Category Archive

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.

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 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 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 »

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]

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.

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”.

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.

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.

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.

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.]

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?

I have been out of contact over the last few days due to the fact I am moving house, so when I finally got my podcasts to listen to there were a few. I saw one from the BBC’s Today program on Northern Rock (warning - multi-megabyte MP3 file) and I thought this may be a good one, in light of my previous experience with them. I was gravely disappointed.
In what is now a continuing meta-story, the journalistic coverage of Northern Rock is showing just how little even financial journalists understand banking.

The errors in this particular piece revolve around a mis-understanding of one of the absolute basics of banking - liquidity risk. The premise of the argument in it was simple - Northern Rock was unable to meet calls on deposits meaning Northern Rock is insolvent and therefore worth nothing.

A basic understanding of banking would show this up as not a logical argument. As discussed in the post on liquidity risk linked to above, banks borrow short and lend long. This gives rise to liquidity risk, which means that if more than a certain amount of deposits are withdrawn in a short period a bank will not have enough physical cash to pay them. This can be, and must be, separated from the overall worth of a bank.

To put it in simple terms (and turn it around a bit) - let’s say I borrow money from a bank to buy a house. I manage to service the loan for a few years, during which time the value of the house goes up by 50% per annum - making me very wealthy (in part due to the leverage effect). Unfortunately, I lose my job and, during the period where I cannot find another one I cannot meet the repayments on the loan.

Am I financially worthless? Clearly not - there is a lot of value in my home. Can I meet the bank’s demands to pay my mortgage? No.

The Today piece confuses these when the journalist and the talking heads pulled in for the piece argue (at some length) that the failure to pay the demands of depositors means that Northern Rock is worthless.

One event I missed posting on at the time was the final agreement of all of the US regulators on the way that Basel II will be implemented in the US that happened 10 days ago. After some seriously silly obstinate argument from the FDIC, I was please to note at the time that the Fed largely got its way in the end, and now those rules have now been given final agreement.

To those of us watching from the outside this has been a painful process. I can only imagine how difficult it must have been for the US banks. The end result was close to the right one - the one I suggested a full year ago. In this, at least, the delay was worthwhile. Going with the FDIC’s original position would have been close to suicide for the whole US banking system - and a long, slow suicide it would have been.

Randall Kroszner’s speech on the matter is worth a read. The way he delicately steps around the blithering idiocy errors of the FDIC and the local bank lobbyists is almost artful.

One bit irks me, though - at the bottom of page 5 of the speech he is seeming to say that the US regulators will be coming up with a “standardised”  method of implementing Basel II. Amazing - I wonder what paras 50 to 210 of the New Accord are?

Anyway, if you are interested in my opinion on the whole process read the category. Reading in reverse order is probably best. I think some of my best posts have been in there.

In most of the rest of the world the process has been fairly sedate - well, as sedate as a nearly complete change to the bank regulatory framework can ever be. What am I going to talk about in this way again while we wait for Basel III?

I am gradually coming to a general rule on actually reading the speeches published by the BIS - the less interesting the title is, the more likely it is that the speech is actually worth reading.

This one “Some thoughts on securitization and financial turbulences” by Jean-Pierre Landau, Deputy Governor of the Bank of France, is a good example. Fairly boring title - quite good content. His (or, more likely, his underling’s) analysis is robust, with a good idea of what happened over the last few months. He is also right that the worst is currently behind us as the real problem was always the liquidity freezing up, not the size of the actual losses.

Where I feel he is wrong, though, is in the policy prescription:

Strong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increases in the demand for liquidity. That’s the job of Central Banks to help in those circumstances. But a strong capital base in the system – and in all its components – is likely to limit future liquidity shocks.

The first two sentences are perfectly correct. Capital is simply not a substitute for liquidity. The next two, though, are wrong - and they do not logically flow from any of the analysis in the rest of his “Thoughts”. Bank regulators commonly get fixated on capital as the be-all and end-all of bank risk management. The attitude commonly seems to be more risk (of any type)? More capital needed. Liquidity, though, is not improved by having more capital; in fact, it may be hurt.

The best capitalised bank in the world will not be able to pay its debts as and when they fall due without liquidity - i.e. it will be bankrupt. Liquidity management is, and always should be, considered separately from capital management.

He is right that a well capitalised bank will find it easier to get liquidity in a liquidity poor market - but Northern Rock was, by the standards of the industry, well capitalised and profitable. Having to go to the Central Bank (the Bank of England) was what destroyed them. Adequate liquidity would have meant that they had no problems and no need for the Bank of England’s help.

The message? Good capital will help - but in a liquidity crisis what you actually need is liquidity. Also, don’t always believe that a Central Banker is right.

Now that many of the banks with some losses in the US sub-prime area have reported it may be a good time to look back at what has happened and then look forward to what is likely to happen over the next 6 to 12 months.

Current Situation

Looking back, I am glad to be able to say that I have been proven substantially correct. None of the bigger international banks have had any real problems - with most not even having this problem to cause them to drop into losses for the year, even though some have reported losses (after full write-downs) for the quarter.

Northern Rock was the only bank outside the US to suffer real problems and this was a liquidity issue - not a capital one. Inside the US several smaller banking insitiutions have failed, but these have been quite small banks that were heavily involved in the lending.

In Australia, again, none of the banks or larger ADIs have had any real problems and, after a few weeks of liquidity problems, we have largely returned to business as usual.

The ones that have had problems are the non-banks that have relied on wholesale funds to keep their businesses afloat - Rams Home Loans being a perfect example. Rams, as a business, did not fail, but they have been unable to secure funding to keep it going and had to be, effectively, rescued by one of the banks (Westpac).

Really, what this “crisis” has done is what any instability should do - prune out the weaker players and allow the well-managed and run (or just the lucky) to continue. The ones that have failed were the ones with a business model that was too reliant on other players in the market and / or had poor timing on their fund raisings. When there was instability they were the ones sitting there exposed. Again - the strong survive and the weak perish. If a firm cannot go for a few weeks withoutexternal funding then, honestly, why should they be able to survive?

As banking crises go, though, this was a puppy - if a bit of a vicious puppy.

The Medium Term

As the remainder of the US sub-prime stuff reprices over the next 6 to 12 months, though, will it get worse? In short, the answer is no. The bulk of it is still to re-price, but most of the banks that have reported have written down their entire sub-prime holdings, not just the stuff that has repriced already. The reason for this is clear - it is both prudent, and required, for them to do so.

A quick look at IAS 39 and FAS 133 (the relevant accounting standards for most of the banks) says that they have to write their assets down as soon as it looks like they have lost value.  In the case of the sub-prime stuff this has already happened. There will be some adjustments to the values over the next few months, but they can be expected to be upward revaluations as the market starts to clear of this stuff. The written down values would be the current worst case - not necessarily their expected outcome.

In situations like this banks (and other listed firms) are increasingly obeying the maxim that ou get the bad news out early, and, if anything, make it look worse that it is. The reason for this is that the market hates downside surprises, but likes upside ones. Getting the bad news out early and big is better than a situation where you just gradually dribble out the bad news.

A single, big, poor number is much better than a few smaller ones.

Banks will take a good look at their counterparties and see if they need to re-visit their lending policies, but the worst of this one can now be expected to be over.

On to the next “crisis”. A Chinese revolution anyone?

As noted in my last post on this area, working out who to deal with in some countries is very difficult. Trying to use the do not deal lists in any form of modern banking practice is very tricky and error prone at best.

A truly risk-based system, though, is going to need to apply differing weights to the differing circumstances of each deal.

Operating on the principle that no deal should be banned unless explicitly forbidden by legislation (a truly risk based system must deal on this basis) a possible, if very simple, way to organise this would be to assign differing risk weights to each deal, with the countries involved being allocated percentages.

As the risk percentage increases then higher and higher approval levels should be sought (and the regulators kept informed).

Under this system, dealing with a counterparty that the bank has been dealing with for decades, and the bank well understands the business and there have been no recent changes to cash flow may attract only a nominal risk weight - say 1%. Dealing with a new counterparty in the US would be, say, 10% and a new counterparty in a known tax haven 50%. Dealing with, say, North Korea, would attract an automatic 70%, with any North Korean government enterprises attracting an additional 30%, placing them in the highest-risk category.

Combine this with percentages based on information on other aspects of the deal and you have a system.

Deals with a total risk weight of under (say) 20% would get the usual process, with between 20 and 50% needing the sign-off of the head of risk management, deals between 50% and 75% needing CFO sign-off (and AUSTRAC notification) and deals over 75% needing Risk, CFO, CEO sign-off and AUSTRAC notification.

This sort of system would be easy to automate - at the simplest level put into a spreadsheet or simple database and could be implemented in a few days. Provided it is done on as part of the initiation of every new deal with the counterparty and updated on a regular basis (say quarterly) this should allow you to claim compliance with the relevant parts of the AUSTRAC requirements.

This is obviously going to slow down the deal process, though. Getting this into your primary databases, along with some further KYC work, will be needed for business reasons.

It is not too late to get this done by 12 December, as required under the regulations. Better hurry, though - AUSTRAC is already sounding annoyed with the apparent lack of progress. You do not want to be the one they choose to make an example of.

I would be interested in comments on this. (Warning for those on slow connections - youtube video over the fold. Read the rest of this entry »

A quick piece in today’s Bobsguide reminded me of another reason why smaller institutions, even when going standardised, need to improve their risk management in response to the implementation of Basel II. The reason is adverse selection.

As the Advanced banks improve their ability to pick the good credits and price all their lending much better they will be able to demand higher prices from the customers their systems identify as poor and give lower prices to the customers identified as good. This means that a institution offering a single price to all customers that meet a minimum standard (the current norm) will end up with, increasingly, the customers identified as poor by the Advanced banks’ systems.

This is a real problem. Banks currently lend at one price for all on the basis that, on average, the good credits will cover the bad and because the systems required to price for risk are expensive.

This implicit assumption breaks down once one or more lenders are genuinely pricing for risk - they will tend to pick up the good credits while the bad credits will tend to move to the institutions that are still offering a single credit price. This will mean that the implicit assumption on which single pricing models are built breaks down - over time, the bad credits will dominate over the good.

This trend will take time. Customers are always slow to change banks. However, proper credit pricing is no longer a nice to have - it is simply a matter of survival.

For those of us who inhabit regularly visit the Bank of International Settlements (BIS) website, today is an exciting day - the BIS have added RSS feeds. All that is really important in bank regulation on feeds. Yeahaa. Who said banking is behind the times and stodgy?

Even better, you can tailor the feeds to cover just the issues that matter to you. I my case that feed may be Basel II and Australia - but you can set up your own.

I will put the main feed on my RSS feeds down the side. Share and enjoy.

The Reserve Bank of Australia issued updated international do not deal lists, with the consolidated version covering people from Yugoslavia, Zimbabwe and companies from North Korea. They also included a Swiss person (Jacob Steiger) on the North Korea list - presumably because they believe that Jacob has been helping the DPRK with a little bit of laundry on the side.

As a side note I doubt the use of such lists. Don’t get me wrong, they are a have to have, but is it likely that Mugabe is likely to be trying to open a bank account in Australia in his own name? Given that, at a minimum, he would be able to ask for a fake passport and other ID to be generated for him in whatever name he chose it does not seem likely to me that an Australian bank would be opening an account in the name of “MUGABE, Robert Gabriel, President - DOB 21/02/1924″ any time soon.

Anyway, if you are in operations in one of the banks checking your list against this would be a good thing to do. Do it now and you may even have it done before the APRA letter gets to you.

[UPDATE - looks like I was wrong. Jacob has allegedly been assisting in nuclear weapons activities]

Following on from the discussion in the previous post on whether bank¹ deposits are money the question arises as to what happens when bank depositors try to convert their bank deposits into money - make a withdrawal, write out a cheque, pay a bill or uses any of the other methods to get at the funds. Will the bank be able to meet the demand for cold, hard, cash?

In short, how do banks manage liquidity?

The Problem

For banks, the problem is actually a fairly simple one to state. Long term, banks typically make money by borrowing short and lending long. As yield curves are typically upward sloping this works well - borrowing borrowing from people who want to deposit short and are prepared to receive between 0 and 4 or 5% to do so and then lending this to people who want to borrow to build homes and pay from 6 to 10%, run credit card balances at around 12% (or more) is a good business. With modern banking practice this even is profitable at a net interest margin of less than 2%.

Given that bank makes the most money by transforming short-dated liabilities into long dated loans the way to make the most money in the long term is to lend it all out and for as long as possible. Great strategy - with only one flaw. Some depositors are inconsiderate enough to want to be able to actually ask the bank to do what the bank has promised to do - pay their deposit at call.

The trick to making the most money, then, is to make sure that you only have enough liquid assets on hand to meet all your depositors calls on the funds and as little as possible more. This is because liquid assets pay little interest, with the most liquid, cash, paying none at all.

Getting this right is the responsibility of the ALM (Asset / Liability Management) function, usually headed by the (gloriously named) ALCO (Asset Liability Committee).

Get it wrong and, no matter how solvent your bank, if it cannot pay depositors calls you will very shortly not be a functioning institution. Read the rest of this entry »

It is always interesting to see bankers, and in particular central bankers, lift their eyes from the day to day and have a look at the long term. Most of the time this is a view forward - which will hopefully be forgotten by the time that the predictions are meant to have come true by as they are frequently embarrassing to look back on.

Someone looking the other direction, which is a much safer option, is Ric Battellino (Deputy Governor of the RBA), in a speech given to the Finsia Banking Conference last week. Unfortunately, it glories in the really boring, almost Greenspanesque¹, title of “Some observations on financial trends”. In it, Ric has a look at the long term growth patterns in the credit market over the last 30 years, with some glimpses further back to look at whether the growth in credit is sustainable.

The argument, backed up with a strong look at the statistics, is that credit growth to households has been artificially suppressed by bank regulation and that, far from being an unsustainable credit bubble, the current period of credit growth is simply a logical result of consumers and suppliers reacting to the relaxation of regulation and increase in financial innovation. It is therefore sustainable. Read the rest of this entry »

After spending last week on a training course I am back in the saddle with an update on the situation at Northern Rock.

It has certainly been an interesting time for them and it now looks like a deal will be done with another institution to buy them out. I feel that the Northern Rock brand has now been diminished to the point where the brand itself is worth nothing (or less than nothing) and the only thing keeping investors in there is the full government guarantee.

One announcement was interesting, though - Northern Rock originally decided (a decision since rescinded) to pay the interim dividend due on 26 October. Given their evident problems this seemed odd. The announcement of the rescission did not say that it was a consequence of the problems (except indirectly) they said it was withdrawn pending “…a full announcement regarding the outcome of discussions with other parties and the development of the business model…”.

To me this is a good illustration of the differences between a capital and a liquidity event. As commentators (at least those who know what they are talking about) have said throughout, this problem was not one relating to the solvency of the bank. At all stages it has had enough assets to pay its depositors and all other creditors at all times. The problem has been liquidity. The assets were not in a form that they could readily convert to what the depositors wanted - cash.

Northern Rock was still trading profitably, so there was no real need to cancel the dividend from a legal point of view. The difficulty here is two-fold. The dividend would have to have been paid in cash, in this case GBP120m, reducing the liquid funds available. The other problem was the appearance. Handing out what looks like 120m of government money (given that was the source of the liquid funds) to shareholders simply looked wrong.

Unfortunately it again looks like the management of Northern Rock have not handled the appearances well, even if the business itself stacks up. Another reminder, if one was needed, to bank management to have a good, clear plan for handling the appearances of your business as well as the actuals.

[Correction - the dividend was to be only GBP59m. Shows I should not rely on US data sources.]

The seeming desire on the part of our politicians to regulate practices known as “predatory lending” simply does not stack up. I say this for a number of reasons:

1. Other than a few anecdotes¹ there is no real evidence that this is commonly happening in Australia.
2. It is covered in any case by the UCCC (Uniform Consumer Credit Code) unless people sign a document stating the loan is for business purposes.
3. A new regulatory regime is not going to be cheap.
4. There is no evidence it is going to help in any case.
5. There is in fact good evidence that “usurious” lending actually helps the borrower.

Regular readers here would know that, while I work in one of the more regulated industries, I generally oppose more regulation and believe that regulation should be minimised and only added to where there is evidence it will help. Basel II is an example of this - while much larger than the regulations it is replacing, the movement towards a truly economic base for regulation is a good thing.

Going back to Middle Ages style usury laws is not. If there might be a serious problem, let’s check it out first. Come up with some evidence it is a problem. work out whether the regulation is going to cost more than the problem does etc. etc. etc. You know, the basic stuff that should be done before you add an additional burden on us all.

1. And remember, the plural of “anecdote” is not evidence.

This is intended to summarise the several posts over the last few weeks on the current market issues. Let me start by making a few issues perfectly clear:

1. No major Australian ADI (authorised deposit-taking institution - i.e. those you can deposit money into) is going to be unable to pay all their depositors their deposits on demand as a result of these issues. None. You are not at more risk than you would otherwise have been.
2. I am not aware of any minor Australian ADI that is not going to be able to similarly meet withdrawal requests as and when they are made. There may be a micro institution out there in trouble, but I would be surprised.
3. The only ones that may have some problems are the ones that do not take deposits, but rely on wholesale funds. Crucially, these will not the the ones you have deposited any money into. Again, I doubt any will collapse, but even if they did the worst consequence for their retail customers would be that they would have to re-finance their loans, or, if you are a shareholder, you may lose that money. It is unlikely, though.

The reason for this is very simple - the Australian regulator of ADIs, APRA, is very conservative (too conservative in my opinion - but beside the point here). If an Australian ADI was writing a lot of loans similar to the US sub-prime loan they would be stopped from doing so and essentially forced to unwind the loans in some way. I would be shocked if APRA had not noticed an Australian ADI running up these positions as they are normally very close to the regulated entities. The reason I am hedging a bit on some of the smaller ADIs is that there is always the potential for fraud somewhere, but I think it unlikely.

For clarity, the situation at Northern Rock in the UK:

1. is illogical;
2. will not result in the loss of any depositor funds; and
3. is probably terminal for Northern Rock as in independent institution

for fairly simple reasons - and I would refer you to my previous post on this. It is unlikely to be copied in Australia for the simple reason that most Australian ADIs have good deposit bases and are not overly reliant on wholesale funds. In any case, as commenter Asa Mark linked to ( the second link) this market is starting to open up again in Australia as the markets work out that the fundamentals of the Australian economy have not changed and that lending is still as safe as it normally is.

If you are really worried and with one of the smaller ADIs, move to one of the big 4 banks or the major regionals. I would think you will move back fairly smartly though, once you get annoyed by the difference in service levels.

The current situation with Northern Rock shows just how important customer confidence is when you are (as are virtually all banks) profiting from the borrow short / lend long play. Without deposit insurance (which, I should add I oppose) panics can develop without logical foundation

As their most recent balance sheet makes plain they are entirely solvent - but cannot realise their mortgages fast enough to meet highly abnormal demands for repayment of deposits. This will may mean that the B of E will have to arrange a sale to the highest bidder - and the rumours I have heard is that a few institutions are looking at it, including the National Australia Bank, which has been looking around for further acquisitions in the UK.

The NAB would be a good purchaser, with, in contrast to the Rock, a good deposit base and no real reliance on wholesale funds - the reliance that triggered all this off for Northern Rock.

The lesson here? Watch that name risk and make sure that any announcement of problems is phrased correctly. Having the Bank of England make an announcement that it was moving in as lender of last resort, as Northern Rock did, probably does not set the right tone.

Have your plan up to date and ready to go at all times - take it off the top shelf, blow off the dust and review it now. You never know when you are going to need it.

APRA have released a discussion paper on Pillar 2 of Basel II - the Supervisory Review Process.

Most of the content has already been well telegraphed ahead, either by the prudential standards already released (particularly APS 110) or in the other discussion papers and speeches. The one real disappointment is the decision to maintain a 10% capital drop “floor ” for the next two years - “…pending a review of experience…”.

The levels of conservatism here are getting frustrating. APRA have already added floors (or is that flaws) into several places, both on a general level (the 20% LGD on housing loans for example) and specifically into many individual ADIs, for example many smaller ADIs have been hit with higher capital levels seemingly in preparation for Basel II.

All of the regulators around the world, and APRA no less than others, have been boosting Basel II as a much better risk management framework than Basel I. I would entirely agree. The new frameworks will make banks generally much safer. Why, then, do they need to keep capital at or near levels that had no justification when they were implemented?

To me, this is akin to a road regulator saying that, despite the improvements in car design, road safety and everything else since the early days of motoring we still need to have a person walking in front with a red flag “as it is just safer that way”. The only difference now is that the guy in front may be allowed to run.

APRA today released a discussion paper on the Basel II reporting requirements to apply from January next year - with the first reports to go to APRA for 31 January 2008.

On a first detailed read the proposals look fairly non-controversial, with the changes to current forms largely down to the changes needed for Basel II compliance. A few interesting points, though:

1. In a speech in March this year (see the top of page eight) Bernie Egan (APRA Basel II program director) indicated that banks having trouble meeting the advanced Basel II requirements may stay with Basel I calculations. There is no room for the “pragmatism” he indicated in that speech to be reflected here - these forms (and APS 330 for that matter) will apply. I am currently presuming that the flexibility will be reflected in the transition arrangements mooted in para 5.2.3 of this discussion paper.
2. For the banks going advanced there are a lot of forms, at least 24 and possibly more if there are some portfolios going standardised. Fortunately these will all be electronically submitted and, in a way, this reduces the difficulty. A fault in one item of data or formatting will not invalidate the whole process, just one file. I am just glad (or is that praying) I will not be the poor sod who has to review all these forms prior to transmission.
3. Para 4.3 asks for the banks to report actual operational risk losses - not just the modelled amounts and the resulting capital requirement. This seems sensible - it allows back-testing - but I wonder what happens when an operational risk loss event (such as a fraud) appears a fair way down the track? Do you re-submit an old form or add it into current period losses? Small point, but one that should be cleared up.

Other than that and as far as I can see “Nothing to see here, move on, move on.”

Media release today from APRA - Dr. Katrina Ellis (of UCD) has been appointed as their new head of research, with the former head, Dr. Neil Esho, going to the BCBS for a while. Dr. Ellis looks like a good appointment for the role - particularly with some real (non-academic) experience through Mac Bank early in her career.

I do not know much about her, though. If anyone has any comments (non-slanderous, of course), feel free.

I was forwarded a link to an article earlier today for comment. Reading it, I just felt like putting my head in my hands and crying - how could a financial journalist write something like this and get it so wrong? It looks like he has taken a press release or a letter to APRA from an LMI (Lender’s Mortgage Insurance) provider and tried to rework it - while misunderstanding it.

I thought writing this up into a piece here would be a good start - but where to start? Can I question his journalism, use of stats or factual issues first? Maybe paragraph by paragraph.

The first two paragraphs are error free - good start, but these seem to be just a rewording of the press release / letter.

The third and fourth start the rot. A 50% risk weight the capital required to be held for a $100 loan is not $50, as stated, but $4 ($100 *50% * 8%). The 8% figure is the full risk weight capital ratio, and is not changing under the new regime. If you are interested in why 8%, my take on it is here. He has also totally missed the new operational ri