Category Archive

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

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

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

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

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

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

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

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

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

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

Give it a read.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thanks to The Sheet for pointing me at this.

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

It’s in today’s Alex.

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

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

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

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

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

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

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

Buttonwood puts it this way:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Soc Gen Explanation

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

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

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

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

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

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

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

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

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

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

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

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

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

The comments from his lawyer are priceless:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

.

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.

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.

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.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Abstract:

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

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

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

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

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

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

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

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

A quick reminder, if any were needed, that it is not just banks that can suffer from an operational risk event. Governments can too. The difference, of course, is that you can change your bank at any time.

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.

I am glad to see someone takes me seriously. Amir from Austrolabe took my suggestion on a Google Maps mash-up and ran with it. The result can be seen here.

He has taken up to nine news feeds and the map then takes a pretty fair guess at where the story relates to. The locations are not always perfect, but most are spot on. The feeds are user selectable, with the BIS feed being the default.

If you have any feedback, suggestions etc., feel free to email using the link on the page or just post them here. If you know of good news links with reliable place names embedded within them he may be open to adding them in.

In the mean time, enjoy - if you find it useful, bookmark it.

Update
First one to work out what building the map considers to be the centre of the world and identify it here in a comment wins a prize.
/Update

When I first saw Google Maps I thought at the time this would be a good thing for me and my kids to discuss the news, where everything was and what is going on where. What is happening now is to cut me out of the process - even my kids can now instantly see where things are happening.

A mash-up, for those of my readers not perhaps as familiar with terminology, is where information from two or more sources is joined into a seamless whole. A good example, using Google Maps and various news feeds (and advertising) , is the “Global Incident Map” where terrorism incidents (as defined by the news feeds) are combined with the maps to show the location of every incident combined with headlines and, on clicking on it, the full news article.

Anyone care to do one for the BIS news feed? Add in the FT, the BBC business news, the ABC business news, The Economist and a ticker above for the latest news and you have near perfection in a banking business news website.

In the taxi on the way home last night after (another) too long day in the office I was listening to a re-broadcast of what sounded like a BBC program on the current market conditions. I was very pleasantly surprised to hear it actually making sense - the talking heads chosen were happy to correct the journalist if she misunderstood and, even better, the journalist was willing to listen and incorporate the comments made by the interviewees.

There was a particularly good section on Citibank and Prince’s resignation. In this, the journalist asked if the sub-prime related write-downs were what had prompted him to go and the interviewee said that the write-downs certainly did not help, but the failure to knit the bits of Citi together over the years since the last lot of mergers was much more important. He also made the point that Rubin was definitely in Prince’s camp and, at 69, likely to stand down soon.

All in all a good program. Unfortunately, after a quick search this afternoon I cannot find it on the BBC website. It was re-broadcast in Australia at about midday GMT, probably live, if anyone can point to it.

This reminded me of an old bug-bear of mine about business journalism - with a few honourable exceptions, a lot of it is wrong or completely misses the point. As soon as it gets beyond simply reporting the facts much of the analysis seems misleading.

In risk management one of the great uncertainties is name risk - how can we be reasonably sure that an incorrect or overblown story does not (undeservedly) damage or destroy our reputation? Is it the fault of the journalists or of the business community if they print wrong or bad stories?

What can we do to avoid it or at least minimise the risks?

All political campaigns generate their own examples of economic idiocy and this one in Australia has been no exception. Listening to the radio this morning, though, reminded me of this. I thought I was listening to some hick economic populist - then I realised it was a serious policy announcement from the Opposition.

The announcement was of a tax break for people who have not yet owned a home to create what amounts to a special savings account for the deposit required to buy a home “so that they can get out of the rent trap”.

Looks attractive - sensible policy right? Wrong - and this is wrong on so many levels it is not funny.

1. Renting is not a “trap” it is a valid financing decision for a home. If you believe that housing prices are going to drop, particularly over the long term renting is a good idea. Renters in Japan over the last decade, for example, would be laughing at those who borrowed heavily to get into the “joy” of home ownership. The same could happen here, particularly given the high current prices.
2. Renting is also very useful if you are only going to be in an area for a few years - if you have the sort of job that moves you around a fair bit then it may be completely inappropriate to buy.
3. Giving tax incentives to buy your first home reduces your mobility - your tendency to move to get that next job. The government will help you get that first home, but not the second. In fact the Australian State governments will tax you for doing so - probably taking all the money the Feds dropped in to help you buy it and more. If you are not prepared to move for a job then you are either going to stay where you are or, worse, become involuntarily unemployed.
4. Most crucially - the housing affordability “crisis” is not going to be solved by throwing money at it. It is not. The problem out there is not that there is not enough money chasing homes, the problem is that there is not enough housing being built. With prices above record levels in most of Australia there is little or no evidence that more money will solve the problem - in fact the reverse is true. All that more money thrown at the housing market will do is to increase prices further, further reducing affordability.
5. Glib, shonky promises like this one give the impression of helping without actually doing so and end up convincing more people that there is something seriously wrong.

There are many more problems, but that is enough to go on with.

If the opposition (or the government) were serious about tackling housing affordability there are a few steps they could take:

1. Release more land for building - either green or (better) brownfield land for multi-unit development. This is the one step that will truly tackle land prices.
2. Reduce or eliminate taxation on land and building construction and transfers to reduce the costs of moving.
3. Do the same for the firms seeking to supply building materials to reduce the costs of those materials.
4. Recognise overseas qualifications to improve the labour supply.
5. After the others - remove the impediments on lending to people seeking to build or buy a house, such as the 80% LVR restriction.

I would also like to see the development of alternatives to the current means of financing house purchase - such as encouraging the development of Musharakah financing, but this is not an immediate way to reduce prices.

Personally, as a home owner, I am very happy with the situation.  I am just glad I got in a few years ago.

After several interesting and, on other blogs at least, long discussions on the nature of money, my view on what money is and why it matters has changed and, in some aspects at least, hardened.

What I remain agnostic on is the need for commodity money - returning to the gold standard or some other commodity. The efficiency of fiat money appeals to me - there is no need to confuse money with gold (or silver), nor is there any need to store anything against the possibility that people will want to redeem their notes and coin for the commodity.

The upside of commodity money is the discipline - the need for the currency issuer to ensure that they will be able to meet any call. This imposes at least some limits on how much they should actually issue. Without it being fully backed, though, there is a long history of governments, at least, cheating on this. The history extends from the collapse of Bretton Woods in the early 1970s to the over-issue of assignats in revolutionary France and past that in many places.

The point to note here is that, as far as I can see, this sort of cheating has been largely restricted to government issuers - but this may just be because private issuers have been rare over the last few centuries.

In the rest of this post, though, I am interested only in the current position - not anyone’s ideal of where we need to get to.

Monetarism

Perhaps a good starting point for a consideration of money is the economics school that focused (or obsessed) on it. A crude monetarist position runs from the old MV=PQ¹ equation - the theory being that since V and Q only changed slowly and predictably, changes in the money supply would directly feed through the general price level. Clear enough - if you know what the money supply is.

Many monetarists took M3 to be the most reliable broad measure. This is normally defined as being:

• M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.
• M1: M0 - those portions of M0 held as reserves or vault cash + the amount in demand accounts (”checking” or “current” accounts).
• M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000).
• M3: M2 + all other CDs, deposits of eurodollars and repurchase agreements. (Thanks Wikipedia)

Other publications

As “Jim” noted in comments on a previous post on this topic, most, if not all, of the textbooks on this topic are adamant that banks create money - he was right in this - but the question is whether they are right, and whether it matters.

By the traditional calculation of the money supply above, he and they are right. Any simpleton can see that, if a bank accepts a demand deposit and then makes a loan on the back of it, the money supply, as calculated above, has increased. The deposit is still money, the loan out (once drawn down) is money, ergo money has been created.

The issue

The problem I have with this is a serious one - are all bank deposits truly “money”? There are probably as many definitions of what money is as there are people - but let’s use this one for the moment:

Money is anything, which has reached such a degree of acceptability, no matter of what it is made, or why people want it, no one will refuse it in exchange for his goods if he is a willing seller. (Professor Walker - Money, Trade and Industry) (thanks to Jim again)

Now, look at bank deposits and some of the other things in M3. Would someone seriously take my bank deposit or CD in exchange for his goods? No. He or she will normally accept cleared funds of one description or another, but not my bank account - there is no real way I can transfer that, other than changing the name on the account, which would be silly. They may accept a cheque, but if it is not met at the bank then I still owe them money (and the bank some additional fees).

The M3 calculation also fails to take into account banking practice, or even the transaction processing ability of banks. If all of the bank deposits, CDs, eurodollars were suddenly to be used for transactions the system would simply collapse - not only because there is not enough physical cash to redeem them all but also because the system would not be able to process that much at once - or even over a few days.

The practice of banks of borrowing short and lending long also, to me at least, makes the bulk of the amount in deposits less than fully “money”. Any given depositor can normally withdraw all of his or her funds, but, as we saw with Northern Rock, if all the depositors appear at once for their “money” there are serious problems.

If much of the amount in the banks cannot be used for transactions, are they still money? Should we only regard the amount held in banks as liquid reserves - or even only the expected daily funds usage as money?

Why does it matter?

Application

In some ways it does matter - and in other ways not. From an individual’s point of view it does not matter - and this was my previous point of view. In practice, I can go and get “my money” from the bank and spend it - using any one of several differing methods. It does not matter if some economist somewhere thinks of it as money or not.

From an bank’s point of view it probably matters only as far as the ALM² function cares - can we meet expected or stressed withdrawals?

From a central bank’s point of view, though, I was wrong - it may be important. Government central banks are now typically charged with maintaining the general price level (remember P above?). The clear result of the obvious disconnect between all of the monetary measures (including M3) and the general price level has resulted in the dropping of monetary targeting and the use of (a measure of) inflation targeting using interest rates to achieve this.

The problem is that the measure of inflation being used is never going to be able to encompass all (or even much) of the detail of a modern economy. Typically, they also ignore asset prices as they are difficult to incorporate. As a result, P is difficult to calculate, much less target. Consumer Price Inflation is typically used as a proxy

Hypothesis

One possible reason for much of the disconnect between the calculated money supply and the (much lower) growth in measured inflation is due to the steadily dropping reserve ratios of banks - and therefore their increased lending ratios. The lower reserve ratios have been driven by improved ALM within the banks - the assets of the banks are sweating more and the amount of needed as liquid reserves is reducing. Deposits, though, are still needed to allow the lending. This means that, using M3 as a measure, the money supply is bounding ahead - but inflation is comparatively static.

If this hypothesis is correct, a better way to calculate the money supply would be to include only physical currency not currently in the hands of the banking system and the amount held at banks and available for either deposits or withdrawals - these being the only amounts that are truly liquid within the system and therefore the only components of M that are actually able to be used for transactions.

Is this useful? Probably not. But I have enjoyed thinking about it.

1. Money supply times Velocity equals the general Price level times the Quantity of transactions. I know the arguments were much more detailed than this, but this is a blog post, not a textbook.

2. ALM - Asset and Liability Management - the function of the bank that is primarily charged with ensuring the bank can continue to pay out what it owes and making sure the assets of the bank make enough profit to keep the res of the show going.

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?

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.

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.

I was doing a quick round of the banking blogs that I link to from here and I thought that I cannot be getting all of the banking related blogs. If you have a favourite one that I do not know about, please put a link in the comments (no more than two per comment please - the anti-spam will pick them up). Add a few words about why you like them.

If I like the content and they look like they will be around for a while I will add a link from here.

Do not feel embarrassed about pimping your own blog - the links from other blogs drive considerable traffic both ways. Go for it.

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 fa