes like increasing customer satisfaction, building the brand etc.

It would also be the only way (except perhaps through a purchase of the ANZ) that a large international bank could gain scale quickly.

If HBOS were looking to sell they could expect a very full price as a result.

The only problem, of course, would be the Bank of Western Australia Act, 1995, and in particular section 23, which mandates that the bank has to be headquartered in WA and, effectively, run from Perth. For one of the big 4 banks this would mean that they would have to accept a subsidiary headquartered in Perth that they cannot fully integrate. This can be got around in some ways (for example the powers of the Managing Director are not specified - a bank teller could carry the title) but it would be tricky and could expose them to legal issues.

This means that the WA government has at least a partial veto over such a change of ownership - and one they can be expected to wield if required. This would reduce the benefits of an Australian bank buying it - and therefore reduce the chances of this occurring. I would be interested, though, to see if (WA Premier) Alan Carpenter has any meetings with senior members of the management of any of the big four over the next few weeks.

My favourite option, then, would be (if it were on sale) a foreign one buying it - but it would have to be well cashed up as BWA has always been a bit weaker in the deposit side, although that has been partially addressed recently with the help of HBOS.

Personally, I think the ANZ is the most likely to be bought - but the new federal treasurer may have other ideas.

Chris has long been one of my favourite bloggers on banking - the problem has always been working out where his blog posts are appearing. This one, though, is a pearler and he is blogging on one of my favourite themes:

… regulators do not make the markets safer. If anything, regulators make financial markets less safe.

Give it a read.

Prompted by a few recent debates I feel some clarity on why banks actually exist would be interesting. The glib answer is “to make profits by borrowing and lending” - although many would put it in terms much more offensive than that.

Why are these profits available, though? What actual function does a bank perform? In short, what economic use is a bank? Read the rest of this entry »

As I discussed a while back the big four are unlikely to be allowed to consolidate between themselves, so, with St. George being the largest of the second tier this is as big as they are likely to get within the Oz banking community. Banking deals in Australia are unlikely to ever be much bigger than this, but, to be frank, I can’t see the point.

The dangers for Westpac I would have thought are large. From a business / strategic sense this means that they are increasing their bet on New South Wales, with both of the entities being heavily concentrated there. NSW has been looking unhealthy for a while, So I would not be making this call. The real advantage is cost cutting - only one headquarters would be needed even if all of the branches are to be kept^*.

That said, few people could claim to be as knowledgable about St. George as Gail Kelly, so perhaps she has spotted some real hidden value there. She is also likely to know which senior executive she wants, so the integration hit list should be a fairly easy thing to sort out - and my guess would be the hit list has quite a few Westpac names on it.

Having one of the other banks come in and trump the deal cannot be ruled out - someone offering a mix of cash and shares at the election of the holder would be good. The question is, who? The NAB I would have thought unlikely - they have their own issues to sort out. CBA or ANZ? Possible, with CBA as the more likely.

If HBOS had not so recently looked at selling BankWest I would have thought them a strong possibility - the price tag would not be large for them and it would fit with their strategy. They may choose to do it anyway to gain the sort of scale they need - it would mean that there were 5 large banks in Australia as a result. This would probably be the best outcome from a consumer’s point of view as it would reduce the stranglehold the big 4 have on the industry.

I would also expect the regulators to have a say, although I think Westpac would have already discussed this with APRA and they would have some very heavyweight legal advice on the likely ACCC response. That one will be fun for the economists to sort out. If HBOS step in, have a good look - the regulatory and reporting situation there is interesting with a foreign parent, so this one would cause the regulators, lawyers and everyone else a bit more work.

The offer on the table is not a killer one - so it looks like we will have interesting times ahead as this one plays out. Fun for all and big fees for the investment banks and brokers as we all buy and sell shares of the various banks.

*Not something I can believe. I do not know of any, but there would have to be a few Westpac branches really close to some St. George’s ones. Having two branches of the same bank on one block to me at least makes little sense.

[Update] I just thought - Gail could be buying it to hide some mistake she made earlier - but I would have thought this unlikely. Disclaimer - this is just a thought and I have no further information on this.[/Update]

I am going to break my (self-imposed) silence and make a post on this. Following on from an earlier post on the situation in the UK it looks like the legal situation is the same here - or in Victoria at least. Today’s Crikey has a story on how one of their contributors took Citibank to the small claims tribunal over a $40 fee - and won, with costs, after Citi simply failed to turn up. Even better, Citi had paid out the claim even before it hit the tribunal.

The Crikey piece notes that this does not set a binding precendent, but

the fact that a full-time VCAT member provided a judgment noting that the bank-fee charged was unenforceable and amounted to an unfair term in the contract is an indictment on the conduct of a financial institution. While Citigroup did not defend the matter, the VCAT member would have been within his rights to dismiss the application if he was of the opinion that it was without merit.

So, this one is just waiting for a test case. We have an interesting possibility here. If you believe the fees you are paying are excessive then - claim them all back. All of them. Just find a lawyer willing to take on your bank.

Surprisingingly, Citi’s newsroom says nothing on the topic of this court loss.

Thanks to The Sheet for pointing me at this.

I am happy to say we have picked up a new author, so I am unsuspending Ozrisk.

Following on from my post below I have one volunteer to act as administrator for the site, but no new authors. As a result, I will be putting ozrisk into hibernation. If you would like to join as an author please contact me on the email address on the “Authors” page and we can have a chat.

I will leave the contents of the blog up for an indefinite period in the hope that someone wants to take it over and run with it. The current 200+ visitors a day also seem to be finding the content useful.

Otherwise, thanks to you all for reading ozrisk over the last (more than) two years and  farewell.

As I will shortly be moving out of a front line risk role (and in fact out of the banking game entirely) this blog is looking for a new administrator and as many authors as possible to support him or her.

The task is not too onerous, but you will need to have a strong risk background and be comfortable with blogging software - which is not too difficult.

If you wish to take on the admin role, or become an author, please let me know on my email - the address is on the “Authors” page link above.

Unless a new admin is found this site will have to close in 3 weeks.

At least for a while this is likely to be the final word on The Rock.

It’s in today’s Alex.

Oh, and thanks to Johan Steunenberg at Calculated Risk for pointing out this one - Credit Suisse looks like they have their own “rogue traders”. If you don’t read German (and mine is not the best, so apologies If I have misunderstood) Johan is speculating that CS may have taken a cue from a previous Alex (mentioned below) and found some rogue traders to cover up sub-prime losses.

That would be false reporting, wouldn’t it? Anyway, It looks like a story worth following.

I can only note with sadness the nationalisation of Northern Rock - an outcome I regarded as fairly well inevitable due to the desperately botched process from the original announcement of problems (not even made by Northern Rock itself) through to the guarantee and on to the sale process.

As I said earlier - this should be an object lesson to governments not to get involved. I would also add to that and say that there are a lot of takeaways from this for banks -  get the name risk procedures in place early and practice them often. Treat liquidity risk as, if anything, more important than credit risk. On a more personal note - make sure your risk management people are amongst your best. Pay them well.

I was re-reading last week’s The Economist last night when I happened across the Buttonwood column that I had missed on my first pass. The title, “Heart of Glass” was not promising, but the tagline was very interesting - “Existing regulation seems to encourage banks to get into trouble“.

Buttonwood makes the very valid point that, despite often being derided as the “Wild West” operators, the hedge funds have come through all this (so far at least) without too many major losses. Only a very few have failed (I can think of only one so far, although I am sure there are more) and there have not been many major losses announced.

Banks, on the other hand, have not had a good record. Apart from actually being behind much of the lending that actually caused the issues in the first place the big losses also seem to be concentrated there - just not in the banks that originated the loans. The question Buttonwood asks, but ultimately shies away from is this - is this despite, or because of, the regulations?

Buttonwood puts it this way:

This suggests two main possibilities. Either the standard of bank regulation is very poor or there is something about being regulated that leads to trouble.

The answer from Buttonwood is that it is both - but clearly puts more weight on the first. I would, respectfully, disagree on where the weight should lie.

There are many faults with bank regulation around the world - Basel I, for example, I regard as having improved matters to the extent it was global, but made matters worse by its reliance on simple rules - for example that a loan secured on residential real estate shall attract a 50% weight - regardless as to whether it was super-prime, prime or sub-prime. It also created strong incentives to “game” the system by the “originate and distribute” model that really gave rise to securitisations. This gave a logical reason why a bank may choose to eliminate assets from its balance sheet (other than the possibility they were bad assets) and the market for these assets grew - and ultimately the market got fed some rubbish oops, I mean high-yield assets.

Basel II, particularly the Advanced methodologies, is much better in that economic capital is much closer to regulatory capital - a point I have made many times. It is, however, nearly impossible for smaller banks to implement and most regulators have also said that, to an extent at least, Basel I will effectively continue to apply for a while through the capital flaws floors.

The incentive to game the system, then, will continue, particularly for the banks going Standardised. There are also many other examples of regulations that, while possibly carefully thought out, end up causing many more problems than the one they were originally designed to stop (submissions invited in comments).

Buttonwood’s proposed solution is, essentially, to re-introduce the US Glass-Steagal Act of 1933, essentially separating commercial banks (that interact with the general public) and investment banks (that do not). The commercial banks would attract a government guarantee and the investment banks would be free to fail. Entities like Citigroup would have to break themselves into two.

In the (probably too many) years I have been dealing with bank regulation I have seen it fall into several categories - ranging from the ones that simply mandate what would otherwise be common sense to the merely annoying to the outright catastrophic. The last ones tend to be introduced and then pulled pretty quickly.

Some of it is needed for legal or criminal purposes - AML/CTF falls into this category. For the rest I would like, as I have said earlier, to see the regulation substantially removed (or at least pared back) and solutions other than a single monolithic regulator for each country to be tried. If a single regulator gets it wrong now the whole system is at risk until the government rides in on its White Charger - see Northern Rock. A truly competitive system would not allow a single regulator to have that much downside on its failure.

The news that SocGen is going out to market with a request for more funds from its shareholders^* reminded me of an Alex cartoon from a few days ago.

For obvious copyright reasons I can’t (or at least shouldn’t) include it here, so follow the link. Maybe a few more “rogue traders” will be found once this possibility strikes home.

BTW - Alex is one of the most consistently on the mark cartoons about banking, a subject that normally does not get much in the way of comic exposure. I would recommend a daily dose.

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*wot - can’t tempt a sovereign investment fund?

Interesting article (possibly behind the paywall) in Friday’s the Economist on the causes of the lax lending standards that have subsequently blown up. It points to some research by Atif Mian and Amir Sufi of the University of Chicago’s graduate school of business which points the finger directly (and unsurprisingly) at the process of securitisation, where the loan assets were parcelled up and sold off with little or no residual risk being held by the originator of the mortgage (i.e. the lender).

While this is the consensus on why this happened, the evidence presented is useful and should allow for these deals to be better structured in the future - with a fair amount of the residual risk retained by the actual lender.

Perhaps the first question that purchasers of such instruments should ask in the future is how much of the risk is with the originating lender - and do not touch it if the answer is either “not much” or “none”. The actual lender should be in the first loss (or “equity”) position for a reasonable amount.

The speech given yesterday by the Archbishop of Canterbury is interesting - to say the least. He goes in great depth into many of the issues confronted by those trying to give some effect to Sharia in Western jurisdictions. For those interested in the area a close read is worthwhile. While his focus, given his background, is on family and allied areas of law, he does touch on other issues.

This blog’s focus is on financial matters I would be interested in feedback on the questions of what real impediments are there in Western (and in particular Australian) law to allowing Sharia to govern financial arrangements? Given there is wide freedom of contract (within the regulatory limits) I am not aware of many contractual problems - provided the parties to a contract agree to the terms then generally the courts here will enforce it - regardless of whether it is founded on Sharia or not.

Regulatory and taxation issues seem to be the big ones - the banking regulatory system as it stands essentially does not cope with many Sharia compliant frameworks.

A good example of this is a Sharia compliant mortgage institution, which would not be allowed to treat its mortgages in the same way as interest bearing ones and would be effectively penalised with a much heavier capital load. This can be fixed, though - the IFSB regulatory framework could be allowed in the same way that the Basel II one has been.

Insurance would be another regulatory issue. A Takaful structure is also not coped with under current APRA standards - but there is no reason why they cannot be. In theory at least, because a Takaful insurance structure is truly mutual it should be less likely to fall over that a traditional Western insurer.

Funds management and superannuation I have dealt with previously, but as these can be dealt with under the “ethical” banner these should be the least trouble of all.

Taxation is an issue. Like the UK, the  tax law is not set up here for many of the Sharia structures - with the bond-like instruments a particular example. Again, like the regulatory issues, and like the UK, these could be dealt with through fairly simple legislative changes.

Media release, requirements and forms relating to the Basel II reporting requirements were today released by APRA - only half way through the period for which the reporting will be needed. Good timing. Maybe the next changes will be released before we have to comply with them. I don’t ask for much.

By the way, there is a slightly misleading title to this piece, as the standards released today are plainly not final. In the response to submissions paper APRA moot two further changes, both to undo changes that have been made to this version. These are covered below.

One other little gripe - I had some trouble finding the response to submissions paper on the Basel II home page at APRA, as, silly me, I was looking for a paper released in 2008. Perhaps in a cunning plan to make it look like they were early, the release date on the page is 6 February 2007, not 2008. I trust this will be fixed shortly. If you are with APRA, you may want to talk to your web people and get his fixed, pronto. On the other hand, maybe not.

OK, onto the actual content. I will use the APRA paragraph numbers from the response paper to talk through them. If you are really interested, print the thing out. Double sided, it is only 7 pieces of paper. Don’t ever print all the requirements. Read the rest of this entry »

The report from the French Justice Ministry came out last night (our time). My French is less than perfect and certainly not up to the job of translating what is a torturous navigation around a legal minefield, so I have been reviewing the published articles on it.

The best I have found is, as usual, from the FT. I would encourage a read if you are interested in the this whole sorry saga. The best quote, though, came from the press conference:

“Very clearly some internal control procedures didn’t work” Christine Lagarde, French Finance Minister, a quote that clearly falls into the “No S***!” category.

As almost always happens with frauds on this scale, some warnings were ignored. The French market authorities did warn SocGen on some unusual positions being taken and the French banking authorities did notice control weaknesses in their surveillance as part of the Basel II process.

Of course, for both of these the bank may have thought it was OK in ignoring them. The warnings from the markets may have only triggered a quick internal probe that identified apparently  balancing trades on other markets or internally - precisely the types of arbitrage activities he was meant to be doing. Regulatory visits (I can say from experience) always identify internal control weaknesses no matter how good controls are. Regulators are also typically not as experienced in the markets as your own middle office, so bank management tend to either ignore or patronise regulatory reports.

The quick report that has been released, though, can’t be the final word. In a way, I just hope he does not plead guilty so that the whole thing comes out in court. That promises to be fascinating.

The attached document was sent to be by a friend who got it from a friend…

Soc Gen Explanation

It seems to be an internal SocGen document on the problems encountered, and puts the chronology of events well from the Bank’s point of view. It closely mirrors the BBC’s version of events, but contradicts Kerviel’s, who insists the bank must have known he was trading outside limits long ago.

There are a few bits it does add, including (again, from the Bank’s perspective) how he got around the internal controls.

Personally, at least some of this does not wash. The margining of those (cash flows resulting from) positions over the period he had them should have been noticed, with the cash flows always needing to be much larger than his apparent position. I suppose it will all come out in the wash - it is just as well it was a larger bank with more capital than Barings was.

Today’s BIS email was an interesting one in the light of recent events. It has a speech by Christian Noyer, the Governor of the Bank of France, regarding Basel II’s implementation in France. Remember while you read it that a certain trader’s activities would have been classified as an operational risk loss.
This passage is interesting in the light of the problems at SocGen:

By 31 December 2007, over 30 on-site inspections will have been conducted in 20 institutions, involving at times up to 100 inspectors at a time. These on-site inspections examined IRB systems for credit risk and advanced operational risk measurement approaches.

As SocGen is one of the largest banks in Europe I am presuming that they were one of the banks visited - I think this a safe assumption. This means that SocGen was assessed for operational risk issues while all of the rogue trading activities was going on - the trading that was risking much more than the capital of the bank.
He goes on to say:

…and 5 institutions (accounting for almost 60% of the total assets in the French banking system) are expected to adopt an advanced operational risk measurement approach. As institutions have the possibility under Basel II of using their IRB approaches to calculate regulatory capital requirements, supervisors must ensure that these approaches are reliable.

I really wonder how reliable the regulators found SocGen’s risk management to be in their supervisory visit? How closely did they look? You would have thought that the trading arm, where most, if not all of these events have historically happened, would have been a primary focus of that review. What did they see?
At the very least, SocGen will probably have to carry a much heavier operational risk capital burden now than they would have originally calculated less than a month ago. I think the BoF will have to have a bit more to say on this in the not too distant future. Who is next in line to resign over this? They may not be at SocGen.

[Update]In the light of the latest revelations - see here it looks like a lot more than a single trader should lose his job. It looks like senior management were turning a blind eye to the trading while it was making a profit and only got concerned once it was making a loss. If so, it would make the criminal charge hard to sustain.

There is a lot more to come from this one…[/Update]

The whole Soc Gen thing would be funny if it were not so serious. The latest information is that a 31 year old trader, apparently acting alone, managed to run up a 50bn euros (USD73bn; GBP37bn; AUD84bn) position without it being noticed. Dear, dear me. This is risk management failure on an almost heroic scale. This is more than the capital of the bank.

Just as well Soc Gen has grown fat over the decades on their home market. The real pity is that it looks like the unwinding of that position has caused losses all around the globe. There will be some very happy counterparties in Paris, though. A few magnums of Veuve Clicquot? More like Grande Dame.

US sub-prime driven turbulence? Probably not. French fraud? Probably yes.

The comments from his lawyer are priceless:

Lawyers for Mr Kerviel, who is being questioned by police, said their client had “committed no dishonest act”.”He did not siphon off a single cent, and did not profit in any way” from the bank’s assets, the lawyers told AFP.

They also accused the bank of trying to “create a smokescreen which would divert public attention from losses that were significantly more substantial than those it accumulated in recent months”.

We have to presume innocence, but I will be fascinated to see how they justify that position. It looks like he had admitted the trading activity, so the only possible defence is the Leeson Defence - which did not work for its originator. At least Kerviel will not end up in Changi Prison if the defence fails.

On question that often arises from situations like the recent, unusual, drop in US interest rates and the stimulus package to support the markets is one of moral hazard. Simply put, the question is whether the tendency of the monetary regulators to respond to widespread market drops with action to push more cash into the system creates moral hazard - a willingness to take more risk in the knowledge that the US Fed (for example) will ride in on a White Charger and help.

My answer is that routine “While Charger” action certainly does create the impression that the “Greenspan Put” is a way out of bad decisions - there is always in the back of the mind the thought that the regulators will act to stop “long-tail” events.

Does this impression actually show through into the real world, though? As the market is really a series of micro events that go to make up a macro picture I would doubt it would have a large impact. To put it another way - will the thought that the Fed may act to bail out the market change the way an individual bond issuer or buyer behaves? If I am considering changing a bond position worth maybe a few million I am really going to consider the possibility of an industry wide bailout if an entire class of assets heads south? Will the thought that the Fed will change rates in the event of a general collapse change the way I trade?

Personally, I doubt it. The individuals actually trading can never really tell whether their position is going to be one of those actually rescued by a general interest rate drop or other action. The only point where this may become a thought is where there is already a widespread drop - but in this circumstance the action would be to point the dealers out of the drop, not into it.

That said, it may affect the risk appetites of the largest of players such as the really big banks, so there is certainly a risk of it. I just think it is overstated by people who look at the macro effects of moral hazard and think that the markets act as some sort of a collective intelligence, rather than looking at it as a series of micro events, which, in reality, it is.

DO NOT READ THIS OF YOU ARE IN THE UNITED STATES, CANADA, JAPAN OR AUSTRALIA¹.

Soc Gen have had a bad quarter, but not a bad year. Unlike several other banks reporting losses this quarter, they are not declaring a loss for the full year - but they do have an additional source of pain - a rogue trader², losing EUR4.9bn. Apparently this one got away with it as he was formerly in the middle office and had an “…in-depth knowledge of the control procedures…”. Guys - it should not matter how well you know the control procedures, they should be designed to work in any case. I have a feeling this one will run for a while. The point here is that a position should be noticed, no matter what, long before it gets to a value in the billions, never mind a loss in the billions.

My guess is that he did a Nick Leeson - put the positions in as counterparty positions rather than prop (bank) ones. Still the cash to fund the positions should have shown up. As he was forex my guess is that he was betting against the euro - the biggest losing bet around in a liquid currency (update - corrected in comments below).

Like most of these frauds, I would guess the auditors will be both asking a lot of question and be asked a lot of questions. Luckily, they seem to have two audit firms in there - I presume this is French law. That must be fun for the employees having to deal with them.

As a side note - it looks like the BBC has got the wrong end of the stick - their report (as it stands now) says that it was all lost in one trade. This is not correct according to the Soc Gen press release.

They are going to market for EUR 5.5 bn to make up some capital losses. I presume this is to cover for growth in the business and a re-rating of the risk of their trading portfolio.

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1. OK - that made you look. The press release from Soc Gen has this all over it. Just shows how ridiculous these restrictions are.
2. (UPDATE) Looks like SocGen has disabled access to the release. I have removed the link. The Economist link lower down the post is much more interesting anyway.

Perhaps I should have called this “reflux” rather than “redux”, as the UK government seems to be determined to keep this one running for a very long time - and painfully for all concerned. The latest step, to attempt to securitize the government’s lending to the Rock, seems guaranteed to keep this whole saga going. If they cannot find a private buyer it will go on even further. Even with a buyer, the government guaranteed bonds will live on for years, keeping open the possibility it may be called on if things get worse.

This should be an object lesson to governments - do not get involved beyond what the law says you must do.

Highly interesting document up on wikileaks regarding the sale of Northern Rock. If true (and the threats from the lawyers seems to imply it is) it confirms what I have said all along - Northern Rock is still a valuable entity and the only problem with it is that it ran out of cash - i.e. it was a liquidity problem that brought it down, not a capital one.

Give it a read for interest’s sake. If you are in any doubt as to the true nature of the Rock’s difficulties, this shows them well.

Thank Amir.

For those interested in how regulatory prudential policy interacts with monetary policy around the world, you could do worse than go to a new paper produced by the Monetary and Economic Department of the BIS.

Introductory paragraphs:

It has long been recognised that that there is a strong complementarity between monetary and prudential policies. A sound financial system is a prerequisite for an effective monetary policy; just as a sound monetary environment is a prerequisite for an effective prudential policy. A weak financial system undermines the efficacy of monetary policy measures and can overburden the monetary authorities; a disorderly monetary environment can easily trigger financial instability and render void the efforts of prudential authorities. Economic history attests to this, as illustrated by the anatomy and consequences of the financial crises that have affected the industrialised and developing world, going back to previous centuries.
So much is agreed. What is more contentious is the view that some fundamental changes in the economic environment over the last quarter of a century may actually have tightened the interdependence between monetary and prudential policies, potentially calling for significant refinements in policy frameworks. In some research at the BIS in recent years we have been exploring this possibility in some detail.

I, personally would disagree with what is “agreed” above - to me, the contrast between “weak” and “sound” is a false one - a “sound” prudential policy can also be a “weak” one, such as using a free banking paradigm and allowing competitive non-state regulators. The “agreement” here is more likely to be amongst regulators and others in the regulatory industry.

That said, within the confines of the current system this is a very useful paper, even if it needs a little bit more proof-reading^*. The authors’ access to data and people looks very good and the conclusions they have drawn out of the data and their references look useful.

The real “meat” here, though, is in the tables starting on page 20 - the analysis of the response of regulatory authorities to various financial events over the last 10 to 15 years. The last column in the table could be fuel for weeks of blog posts and discussion. The annex is also useful, being a “first pass” at assessing the impact of the measures taken. Again, for those interested in the area, this stuff is highly contentious, but this analytical framework is a useful one - comparing those countries with took both prudential and monetary approaches to tackling what was viewed as an imbalance to those which only took a prudential measures and looking at the results.

I am not strong enough in statistics to fully evaluate the results, but the methodology looks sound. If you are interested give it a look - and if your stats knowledge is better than mine feel free to give some feedback.

*Last time I checked it was the United States that had an S&L crisis, not the “Untied States”.

Forgive me for a little bit of cynicism regarding today’s announcements from Citi and Merrill Lynch. I have seen all of this so many times it is not funny. Having been in banks when this happens the story internally is that before the CEO leaves or is pushed the emphasis on staff is to minimise losses - “take an optimistic view”. New CEO comes in, the view is to “take the pain” or “look at the position conservatively” or “make a prudent provision”^*.

The script usually seems to go like this:

1. Company does something silly;
2. CEO, Chairman of the Board and sundry other executives or senior officers leave;
3. New CEO appointed;
4. New CEO announces massive losses and uses words like “pain”, “unacceptable”, “crisis” etc.;
5. Rescue package announced (optional for added effect);
6. New CEO announces large cuts / restructuring / divisional sales / redundancies;
7. Next quarter CEO announces big improvements;
8. Full year report shows big turnaround, losses almost all / all made good;
9. New CEO is big hero and acclaimed a turnaround expert.

Seems we are at step 5 so far - step 6 will come in a few weeks

My guess is that today’s dip might be a good buying opportunity in advance of step 7.

* Note that I am not alleging any form of illegal or unethical behaviour by anyone at all - it is just the way that the “tone from the top” comes down.

Report in the BBC today saying the British government is about to nationalise Northern Rock. This was probably inevitable after the search for new owners failed. The loss of confidence in the name of the business meant that getting new depositors to replace the old, without a complete change in ownership, was always going to be impossible.

What will happen now looks fairly clear - the government will pass a bill, the doors will shut to new business and current depositors will walk away. Mortgage holders will be encouraged to refinance elsewhere. This will both increase the exposure to the government and reduce what value is left to pay out to shareholders, if any.

Really, it should have been allowed to fail. As my several posts on this situation have made clear, this would have resulted in the business closing, the depositors paid out a reasonable amount at first and then all of it (including interest) over time. Shareholders would then have got a return out of the residual funds - which there would have been. The FSA’s deposit insurance scheme would have been up for some payouts, but they would have recovered it all. The only (minor) losses would have been to shareholders.

Admittedly, this may have caused worries about other institutions - but none was in a position like the Rock and this could have been made clear.

The real panic here was from the regulators and the government, who were blind-sided by something they probably believe they should have spotted.

The blog debate on the practicalities, or otherwise, of “fractional reserve” continues. The more informed debates also make the point, correctly, that it is not just “fractional reserve” in there, but the whole question of maturity (or term) transformation. If you are interested I would like to compile a listing of current blog debates.
These are the few I am aware of - feel free to link to more in comments. Just be aware that if you put more than 2 links into a single comment I will have to rescue it from moderation. Not a problem, it will just take a bit of time.

• Catallaxy: “Rothbard and the Social Credit Theorists” has restarted after a bit of an hiatus.
• Unqualified Reservations: “A straightforward explanation of the current credit crisis, part 1” explains the process well - but just to re-iterate, I disagree. The debate is considerably more civilised, though.
• Marginal Revolution: “New money does not have to enter the loanable funds market” seems to confuse Rothbard with the whole of Austrian economics, but is worth a good read.

Those are the three that I am aware of that are currently active. If you know of more, let me know. I know this is not strictly bank regulation, but I enjoy the topic.

Normal service on banking regulation will resume one I have completed a current job at one of my clients.

On a previous thread, regular commenter Shyamsundar Baliga made the point that a recent list of global banking regulations put out by the BCBS does not cover Basel II implementation approaches by any of the national regulators. Having had a look round (well, a quick Google) I could not find any lists.

I think this would be a good Wikipedia page, or at least a good addition to the current one on Basel II. If you would like to put down notes on your own national regulator’s approach(es) to Basel II implementation please put them down here. Once there are a few I will transfer them to the Wikipedia page - or, like anything on Wikipedia, you can just put them in there.

Suggested format (I will work it into a decent table):

Country: Australia
Regulator: APRA
Approaches Allowed:

Credit Risk: All
Operational Risk: Standardised, Advanced
Market Risk: All

Implementation date(s): 1 January 2008 - All approaches
Notes: Some banks (NAB, BankWest) are delaying full implementation until they are accredited for the advanced approaches an are staying on the Basel I based regulations until this is complete, expected 1 July 2008.
Links: Prudential Standards (the implementing regulations)

Feel free to suggest changes or further information to add in.

Over the break I was sent a copy of “The Long Wave” which is a newsletter by Ian Gordon, an analyst looking at Kondratieff cycles and postulating that we are about to go through a cyclical downturn.

On this matter I must firmly disagree. Much of the economics that came out of the Soviet Union was bunkum, but there were a few bright sparks. Kondratieff did some useful work retrofitting theory to the data, as beloved of technical analysts, but it is too easily proved wrong by looking at his supposed causes.

Despite my (well documented) disagreement with Rothbard on the matter of banking, I believe he (and the rest of the Austrian School) puts the position correctly on business cycles - they are caused not by underlying instabilities in capitalism but by government action. There is nothing inevitable about a business cycle: there is a lot that is inevitable about governments.

If you are looking for the causes of any future downturn in the US look to the budget deficit, wasteful spending, attempts to block free trade and to over-regulate other areas of the economy. Blaming a downturn on a cycle over which you have no control is a cop-out.

Just a quick note to welcome the (sort of) full implementation of Basel II in Australia - and its full implementation in most other jurisdictions (apart from, of course, the USA).

I say sort of in Australia as a few banks are staying on Basel I for some things, not others. The usual sort of “phased implementation” (AKA foul-up) you often get with major changes like this. Anyway, welcome Basel II.

The sideline on liquidity risk is to note that the one area that has caused the recent problems has been liquidity, not a lack of capital or other problems. Liquidity is the one area that is not really covered by international standards, with all differing regulators following different mechanisms (as noted below). The next project of the BCBS really should be to establish some standards in this area, and it looks like (thanks GRR) this is underway. While not a great fan of regulation, common standards I always believe to be useful, so perhaps some principles-based standards would be a very useful thing here.

Anyway, happy new year. My wishes for this year are:

1. May we get better risk management from our banks;
2. Less regulation from the regulators; and
3. More principles-based standards to follow.

I also believe porcine aviation will make great leaps this year. If you have any similar wishes, feel free to add them in.

My earlier piece on Rothbard and Social Credit sparked off a long thread on another blog. One of the arguments made over there was that, in the absence of much other regulation, “fractional reserve”, as Rothbard understood it, simply could not be effectively banned.

Rothbard’s (and the Social Credit mob) saw fractional reserve as an evil thing as it allows banks to create money, as it is commonly defined - in that accepting a call deposit and then making a loan from the funds deposited effectively creates money. Both the deposited funds and the loan funds are money - so the bank has created money. I explored this a bit further on the earlier thread and so will not go into it here.

The point I would like to raise here is whether, in the absence of much other regulation, it can just be banned. My point is this. Say a government (for some odd reason) decides to agree with Rothbard and then bans the maturity transformation of call funds. I believe there will be a couple of major problems with this:

1. Firstly, the legislation would have to define “call” precisely. Once you think about this is becomes, to me at least, a tricky thing. How long a call period, and under what conditions, means that a deposit remains “money”? Is it only instant call, 1 second call, 1 hour call, 24 hour call, 11am call or what? Additionally, would a term deposit (of, say, 12 months) that has a call option with penalties remain a  term deposit or does the call option render it a call deposit? If so, what penalties would be needed to make it a “term” deposit?

2. Would the banks not just walk around this anyway? Say the call period decided upon was one week. Could the customer not just deposit funds on one week term and the bank then just grant a revolving line of credit up to the value of the deposited funds, effectively allowing the customer full access to the total value of their deposit (and creating the same effect as an instant call deposit) without breaking the legal definition of “call”?

To me, the only things keeping banks within any mandated ratios that they could walk around are:

1. The ratio is set at a point where the bank would keep it anyway, such as a typical 7% reserve asset ratio (or 9% HQLA in Australia); or

2. The regulators have lots of other tools that the banks fear so they do not bother to try.

Rothbard imagined a world where the “fractional reserve” could be banned and then other regulations become unnecessary.  I cannot see how he could be right.

I was going to do a full update on this issue, but I can do little or no better than Stephen Mayne. Go over there - it makes for interesting reading. If what he is saying is true, it should make the management, board and auditors of Centro very worried indeed.

Every once in a while I solicit (a banker soliciting?) comments from my readers - and this is one of those times. If you would like to let me know what you find useful / interesting or make (hopefully) constructive suggestions, go right ahead.

Otherwise; have a Merry Christmas for those who celebrate Christmas or, to my Muslim readers Eid Mubarak for Eid al Adha, or for the rest of you just enjoy the Summer break - unless you are in the wintry North, in which case it is a Winter break.¹

I may post if there is anything particularly interesting over the holidays, otherwise, see you in the new year.

Lets all hope 2008 starts better than 2007 looks like it may finish.

1. Trying to get all this right is a bit tricky.

Interesting publication from the Markets Committee of the BIS yesterday. It does a pretty full comparison of the practices of 16 of the major world central banks, covering what their targets are, how they carry out any prudential functions they have and lots of information on how they carry out their other duties.

The 16 covered are the members of the committee: Reserve Bank of Australia, Central Bank of Brazil, Bank of Canada, People’s Bank of China, Eurosystem (European Central Bank plus the national central banks of Belgium, France, Germany, Italy, the Netherlands and Spain), Hong Kong Monetary Authority, Reserve Bank of India, Bank of Japan, Bank of Korea, Bank of Mexico, Monetary Authority of Singapore, Sveriges Riksbank, Swiss National Bank, Bank of England and Federal Reserve Bank of New York.

It is a very useful start for anyone researching the operations of the central banks and for general information on them.
.
(Updated - link changed so you do not have to go hunting through the site from the press release. Thanks Sadashiv)

This whole Centro thing is looking interesting. The core problem is simply stated - they have a lot of debt that is maturing now and, given current conditions, they have not yet been able to refinance on anything like reasonable (for them) terms. The firm has also been highly geared, so refinancing in this market means that they will need to raise more funding through equity.

Listed property trusts are notorious for their complex structure, with individual shopping centres frequently having differing investors with the overall management (and an equity stake) being held by the listed entity (or entities) as at Centro. This makes sorting things out when they have problems very difficult.

The problem, as simply put above, raises a few questions - not least of which is “How did they let this happen?” There are likely to be more than one investigation of this over the coming months - and a lot more if they do fail as a company (which does not look likely at the moment), so any views here must be treated as uniformed conjecture.

At the moment, it looks like an old fashioned liquidity issue - the company has simply let too much of its debt mature at once and that maturity is happening at a bad time. I have said this before and I will say it again - it is bad policy to bet the house on being able to roll any debt facility at any time. A good treasury policy (like the one on CPA Australia’s website) will cover this risk like this:

The XYZs funding requirements and funding strategy, will be reviewed annually and set out in the Treasury
Funding and Risk Management strategy paper. The funding strategy detailed in the Treasury strategy
paper will be developed consistent with the following parameters.
1. [Determine the debt maturity profile. For example provide a information on how much debt will
mature over 1, 3 and 5 years. What is the maximum level of debt that is permitted to mature in next
12 months?]
2. [Does there need to a policy on whom debt can be borrowed from; does debt raising need
diversified in terms of counterparties, types, maturity and geography and do limits need to be set?]
3. [What is policy in terms of raising debt in foreign currency and management of the associated
currency risks?]

This is not just a few things to fill in, but things to think carefully about. Getting all your funding in large blocks may be tempting, but it can be horrifically expensive - ask Centro.

Quite often, though, a liquidity issue is masking a deeper solvency issue. Banks will normally lend (if on occasionally difficult conditions) if they are satisfied they will get their capital back and interest in the interim. It looks like Centro has not been able to convince them this is a strong possibility - which is why they cannot roll the facilities.

If they have over-paid for the shopping centres in the US - a possibility since the economy there looks like it is slowing.

Another interesting point is the disclosures in the last full year report. They disclose only just less that $1.1 bn in total current liabilities (look at page 34). This figure is meant to include all debts maturing during the next 12 months - all of them, including any short term accounts, ordinary trade debts, etc. etc. as well as all major debt facilities. They are now trying to refinance $1.3bn in total facilities - so what are they doing refinancing in one hit $200m more than the total current debts of all types they had at 30 June? Something looks odd here. As I said, these entities have a convoluted structure, so it may be OK, but it does look odd.

My guess is that the audit team is currently being pulled off any other work they were on and are now starting to go back over the files. It should be an interesting period to the the auditors of Centro - and, possibly, a few other listed property trusts.

Just a quick clarification on my earlier piece on APRA’s announcement process. APRA have apparently, and informally, let it be known that the answer to the question on how much capital BankWest and NAB will have to carry next year is that it will be the Basel I number until they get Advanced credit risk clearance.

Now - how long before they formally tell the banks concerned? So far, as far as I have heard, they have not yet been told. You would have thought it would be polite to tell them.

Malcolm Knight, General Manager of the Bank of International Settlements, gave a speech last Thursday to the 2nd Islamic Financial Services Board Forum, outlining how the IFSB, the BIS and the BCBS are working together on developing the institutional framework for the globalisation of Islamic Finance. He emphasises the areas the conventional and Islamic finance have in common - the needs for sound risk management, corporate governance and capital adequacy.

All I can do is encourage those interested in the area to read it.

Abstract:

Although there are differences between Islamic banking and “conventional” banking, there are some fundamental principles that apply equally to both. In particular, rigorous risk management and sound corporate governance help to ensure the safety and soundness of the international banking system. In the light of the growing importance of Islamic banks and Sharia-compliant financial innovation, the increasing integration of Islamic financial services into global financial markets serves to strengthen this point.

The Basel II framework improves the risk sensitivity and accuracy of the criteria for assessing banks’ capital adequacy. This framework is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure, the importance of which has been underscored by the recent problems that have arisen in the banking industry worldwide. The guidance provided by the Islamic Financial Services Board (IFSB) is a useful contribution to the realisation of these global goals. It will support the establishment of resilient financial market infrastructures and sound and robust core Islamic financial institutions operating according to safe and sound risk management practices.

Activity in the US sub-prime area continues to hot up, with UBS acting to strengthen their balance sheet at the same time as announcing that there is not likely to be a profit this year. The measures are:

• Issue an additional13bn (CHF) in fresh capital;
• Sell about 2bn in treasury shares they had figured on cancelling; and
• Pay this year’s dividend in stock.

This is all from revising “…key input parameters of the models that are used to estimate lifetime default and resulting losses for sub-prime mortgage pools.” In other words we got our mark-to-models wrong and we changed them.

I continue to maintain that the whole sub-prime problem is over-done, with the banking system in general able to absorb these losses with ease - but individual banks getting caught. From their press release, UBS would have been able to absorb these losses out of profits from other areas and some capital deterioration but decided not to - presumably because they wanted to reassure the markets on their capital base.

It may also be that they have adopted very conservative valuations, having been caught once. We will see over the next 6 to 18 months.

Look for heads to roll there over the next few months. Investors hate things like this.

As you can read from the post below, the approvals for various banks to use some of the advanced approaches for Basel II compliance have been released. An interesting point that arises from it is the approach to the announcement.

With about 20 days to go, the banks were simply told this morning whether they were going Advanced or not and what they were allowed to do. It included a couple of real surprises - not about which banks, but a whole approach.

APRA have been consistent from their first letter on Basel II (23/6/2003) that “…AMA will not be available to non-IRB banks.” Yet their announcement this morning gives AMA to two banks not going IRB - NAB and BankWest. Better yet, these ones are not even going Basel II Standardised yet - they are staying Basel I for credit risk.

Of course, that leaves a very big question for these two - what will our capital requirement be next year? Basel I implicitly included the capital for operational risk within the credit risk component. Basel II explicitly splits these - meaning the banks going Basel I plus AMA are having their operational risk capital double counted. APRA will need to clear this one up - and fast. For Australia’s biggest bank (never mind BankWest) this is only a slightly important question.

Macquarie’s announcement to the exchange this morning was very interesting, claiming to get the “advanced approaches”. Note the (presumably very careful) omission of the capital “A” on advanced. This is because they have gone “Foundation” not “Advanced” for credit risk. To me, this comes close to “misleading and deceptive conduct” - but probably not quite there.

Likely attitudes to the announcement:

• ANZ - happy and able to crow about excellence in the usual things that banks like to crow about;
• BankWest - wondering what APRA was thinking about to come up with this approach;
• CBA - happy and able to crow about excellence in the usual things that banks like to crow about;
• Macquarie - reasonably content (and quite smug on the wording of their press release);
• NAB - wondering about how to calculate their capital requirement for next year and how the market will digest this over the next few days (and how to phrase their press release - not out yet);
• St. George - feeling a bit sore but confident they can fix it; and
• Westpac - happy and able to crow about excellence in the usual things that banks like to crow about.

All in all, an eventful day.

With 21 days to go to the start date of Basel II in Australia, APRA have announced those banks that will be able to use the Advanced methodologies for compliance. They are:
Advanced Everything -

• ANZ
• CBA
• Westpac

Foundation and AMA -

• Macquarie

AMA only -

• NAB
• BankWest

There is a lot of gossip in here. Just as a first cut, I went to the banks’ websites to have a read - at this point only CBA had their media release out. The rest still had their usual “we are wonderful” media releases.

Macquarie going Foundation is interesting. The difference between Foundation and Advanced is really only in the Retail area and, as Mac Bank does not have a huge exposure to retail lending (except through securitisations) this seems a sensible approach.

NAB not getting Advanced credit risk is really a smack in the eye. They have (according to rumour) spent the most on their project of everyone and have failed to do it. For Australia’s biggest bank this is not good. They, and BankWest, can beexpected to catch up soon, though. APRA originally said that no-one would be able to go AMA without an Advanced credit risk approach, o this means they, and the Millionaires’ Factory can be expected to go Advanced credit risk soon.
The notable absence is St. George - who seem to have disappeared off the radar. Anyone with decent gossip on this?

[BTW - if you do leave gossip I maintain I will not hand out contact details or other information unless compelled to do so by a court of law. Keep it factual and there should be no problems.]

For those who want to see who we can blame thank for the various pronouncements of the Bank of International Settlements - and actually see what the buildings look like etc. - go here.

With just over a month to go, (and not a moment too soon) APRA have release the final versions of all of the Basel II standards, applying from 1 January 2008.

Go here for the announcement and here for the standards. I will be writing up a review of them if there is anything truly different about them. I hope there is not, as we all have to apply them only a month from now - well, almost all of us. See below.

I will also be retiring my page on the standards, as it is now redundant.

In all the excitement going on about the US implementation and several other matters (like work) I have not been saying much about how the Australian banks are going on their applications for “Advanced” accreditation.

Just out of interest, I did a search for Basel II on each of the Bank’s websites earlier this week. Hit stats went something like:

Majors:

ANZ - 36
Commbank - 4 (2 identical documents in two places)
National - 1 (an employee profile only)
Westpac - 1.

Very poor outcome - but try the same using Google site search and the results change a bit:

ANZ - 26 (a drop?)
Commbank - 21
National - 1 (the same)
Westpac - 52.

Others:

BankWest (HBOSA)- 0 (I cannot find a search facility. Odd)
Macquarie - 29 (but many repeats)
St. George - 8 (again, a few repeats)

Google:
BankWest (HBOSA)- 0 (looks like the search facility would not have helped)
Macquarie - 13 (no repeats this time)
St. George - 3 (again, no repeats)

Additionally, not many of the documents are recent. This is, I suspect, for a good reason - several of them will not be ready on time or have been otherwise failed by APRA.

Under the prudential standards, this leaves them in an interesting place - the existing prudential standards will be withdrawn on 1 January and the Basel II ones will come in - but the banks that APRA have “delayed” accreditation for will not have done Standarised projects, and so will not be able to go to either system.

In practice, as Bernie Egan (APRA Basel II program director) made plain, these guys will stay on Basel I until they are cleared.

The big question is - who has already been cleared? Maybe those making the most noise about it?

A quick reminder, if any were needed, that it is not just banks that can suffer from an operational risk event. Governments can too. The difference, of co