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 Despite the fact they are built on technology that was outdated 20 years ago they still work.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]

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.

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?

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.

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.

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.

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.

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.

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?

APRA has its annual publication of the ADI (banks, building societies, credit unions etc.) “Points of Presence” out. “Points of presence” is, for the non-banking junkies out there, APRA’s terminology for branches, head offices, ATMs etc.

See the summary here, and the full spreadsheet (warning 8+ Mb in a zip file) here.

Apparently there has been a slight drop in branch numbers over the last year, with the total number of points of presence up due to an increase in the Bank@Post (giroPost) outlets.

The definition used of a “branch level of service” is interesting:

Branch level of service comprises all service channels that meet the following minimum criteria:
· accepts cash and other deposits (including business deposits) and provides change;
· facilitates the keeping of accounts for customer access, including the provision of account balances;
· opens and closes accounts;
· can facilitate or arrange the assessment of the credit risk of existing and potential customers; and
· offers additional services in the one establishment such as financial services, business banking and specialist lending.

Depending on how you read the definition, this is a fairly high level of offering - some local “branches” I know of would find it difficult to pass the last two tests.

Anyway - knock yourselves out. There is a fairly good amount of data here to support any number of arguments about the retreat or advance of banking presence in Australia.

For those with a quite British view of comedy and its relevance to the sub-prime market, try the youtube video over the fold.

Read the rest of this entry »

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?

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 »

Or - Why Murray Rothbard and the Social Credit Theorists are Wrong

One of the arguments that rumbles around some of the various blogs I read is an old one about the nature of what banks do. It pops up on a regular basis when economic theorists get involved in discussions about banking. This argument is founded in what I consider to be a misunderstanding of the nature of money itself.

To me, the argument boils down to a simple question - are deposits in banks “money”, properly so called? If it is, then banks can create money simply by accepting a deposit at call and then making a loan.

To those who are horrified at the idea that Rothbard (in this area at least) can be lumped together with the Social Credit of C. H. Douglas - sorry, but they are both wrong and for the same reason.

What follows is a short, but I believe still correct, discussion. If you want more, please raise points in the comments.

Rothbard’s Argument

Rothbard founds his argument against modern banking practice (see Chapter VII of the link - opens in new window) on what I believe to be a misconception: that when you deposit money in a bank what you have is still money, only in the form of a bank deposit, rather than a claim on the assets of the bank. To emphasise his point he calls bank deposits “warehouse receipts” as if the process of putting your money in the bank is the same as storing furniture in a warehouse.

Social Credit

The Rothbardians out there may be horrified at the thought, but he is making a very similar argument to Maj. C.H. Douglas in his Social Credit framework - that banks manufacture money. Here, in a speech to the King of Norway (opens in new window), is the clearest exposition of this I can find:

[banks] make … it in exactly the same sense that the brickmaker makes bricks, and not in the sense that Mr. Jones makes money; Mr. Jones only gets it from somebody else, but the banker makes it. The method by which the banker makes money is ingenious, and consists very largely of bookkeeping.

The social credit people then move from there is all sorts of directions, some into outright socialism and some to a position very close to (if not actually in full agreement with) the Rothbardians.

Why they Are Wrong

They are both wrong. Banks do not “manufacture” money and for a very simple reason. To use Rothbard’s analogy - when you deposit your furniture in a warehouse you pay the warehouse to store your furniture. When you “store” your money in a bank, the bank pays you. Why is this? Simple. When you loan your money to a bank you are (implicitly or explicitly) authorising them to lend that money back out to someone else and for the bank to make a return on it.

The interest I receive in lending my money to the bank is to compensate me for two main things (and several others, not important here):

1. the time value of money, where I get compensated for delaying my use of the money while the bank uses it; and
2. credit risk, the risk that the bank will not be able to pay me when I walk up to the bank (or now my web browser) and tell the bank I want to withdraw.

To use Rothbard’s analogy, if I was doing the equivalent thing with my furniture I would expect to get rent for it - the rent amount being to compensate me for not using the furniture for the time I do not have it and for the risk that my furniture will have been lost or stolen when I ask for it back.

To put it another way - when you deposit your money in a bank it is no longer your money. It is the bank’s money and you are compensated for this transformation through being paid interest - or at least not having to pay them a storage fee. In this I fully agree with Lord Cottenham in Foley v. Hill and Others (I am quoting here from Rothbard as the Google copy is not in text form)

Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it . . . . The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the mount, because he has contracted . . . .

Rothbard, looking at Foley which clearly stated this principle, saw it as a disastrous mistake. I would agree if I were paying the bank to store my money. I am not, though. The bank pays me while they have it. Where do they get this money? By lending it out - therefore, when I deposit my money in a bank it is no longer my money, but a claim on the assets of the bank.

If what you want is a place to store your money and be sure that the money is safe, great. They are called safety deposit boxes and are available in the vaults of most major banks. Just expect to pay for their use.

[Update - I changed the title to more closely follow what I actually said in the post]

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.]

Noticed an hour or so ago that Westpac’s website was not responding and they now have a “Website Unavailable” page up. The link to “Westpac Online”, which is meant to be another server to allow you to do your banking, is also down. Good to see the standard PDS is there*, though - risk management will always win, even with a server crash.

If there is any scuttlebutt out there I would be interested…

*”General advice on this website has been prepared without taking into account your objectives, financial situation or needs. Before acting on the advice, consider…”

Interesting question raised on Finextra today (OK - yesterday, then - in Oz the timing thing can be annoying) on the question of whether banks should start blogs about themselves - allowing feedback direct from customers and other interested parties.

I know this has been raised many times before, and a few (very few) banks are actually doing it. The question is how you would actually go about it. From what I can see the risks to a bank are fairly finely balanced - in that being perceived as being open and friendly is a good thing, but also that banks (rightly or wrongly) will always have a few, noisy, detractors - ranging from dissatisfied customers (or former customers) - to those who for political or ideological purposes simply detest banks.

The logical answer to this is to have a moderated discussion, but, given the blog is an official one, the moderation would have to be reasonably heavy or there would have to be humans on the bank’s side posting responses reasonably quickly. Either that or it simply does not allow comments - but this would then make it boring beyond belief.

Unmoderated it would be highly risky; if moderated it loses the spontaneity of a blog; with humans actively monitoring it would be expensive and as just another media channel - boring.

The options can then be summarised, to me at least, as being highly risky, expensive or boring - or, at worst, two of the three.

This post over at John Quiggin’s blog reminded me of my first job in a back office. In short, the job was to replace an ad-hoc, paper based settlements “process” with one based on computers - with no budget. The solution ended up being an Access database that not only managed the settlements process but also did full online reporting. It also, in a large part, removed the need to print anything out - saving a lot of paper.

As with a couple of the commenters on that thread, I now print out very little - confining it to large documents I reference regularly and those I need to sit down and read carefully.

Bank regulation, though, often mandates printed documents. In Australia, for example, every time a bank or other financial firm licensed to provide advice, provides that advice or sells you a product, they need to give you what amounts to a mountain of paper, signatures everywhere and normally also a few printed documents. None of this, in most cases, will ever be read again and (in my case at least) normally ends up in the bin as I know I can always get a copy if I really need it off a website somewhere.

Another good example is the need to send a copy of annual reports to all shareholders under the various listing rules.

APRA have just made an important step in allowing the quarterly disclosures under pillar 3 of the Accord to be made simply by posting them on the banks’ websites (discussed here). The use of online form submission to APRA by regulated entities is also very good.

Any other ideas for reducing the amount of paper we have to use - particularly those forced on us by regulation?

Just a brief post on Mike Smith’s appointment to head the ANZ. It is good that they have acted early to replace McFarlane, but there must be at least a few disappointed internal candidates. Headhunting externally is normally a sign that either an organisation is in crisis and / or internal succession planning has failed. It may also (more rarely) mean that there is a compelling case for a particular person.

As the ANZ does not appear to be in crisis then it means that either the internal candidates were considered not up to it or that Mike Smith brought something special. Either way, look for an exodus of senior people at the ANZ over the next few months as they gradually find jobs elsewhere.

This piece in Bobsguide is a touch self-serving (it was inserted by Algorithmics), but it makes a valid point.

Much of the press coverage concerning the ‘subprime meltdown’ has focused on the products themselves and the credit risk involved. They have variously been characterized as too risky, unsuitable or designed to appeal to unsophisticated buyers by offering cheap teaser interest rates.
However many of the subprime mortgage product cases appearing in Algorithmics’ FIRST database of loss events involve an element of insufficient operational risk processes; primary among these processes is lax underwriting, which often involves insufficient background checks, inadequate documentation and a failure to train and supervise front-line personnel. Eighty three per cent of the cases can be attributed to relationship risk, including mis-selling, suitability issues, contract obligations and regulatory and compliance violations.

Much of the bad lending that gets done is not simply lending that goes bad after being written - they are loans that probably should not have been written in the first place. If the loan is written in contravention of established procedures, or was written due to fraud, that is not a credit risk loss but an operational risk loss. The difference is crucial when it comes to finding a solution.

Credit risk can properly be regarded as something that happens as part of the business of writing loans - some of them will go bad. If too many go bad, then you need to update your policies and procedures and maybe find some additional capital. If loans are being written in contravention of policies and procedures, however, then a different solution is needed. This may include retraining, counselling, targeted redundancies (i.e. sackings) and probably some management changes.

If you identify the problem incorrectly, the proposed solution will also be wrong.

With just over 6 months to go APRA have today released their draft of the standard giving the market disclosures needed under Basel II.

In short, and as expected, they have largely followed the disclosures under Pillar III of the accord for the banks going Advanced - with the bulk of the disclosures copied (sensibly) word for word. As with any of these, APRA needed to make some changes (discussed below). The real interest is in how scanty the disclosures will need to be for the ADIs (authorised deposit taking institutions) going standardised. For these guys the disclosures are (very) little more than they have to make now.

The other interesting point is in how you may disclose these - release to the website (para 18)! There is no need to formally publish the results in hard copy. Good move.

Many of the changes are simply textual - just making the disclosures work with the previously released standards. I will confine my discussion at this point to the substantial changes from Pillar III. Read the rest of this entry »

Just reading an interesting article on the Economist’s website on the past and present of investment banking. Selected quotes:

AT LEAST since 1823, when Byron’s Don Juan described “Jew Rothschild, and his fellow Christian Baring” as the “true Lords of Europe”, investment bankers have inspired awe, envy and, rightly or wrongly, a measure of disdain.

Read the rest of this entry »

Thanks to Colin over at Bankwatch for this one on losses suffered by the Bank of Montreal (BMO). At first sight it looks like just another bad day at the office for some traders - until you see the amount (currently estimated) as having been lost (CAD 680m - just over a quarter’s profit) and the bank’s reaction. This looks like a textbook case of how not to announce this to the market. Read the rest of this entry »

With the fuss about the (allegedly) over the top salaries being paid to the senior executives of Macquarie bank hitting the headlines yesterday, I thought the Alex cartoon published in the AFR yesterday was excellent timing.

If you want to see the cartoon, it was this one (yes, we are a few days behind in Oz) and a good example of the less extreme reporting of the news on salaries is here.

The Alex cartoon makes a good point - as those of us who have worked (or currently work) in the investment banks know - you work extraordinary hours, sacrifice the bulk of your life and have to have a very understanding family if you are going to do this successfully. Very few also ever get close to these sorts of salaries / bonuses / packages and many burn out before they get to 40.

It is the hope of being one of the successful ones that all this effort is put in. We should not begrudge the few (I will not say lucky few - luck plays little part) who make it to that level. They have made a life choice in trying to get there. Let them enjoy their gains - and hope, for ourselves, that we can also gain from the success.

It is not that far away to the date of Basel II implementation. Most banks would be on their final hurdle, well, at least for Pillar 1.

Up until now, firms who were planned to be beyond standardized, have spent millions. With lot of projects start winding up. One question has floated to the surface, which somehow, did not have a clear answer back then.

Read the rest of this entry »

HSBC has annouced its financial results last week (5/3/2007), indicating a profit warning due to its US lending units, one third of the group’s total earnings, that risk management and other controls are not meeting the expectations of with the group’s overall direction. The “specific” unit which Stephen green, chairman of HSBC holdings, was referring to the US mortgage business, which profit has substantially dropped due to the unexpected increase in delinquency in the sub-prime mortgage area. I am not going into too much details of what has already been announced, you can read them in http://www.hsbc.com/hsbc/news_room/news/news-archive-2007?cp=/public/groupsite/news_room/2007_archive/hsbc_holdings_plc_2006_annual_results.jhtml&isPc=true

or google it.

Anyway, reason I raised this topic, along side from the above, here are couple of articles I have read today: Read the rest of this entry »

This is the second in my (much delayed) account of the Basel II projects of the banks in Australia with a current waiver application (the APRA jargon for applying to use the advanced methodologies) in. Today it is the Comonwealth Bank’s (CBA) turn.

CBA have actually put out probably the least information of all of the majors on their project and I personally have not been there, so this is probably going to be the most sketchy of all of the summaries, relying on some further hearsay and scuttlebutt. That said - it is not the most interesting scuttlebutt.

Their annual reports are very short on the subject, just giving the barest possible information - essentially just that they will be going advanced. For what they are worth, they are here. There is also the usual announcements from vendors on being chosen to do this or that component - for an example, see here. Read the rest of this entry »

Prompted by this piece over at the Banking Law Professor’s Blog, the situation in regards the US Basel II implementation is getting a little clearer.

What is clear to me now is that the US regulators are trying to achieve two, contradictory, objectives. They are:

1. Implement Basel II in the US; and
2. Not disadvantage the banks that cannot achieve “Advanced” accreditation.

Problem is, you cannot do both. The result is the confusing muddle you now see in the US.

Read the rest of this entry »

It is confirmed that APRA are seeking to impose a doubling of the minimum capital required for home loans - the banks have all received their letters confirming this over the last couple of days. This will mean two things - a home loan will be both more expensive and difficult to get in Australia.

As background (and without getting too technical) the amount of capital (the safety margin, in a way) that a bank is required to keep against any lending it makes is calculated based on past losses and the current economic situation. The ‘LGD’ is one of the factors in there. Double one of the factors and the safety margin doubles with it. This safety margin costs the bank money - so this is passed on in the form of increased interest charges on the home loan. Read the rest of this entry »

Over the next week or two (as I get some time) I will be doing a series on the Basel II projects of the majors and the large regionals. All of these are currently targeting “Advanced” accreditation.

I have only been personally involved in a couple of these so the posts in this series will at least partly be based on hearsay, scuttlebutt and may, in some cases, be out of date; so feel free to correct and update as you believe is correct. I also remind you of our comments policy have a look at the FAQ page. I propose to tackle these in alphabetical order, so it will be the ANZ, Commonwealth, HBOSA (BankWest), NAB, St. George, Suncorp, and Westpac. Read the rest of this entry »

There have been recent moves in the UK by some consumer advocates (notably Martin Lewis) to obtain refunds of fees that they believe have been unfairly or illegally levied in their accounts. For a fairly unusual, but very dramatic, approach read this article where the baliffs actually went into a bank branch (thanks to Stuffem).

This is driven by UK law that fees and charges must be no more than actual cost of the activity being undertaken.

I am not sure of the law in Australia on this point, but some of the fees and charges being levied by the banks do seem excessive ($35 for a returned direct debit?). All banks would have undertaken full ABC (activity based costing) analysis and so would know how much these activities truly cost. Whether the true cost is the average cost or the marginal cost is a point to be debated, but I would like to hear from anyone with knowledge of the law on this point and then see if a test case could be started.

A little reminder came out yesterday about the current co-operation process between APRA  and ASIC, the two main regulators in Australia. They are currently working together to align regulatory definitions, reduce duplicated reporting and generally make the sets of regulations they work with easier for those of us who have to comply with them.

This process is helpful and I would encourage compliance officers in particular to identify overlap and then encourage them to look at it. The only suggestion I would make would be to add in the ASX to the proces and see if their reporting requirements can be streamlined.

It may be difficult, given that the ASX is a private company, but for listed firms this would mean that a further reporting channel would be streamlined and the checklists on releases could be shortened; reducing the scope for operational error.

Any further reduction to operational risk, even if only minor, is always a help.

Today’s Finextra has an interesting article - placed by RSA Security - on customers’ willingness to adopt improved security in place of the usual username / password combination. According to RSA (and, remember, their main products are security software and hardware) 91% of customers would be willing to use new authentication methods, including risk-based assessments. Personally, I find the idea that 9% would not be willing to use new methods odd.

I have recently changed my main banking relationship, partly on the basis of improved web security, but I am not aware of many people who even take this into consideration when deciding on which bank to use. To be honest, the 4 major Australian banks are fairly similar in their pricing of their main products, so differentiation now comes down to items like this and things like branch locations.

I would be interested in comments from people who are looking at changing their bank and what factors you would be looking at.

Over the page is a little video from the 1940s. It gives a simplified view of most common banking processes. It is interesting how little changes in banking - the technology has improved (well - at least it has more flashing lights), but the processes remain. Read the rest of this entry »

Today’s finextra has a piece on the merger announced between the Bank of New York and Mellon Financial. While I think this ends up with one of the more “interesting” acronyms of recent times (1970s disco band, anyone?) I am trying to think of other silly bank acronyms out there.

Submission invited.

APRA released a discussion paper yesterday updating us on their proposed approach to several issues on Basel II that remained open. These areas are:

• Securitisations;
• Credit derivatives under the standardised approach; and
• A few regulatory discretions

The section on securitisations is particularly important, considering their popularity in the Australian market and also for the changes proposed. Read the rest of this entry »

This is to be the first in a series of posts over the next few days outlining the basics of Islamic finance. This one provides the basic framework and rules. We hope you find them interesting.

Introduction 

In the 1970s changes took place in the political climate of many Muslim countries which led to a number of Islamic banks, both in letter and spirit, being established in the Middle East, e.g., the Dubai Islamic Bank (1975), the Faisal Islamic Bank of Sudan (1977), the Faisal Islamic Bank of Egypt (1977), and the Bahrain Islamic Bank (1979).

Islamic banking is now one of the world’s fastest-growing economic sectors, comprising over 300 institutions in over 75 countries. They are concentrated in the Middle East and Southeast Asia (with Bahrain and Malaysia being the largest hubs), but are also appearing in Europe and the United States. Total assets worldwide are estimated to exceed $250 billion, and are growing at an estimated 15 percent a year. Read the rest of this entry »