Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks

TO BE NOTED: From the BBC:

"Making banks safe

Robert Peston | 12:05 UK time, Tuesday, 28 April 2009

Let's talk about banks' capital ratios, or the amount of capital banks are forced to hold as a proportion of their assets (or their loans and investments).

Stay awake. This stuff matters to you.

For those who don't know, banks' capital is a buffer against the losses they always face on lending and investing.

It's supposed to be the guarantee to depositors like you and me that we wouldn't be damaged when banks' loans go bad or when banks lose money on trading in securities: the hurt would instead be felt by shareholders and other providers of assorted forms of risk capital.

Now one of the main reasons the global economy is in such a mess is that big banks systematically lent far too much relative to their capital resources - which is mainly their fault but also that of numpty regulators, who allowed banks to drive a coach, horses and an entire wagon train through international rules that were supposed to ensure they kept adequate amounts of capital.

A few banks - such as Royal Bank of Scotland, Switzerland's UBS, Merrill Lynch and Citigroup of the US - took leave of their senses with their manic lending (by the way, the FT's Gillian Tett gives a particularly hair-raising account of their descent into madness in Fools' Gold, her new book).

The way most banks stretched their capital resources in their lending sprees both pumped up a dangerous bubble in asset prices and meant that when the bubble burst they didn't have enough capital to cover the losses.

So taxpayers, all over the world, had to step into the breach.

We taxpayers have pumped hundreds of billions of dollars of new capital into banks - we've nationalised or semi-nationalised loads of them - because the alternative of allowing the banks to fail was too scary for governments to contemplate (there was no desire to see the mobs of anxious depositors which formed outside Northern Rock's branches in September 2007 turn into a rampage outside most other banks).

But to state the bloomin' obvious, this global banking rescue is not something we'd want to repeat in a hurry.

It's quite important therefore that measures are taken to minimise the likelihood that banks will again systematically extend far too much credit relative to their capital resources.

However, closing this particular stable door is by no means simple, for two main reasons:

1) banks are global businesses, so new rules will have to be agreed by governments and regulators all over the world (never easy);
2) if we clumsily implement hastily and crudely devised requirements that all banks have to hold vast amounts of additional capital relative to their assets, there could be a permanent and significant reduction in the availability of credit - which could significantly reduce the potential for future global economic growth (we could all end up poorer from our natural desire to have a safer banking system).

For me, one of the big questions (about which there has been almost no public debate) is whether we should endeavour to make safe the global financial system that developed over the past few years - characterised by massive flows of capital across borders and the packaging of debt into securities for sale to investors - or whether we should give that up as a bad lot and regulate ourselves into a simpler but possibly poorer world, in which credit extended in any particular country is more closely matched by savings in that country.( NB DON )

The efforts of most governments, including our own, appear to be to sanitize the globalised status quo. It's obvious in our case why that's happening: as a nation, we don't save enough to meet households' or businesses' demands for credit (so we have to import credit from abroad).

But our government is doing its best to preserve the structures of financial globalisation, without explicitly making the case for doing so.

By contrast, it's possible to see in the words and deeds of the governor of the Bank of England that he believes some important elements of financial globalisation need to be rolled back (the Bank of England has, for example, been much more cautious about helping to rekindle securitisation - the conversion of debt into tradable securities - than Downing Street would like).

Here's the danger: we'll muddle through and devise yet another sub-optimal regulatory system.

Some of the second order issues were aired yesterday by Adair Turner, chairman of the Financial Services Authority (although he raised one very important question, which is whether financial innovation will always engender instability, and whether it's now clear that the costs of that instability outweigh the benefits of innovation).

Strikingly Turner said he was "open-minded to a [proposal]...that large systemically important 'too-big-to-fail' banks should have to maintain higher capital ratios than applied on average".

This is a nod to an idea that the chancellor is planning to float in a couple of weeks in a white paper on reforming regulation of the banking system (and the US authorities are moving in the same direction).

For what it's worth, there are two reasons why it might make sense to force our biggest and most complex banks to hold more capital than their smaller, simpler peers: if big super-banks have the privilege of knowing that we as taxpayers would always bail them out in a crisis, surely they've got to put in place treble protection against the risk that they'd call on us for such help; also the costs of holding the extra capital might encourage them to slim down and simplify their operations.

That said, such a regime could achieve the precise opposite of what would be intended.

The public imposition of a higher capital requirement on, for example, Barclays than on smaller, simpler banks would be a public declaration that Barclays would never in any circumstances be allowed to collapse.

And, paradoxically, that could give an unfair competitive advantage to Barclays - because safety-conscious depositors might well choose to give Barclays a disproportionate amount of wonga in the belief that there are no circumstances in which that wonga could be lost.

Which is partly why some, like the Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks, so that these sorts of competitive distortions are minimised and so that banks don't abuse ordinary depositors' cash by gambling it in the supposed casinos of wholesale markets.

As I've recently noted, the Tories have also come out in favour of dismantling the big banking conglomerates - and Mervyn King, the governor, has said it's an idea he would like explored properly.

Even so, Lord Turner isn't in favour of the prohibition of Barclays-style universal banks, and nor are the chancellor and prime minister. They believe that delineating wholesale banking and retail banking in a clean way is easier said than done.

Certainly what's been striking over the past 20 months is that disaster has not been confined to one kind of bank: there have been egregious losses and humiliation for universal banks, such as Citi, UBS and RBS, as well as for narrower, more specialised banks, including Lehman, Bear Stearns, Washington Mutual and Northern Rock.

Oh, and lest we forget, the single biggest stimulator of the excesses of the banking system wasn't a bank at all: it was AIG, whose crazy insurance of financial products gave banks the lethal confidence to lend to those who could never repay."

promising more intrusive regulation and warning that people “should be frightened” of the FSA

TO BE NOTED: From Bloomberg:

"FSA Light Touch Turns to Iron Fist as Interviews Rise (Update1)

Share | Email | Print | A A A

By Caroline Binham

April 28 (Bloomberg) -- U.K. banks including Barclays Plc, HSBC Holdings Plc and Lloyds Banking Group Plc are having as many as four times more employees interviewed during routine inspections as the nation’s financial regulator’s “light touch” morphs into an iron fist.

As many as 150 people are being questioned by the Financial Services Authority during examinations at Britain’s biggest banks, according to lawyers and a person familiar with the visits. In previous years, the maximum for a major bank would have been 40 interviews, they say.

“The FSA is becoming nastier,” said Sara George, a former FSA prosecutor who is now a regulatory lawyer at Allen & Overy LLP. “There is a feeling that the FSA is now a lot more answerable to Westminster and to the taxpayer than to the City,” she said, referring to the home of Parliament, and London’s financial district.

The regulator, criticized by lawmakers for not doing enough to prevent the financial crisis, has broken with its past approach, promising more intrusive regulation and warning that people “should be frightened” of the FSA. It has pledged to become more involved in banks’ business, from scrutinizing strategy to influencing hiring and compensation.

The U.K. now owns stakes in Royal Bank of Scotland Group Plc and Lloyds, while Northern Rock Plc and Bradford & Bingley Plc have been nationalized. The International Monetary Fund last week estimated the total cost of bailing out British banks will be 175 billion pounds ($255 billion).

Brown Creation

Prime Minister Gordon Brown, who created the FSA in 1997 when he was Chancellor of the Exchequer, had up until the credit crisis championed London’s “light-touch” regulation for being business friendly.

“Where more people are interviewed, that is in line with our more intrusive approach,” said Heidi Ashley, an FSA spokeswoman.

FSA inspections are known as ARROW visits, which stands for “advanced, risk-responsive operating framework.” Before this year, they consisted of assessments of financial companies’ compliance and risk-management.

Over 100

“Whereas before an ARROW visit may have taken in 20 to 40 people, now it’s over 100,” said Carlos Conceicao, a former FSA enforcement director who’s now a regulatory lawyer at London- based Clifford Chance LLP.

The FSA interviewed about 80 people at one of Britain’s biggest banks in the final quarter of 2008, according to a person familiar with the visit. The bank was told that more than 100 will be interviewed next time, said the person, who declined to be identified because the inspections are confidential.

Non-executive directors are now being questioned more intensely and are being asked to provide evidence of where they disagreed with management and how they made their views known, said George at Allen & Overy.

“The FSA is doing two things,” said Jonathan McMahon, a former FSA bank supervisor who is now a regulatory adviser at the consulting firm Promontory Financial Group. “It’s asking more detailed, probing questions. It’s also interviewing people previously untouched by ARROW,” including more junior employees.

The FSA’s more intensive approach can also be seen in the time it takes to approve applications for roles of “significant influence” at companies, said Darren Fox, a regulatory lawyer at London-based Simmons & Simmons.

‘Far More’ Interviews

The regulator is undertaking “far more” interviews before signing off on such appointments, Sally Dewar, the FSA’s Director of Wholesale and Institutional Markets, said yesterday at a conference in London.

Overhauling the ARROW visits mirrors the “revolution” in regulation that its chairman, Adair Turner, promised last month.

ARROW “has embodied our principles-based approach, delivering a lighter regulatory touch for those firms that pose less risk,” an FSA paper said in 2006.

The light-touch approach was criticized by opposition Conservative Party lawmakers who have recommended that bank supervision be returned to the Bank of England should they win the next general election, which must be held by 2010. Turner, presenting his blueprint for regulation, said last month the era of light-touch regulation was dead.

Turner pledged that after a recruitment drive, as many as 20 supervisors will be assigned to each large bank to undertake more rigorous assessment.

More FSA Staff

“They’ve got 100-odd new supervisors and one of the great unknowns is how quickly they’ve been brought up to speed,” Conceicao said. “If they’re not the right caliber with the right experience, then you’ve got inexperienced people looking at vast amounts of information.”

The financial crisis has brought to light scams such as the $65 billion Ponzi scheme to which Bernard Madoff pleaded guilty on March 12. He faces as many as 150 years in jail for using money from new investors to pay off old ones.

“No one wants to be the one who misses the red flags of the next Ponzi scheme and so the FSA is adding a whole new layer of scrutiny,” said Simmons & Simmons’s Fox.

While the FSA is responding to politicians’ concerns by asking for more information, it could also be setting itself up for more problems, Fox said. “The more information the FSA asks for, the more risk they take that if something goes wrong, they will have missed it.”

To contact the reporters on this story: Caroline Binham in London at cbinham@bloomberg.net"

S&P also downgraded all the major US mortgage insurers, and most by multiple notches.

TO BE NOTED: From Alphaville:

"The travails of the financial guarantors Posted by Stacy-Marie Ishmael on Apr 22 15:40.

There’s been a slew of (mostly negative) ratings actions on the financial guaranty sector - the bond insurers, mortgage insurers and the like - recently. Here’s a recap.

Subsequent to a warning from FGIC’s auditor that there is substantial doubt over the bond insurer’s ability to “continue as a going concern,” Standard & Poor’s on Wednesday wrote off the company completely:
NEW YORK April 22, 2009–Standard & Poor’s Ratings Services said today that it lowered its counterparty credit, financial strength, and financial enhancement ratings on Financial Guaranty Insurance Co. (FGIC) to ‘CC’ from ‘CCC’ and assigned a negative outlook.

Standard & Poor’s also said that it subsequently withdrew the ratings on FGIC and its ‘CC’ counterparty credit rating on the holding company, FGIC Corp., because of our expectation that timely and comprehensive financial information will no longer be available.

“Recently released GAAP financial statements for both FGIC and FGIC Corp. contain a statement from the independent auditor that there is substantial doubt regarding the company’s ability to continue as a going concern,” noted Standard & Poor’s credit analyst Robert E. Green. “The issuance of this opinion results in an event of default by FGIC Corp. under the terms of the company’s revolving credit agreement.” There is $46 million outstanding under the facility, and FGIC Corp., though it is attempting to secure a waiver, does not have the resources to repay this amount in full if it were to become due on an accelerated basis. In addition, because FGIC is in a negative earned surplus position, it is not able to pay dividends to FGIC Corp.

The negative outlook reflected the possibility that additional losses incurred, as suggested by our RMBS and CDO of ABS loss estimate, could result in capital and surplus below the minimum statutory requirement of $65 million. The negative outlook on holding company FGIC Corp. reflected the independent auditor’s issuance of a going concern opinion, which triggered an event of default on the company’s revolving credit facility.

S&P also downgraded all the major US mortgage insurers, and most by multiple notches. Companies affected include Radian, PMI, Genworth Mortgage Insurance and RMIC.

But - in a rare display of confidence - S&P affirmed the triple-A rating on Financial Security Assurance (FSA) and removed it from credit watch negative.

Over at Moody’s, Ambac was downgraded to Ba3 from Baa1 (deep, deep into junk territory):

The downgrade of Ambac’s ratings primarily reflects weakened risk adjusted capitalization, as Moody’s loss estimates on RMBS securities have increased significantly (particularly with respect to Alt-A transactions). These higher loss estimates increase the estimated capital required to support Ambac’s sizable direct RMBS portfolio (including securities owned as well as securities guaranteed) and also the insurer’s large portfolio of ABS CDO risks. The rating agency noted that the claims-paying resources of Ambac remain above Moody’s expected loss estimates for the firm, though this cushion has been significantly eroded, and losses in more severe stress scenarios would exceed available resources.

Related links:
Moody’s sets its sights on the mortgage insurers - FT Alphaville

This entry was posted by Stacy-Marie Ishmael on Wednesday, April 22nd, 2009 at 15:40 and is filed under Capital markets. Tagged with Ambac, FGIC, Financial Security Assurance, Monolines, PMI, radian.

let's not forget that the FSA deserves a hefty share of the blame as well.

From The Economics Of Contempt:

"The FSA Deserves Some Blame for Lehman Too

ECB official Lorenzo Bini Smaghi responded to Paul Krugman's recent contention that Europe's response to the financial crisis has been inadequate. One of Smaghi's arguments, though, unfairly places all the blame for allowing Lehman to fail on the US:

[Krugman's argument] doesn’t explain how the most fateful decision of all – the decision to allow a systemically important bank to fail in the midst of a financial crisis – was taken by a single decision-maker, while the 16 euro area governments have managed to avoid making such a large mistake.

Whoa, let's remember what actually happened. The Fed and the Treasury successfully brokered a private-sector rescue for Lehman, in which Barclays would buy all of Lehman except for $40 billion of commercial real estate assets, which would be acquired by a consortium of major banks. Since Barclays is a British bank, the deal required approval from the UK's Financial Services Authority (FSA). On Sunday morning, though, the FSA unexpectedly rejected the deal. As William Cohan recounted:

The Barclays deal required the blessing of the Financial Services Authority, in London - the UK equivalent of the SEC. So Paulson spoke with his UK counterpart, Alistair Darling, the Chancellor of the Exchequer, and to the FSA. He then summoned McDade, Lehman's president, to the New York Fed and told him at around 9:45 a.m., "Deal's off. The FSA has turned it down." At roughly 10 o'clock, Paulson and Geithner briefed the bankers at the Fed.

So while the Fed and the Treasury undoubtedly made a mistake in letting Lehman fail, let's not forget that the FSA deserves a hefty share of the blame as well.

Posted by Economics of Contempt"

Me:

Don said...

Here's a little more on that from Bloomberg on Nov. 10th:

http://www.bloomberg.com/apps/news?pid=20601109&sid=aMQJV3iJ5M8c&refer=home

"Barclays Deal

One of the attendees, Merrill CEO John A. Thain, 53, took stock of his own company's best interests and initiated merger talks with Bank of America. Lewis had concluded on Friday that he couldn't do a deal with Lehman without government backing, which he thought would be forthcoming. After Paulson made it clear to Lewis that a government role wasn't in the cards, the Bank of America CEO pulled his team out of the Lehman talks.

That left only Barclays, since Nomura told Lehman it was unable to move fast enough. Fuld, who rarely left his office that weekend -- working the phones, fielding calls from deputies, talking to Barclays executives -- thought he had a deal Saturday night. Barclays was willing to buy Lehman for about $5 a share if it could leave behind the most troublesome assets, the ones Lehman had proposed spinning off into a separate company as well as some others Barclays didn't want.

Sunday morning brought a false dawn. Geithner and Paulson had talked a syndicate of banks into backstopping the creation of a new entity that would take over $55 billion to $60 billion of Lehman's problem assets, according to people with knowledge of the negotiations.

No Lifeline

Everyone was basking in what seemed a done deal until word came at 11:30 a.m. in New York that the U.K.'s FSA, which regulates that country's banks, refused to waive normal shareholder-approval requirements or to allow Barclays to guarantee Lehman's debts until obtaining that approval. The reason, people familiar with the decision say, was that Barclays lacked sufficient capital to absorb Lehman.

``The only reason it didn't happen,'' Leigh Bruce, a Barclays spokesman said today, ``is that there was no guarantee from the U.S. government, and a technical stock-exchange rule required prior shareholder approval for us to make a similar guarantee ourselves. We didn't have that approval, so it wasn't possible for us to do the deal. No U.K. bank could have done it. It was a technical rule that could not be overcome.''

Don the libertarian Democrat

March 20, 2009 8:38 PM

Nevertheless, this report is a milestone.

In case you want to read The Turner Review, here it is:

http://www.fsa.gov.uk/pubs/other/turner_review.pdf

Here's a few good posts about it:

"Towards a rational exuberance

Lord Turner's report "A regulatory response to the banking crisis" was released yesterday.

One of the key findings is that markets, and market participants, can be irrational. This can lead to problematic outcomes such as bubbles in asset prices and massive mispricing of derivatives such as CDOs and CDSs.

However, Turner's recommendations barely address this problem. There are several valid recommendations about procyclical reserves and a hint at a power to intervene in momentum trading (such as short-selling which feeds on itself). But this only dances around the edges of the problem.

He also recommends technical training or qualifications for bank executives. But that's not where the irrationality is. Indeed, many bankers have been all too rational throughout this crisis - extracting rents for themselves at the expense of shareholders and creditors. Turner does recognise this principal-agent problem and some of his recommendations deal with it. However it is not a problem of irrationality; the irrationality that matters is that of borrowers and investors, not of banks.

The corollary of this is a more radical proposal.

Regulators - central banks or financial regulators such as the FSA - need to monitor aggregate irrationality. There are two ways to do this:

• measures based on the behaviour of individuals, aggregated across a whole market
• measures based on the aggregate risk taken and valuation implied by market asset prices

The second of these can be measured using (fairly) standard financial measures - projections of economic growth, share of output accruing to capital or to profits, discounted and compared with asset prices. The answers won't be exact, but measures that are wildly outside of economic rationality will be apparent.

There will certainly be challenges in measuring across different asset classes - typically a single regulator does not cover equity and debt markets, for example, and if there is an aggregate overvaluation, it will be very hard to gauge whether equity holders and debt holders are both expecting a too-high share of overall returns, and who is wrong. But with unified or at least coordinated regulation, it should be possible to determine that overall prices are too high.

The former requires insights from behavioural economics and particularly from behavioural finance. In many situations it is possible to measure objectively what the rational outcome or decision is. And it is possible to see where an individual investor diverges from this. Sometimes this does not matter for the system as a whole; and sometimes it does. But as Turner points out, markets are not always self-correcting and certainly not in the short term. Thus, it is likely that a dedicated regulator could identify substantial deviations from rationality in large populations.

On the border between these is the collective action problem: where individual rationality leads to an outcome which is not a rational one for the group. Turner does mention this but offers no solution. Again it is clearly measurable: at present, for example, we have an excess of desired savings leading to a reduction in overall output - clearly not a desirable outcome for the population as a whole, but perhaps rational for each individual saver. Somehow the interest rate mechanism is not resolving this problem (the zero bound is one reason; sticky prices, wages and investments are another).

So our hypothetical regulator has identified irrationality of some kind - irrational exuberance or irrational depression. What should it do?

Here we turn again to behavioural economics. There are clear ways in which irrational behaviour can be guided or corrected by specific stimuli. Specific examples:

1. Framing of choices. The right kind of framing can influence people to take more or fewer risks, to consider the future more or less, and to put a higher or lower value on assets. Framing methods include choice of language, the range of pricing and risk choices available to buyers, subconscious signalling such as branding, and sensory cues such as colour and music. The mechanisms for regulators to communicate their decisions downward to the framing of commercial decisions do not yet exist, but could certainly be put in place. After all, they currently influence interest rates, so the argument for commercial freedom is not an absolute barrier to this.
2. Visibility of irrationality. People tend to become more rational either if they have more time to reflect, or if their irrationality is made visible to them. A regulator could certainly have a role in making this happen. Simplistically, one could ask why not make people more rational all the time. But there are transaction costs and diminishing returns involved. It's not realistic for a regulator to step into all transactions everywhere; but if they are able to measure who is irrational, when and where, they can focus their efforts where they'll have an effect.
3. Lengthened time horizons. Buyers generally make less rational decisions when they consider the consequences over a shorter time period. The longer a period that is considered, the better the decision will be. Interest rates are one way of influencing the time periods that investors consider; others include the credibility of inflation targets or the availability of externally anchored future events. For instance, subjects who are asked questions about their age and retirement dates will subsequently make a different kind of investment decision than those who are not.
4. Increased scope of social contract. Buyers who act purely as individuals will make different choices to those who also consider the effects on their family, their social groups or their society. It is possible to measure the divergences between individual and group interest, and to influence the degree to which people consider the consequences for a group when making decisions.

This proposal undoubtedly needs further research: we don't yet know the most accurate measures of irrationality or the most effective influences on it. And there are obvious limits on rationality in all circumstances - predictions of the future are not perfect, information is not always available, and people cannot always know their own preferences with regard to time discounting.

But I am confident that direct methods to help people and groups to be more rational will have a more powerful, and more timely, effect than relying on banks' capital cushions to make the corrections for them. This isn't all about correcting for overconfidence; it will also work on the risk aversion and underconfidence we're seeing now. Exuberance can be rational, and growth will be more steady and reliable when it is.

at 16:50 "

And:

"Wolf on Turner

Martin Wolf's article on Lord Turner's review is a good one (by which I mean, of course, that he agrees with me). He identifies irrationality as "the main analytical conclusion" of the report, but he doesn't take the next step of suggesting that it can be directly regulated.

There are a range of interpretations of Turner's report. Some think his diagnosis was that banks are too thinly capitalised. Some that he condemns financial innovation. I think Martin Wolf has found the most important part: his conclusions about irrationality, both collective and individual.

But while Turner has diagnosed the right disease, he doesn't propose a workable cure. To combat irrationality, he suggests a set of tools that work through rational means. Counter-cyclical capital requirements, leverage ratios, remuneration and centralised CDS clearance are perfectly sensible measures, but - like interest rates, the main tool of existing counter-cyclical policy - they work by market participants responding rationally to incentives, with consistent discounts on time and risk.

As Turner points out, this criterion is unfulfilled often enough to matter. Investors and borrowers do not always act rationally, and if regulators want to combat that, they need to tackle it directly.

Fortunately, they are starting to gain the ability to do so. Behavioural economics research provides tools both to measure irrationality - on an individual or aggregate basis - and to influence it. If equity market participants take too much risk (as they, sometimes, objectively do), there are specific framing mechanisms which can increase risk aversion and have the effect of making investors more rational. If monetary and fiscal policy fail because of hyperbolic discounting, there are 'mental accounting' techniques which can correct for this.

Naturally such policies will require research and testing before being implemented; in particular, the methods for transmitting central policy decisions into the marketplace need work. Just as the mechanisms for transmitting central bank interest rate decisions into the money markets and the consumer debt markets have gradually developed over decades and are still not fully understood - quantitative easing, anyone? - rationality transmission will need time and experimentation to take root.

But if effective controls can be developed, we will be able to avoid restrictive controls on financial innovation by using a more targeted and direct toolkit to mitigate irrational exuberance or irrational fear. The economy - with help from the financial markets - will have room to grow, with a much lower chance of building up large internal imbalances.

at 10:28 "

And:

"Why the Turner report is a watershed for finance

By Martin Wolf

Published: March 19 2009 19:28 | Last updated: March 19 2009 19:28

Lord Turner is the UK’s man for all seasons. A few years ago, he fixed pensions. Today, it is finance. The report by the new chairman of the UK’s Financial Services Authority is a turning point.* The authorities of a country that used to boast of its light financial regulation have changed their minds: the UK has lost confidence in its financial sector.

“Over the last 18 months, and with increasing intensity over the last six, the world’s financial system has gone through its greatest crisis for at least half a century, indeed arguably the greatest crisis in the history of finance capitalism.” This is the report’s starting point. It advances two explanations for this disaster: exceptional macroeconomic conditions – particularly the emergence of excess savings in large parts of the world – and reliance on “the theory of efficient and rational markets”. As the report notes, “the predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational”. So regulators were expected to stay out of the way. In the report’s new view, they should be in the way, instead. The financial sector no longer enjoys the benefit of the doubt: it may burn up the world.

The most important analytical points are that individual rationality does not ensure collective rationality, that individual behaviour is frequently less than rational and that, in consequence, markets can overshoot, in both directions. Above all, such failings create systemic risks: if everybody believes in the same (faulty) risk models, the system will become far more dangerous than any individual player appreciates; and if everybody relies on their ability to get out of the door before anybody else, many will die in the inferno.

To these points must be added the vulnerability inherent in borrowing “short and safe”, in order to lend “long and risky”. If we were not so familiar with banking, we would surely treat it as fraudulent. Moreover, far from reducing the frailty, securitisation enhanced it by spreading “toxic assets” everywhere.

The recommendations include: increased quality and quantity of capital, particularly against trading activities; a strongly countercyclical capital adequacy regime; a maximum gross leverage ratio; enhanced regulation and supervision of liquidity; coverage of all significant institutions; enhanced supervision of rating agencies; codes covering remuneration in systemically significant institutions; and centralised clearance of the majority of trades in credit defaults swaps.

Also recommended are enhanced “macro-prudential” analysis by the FSA, the Bank of England and global bodies; a big shift in regulation by the FSA towards high impact businesses, by focusing on business models, strategies, risks and outcomes in the supervised companies; greater international co-ordination of supervision; an independent European regulator; and an end to the “untenable present arrangements” for cross-border activities of European banks – the “Iceland problem”.

In short, the stable doors are to be locked tight, though only after a herd of horses has already bolted. Nevertheless, even Lord Turner’s radicalism is limited: the report rejects division of the financial system into utilities and a casino. The arguments against are that the casino would still need to be regulated, that such a distinction could not be introduced by one country on its own, particularly in the European Union, and that global companies need “large complex banking institutions providing financial risk management products”. So securities underwriting by banks is still needed, though “large-scale proprietary trading through in-house hedge funds is not”.

In all, this report offers radical tightening of regulation and supervision of a financial system that would remain broadly the same as today’s. The most regulated businesses would be less profitable and so would shrink. That would be no loss, suggests the report: the profits they reported were illusory, but the dangers they created all too real. This judgment is surely right.

Yet even this report leaves important questions unaddressed.

First, it does not explain why we can hope to contain the behaviour of companies too important to fail.

Second, it does not demonstrate that regulators can contain regulatory arbitrage by profit-seeking financiers.

Third, it does not deal with risks posed by institutions that may be too big to rescue by some host countries.

Fourth, it does not explore the room for charging heavily for guarantees.

Finally, it does not consider the incentives towards excessive leverage inherent in the tax system.

Nevertheless, this report is a milestone. It should help catalyse the needed global discussion of regulatory reform. Other countries – and, above all, the US – should commission comparable analyses of their own regulatory failures. I would also wish to see equally searching analysis of mistakes in monetary policy, both in the UK and elsewhere.

Humans learn far more from failure than success. The failures this time are big enough to make learning the lessons essential. The Turner report is a start. More learning must follow.

*Turner Review, www.fsa.gov.uk

martin.wolf@ft.com"

And:

The Turner review: some questions

The Turner review (pdf) of financial regulation (pdf) is intended to be the first words on the subject, not the last. It leaves open several questions. For me, the main ones are:
1) How do we get from here to there? Turner wants banks to have higher capital-asset ratios - even higher than Basel II ones. But banks are now under-capitalized; in my day job, I’ve estimated, from Bank of England data (table B1.2) that banks need over £80bn of capital just to return to 2006’s capital-assets ratio. How can banks raise their ratios so much? Turner says we need a “lengthy transition” period to ensure that his proposals don’t cause a halt to lending. But this period might be very long indeed. Not does he say how banks are to raise such capital, without further government help.
2) Turner wants banks to have counter-cyclical capital requirements, building up reserves in good times. But are these really enforceable?
Imagine the next boom, in which banks restrain lending. Young people will complain of being unable to get on the housing ladder. Firms will complain of being starved of finance to invest in profitable new equipment. Banks will resent the foregone profits. And everyone will downplay the probability of a recession - that’s what happens in booms. Can regulators or governments really resist these pressures to abandon counter-cyclical requirements?
3) Won’t regulatory arbitrage circumvent these problems, for example as offshore lenders step in to fill the gaps left by banks? Turner says that purely national regulation is “by far second best”, and calls for “internationally agreed” regulation. But isn’t this rather idealistic?
4) Far from accepting calls for a Glass-Steagall style separation of “utility” and investment banks, Turner seems to want a merger of the two. His call for very high capital requirements against banks’ trading books mean that stand-alone investment banks would face huge capital costs. This would encourage banks to take them over. Is this desireable?
5) If Turner gets his way, we’ll have slower, more stable economic growth. But what are the benefits of this over higher, more volatile growth? It’s easy to forget that booms can have lasting benefits - for example by bequeathing us a higher stock of physical capital or houses, or giving some of us nice capital gains as a result of irrational exuberance; I speak as one who sold a London flat for silly money a year ago.
6) Is Turner really wise to downplay the role of inadequate management structures in this crisis? He points out that managers’ big equity stakes did not stop Lehmans‘ collapsing. But he doesn’t point out that unrestrained hubristic chief executives (Dick Fuld, Fred Goodwin etc) played a role. And, aside from calling for banks to use some counter-conventional wisdom academic research, Turner doesn’t ask how to break up the deference to individual leaders or groupthink that led banks to so willingly take on high risks.
And herein lies the paradox of the report. The dominant theme of it is that banks are incapable of managing themselves. But to Turner, the solution is not a change of ownership (the N-word isn’t mentioned as far as I can see), nor or management structure, and certainly not the introduction of more market forces. Instead, it’s management at arm’s length, by regulators.

March 19, 2009 | Permalink"

Happy reading!

major reform of regulation and supervision was required to reduce the "probability and severity" of severe disruptions.

From the Guardian:

"Weakened banking system is creaking further, warns City watchdog

• Larry Elliott, economics editor
• guardian.co.uk, Monday 9 February 2009 13.33 GMT

The greatest financial crisis in the post-war era has left the banking system in a weakened state despite last autumn's efforts to prevent a systemic collapse, the City's watchdog said today.

In its annual risk assessment, the Financial Services Authority said major reform of regulation and supervision was required to reduce the "probability and severity" of severe disruptions.

The FSA wants banks to set aside more capital during upswings to put a brake on lending in a boom. The regulator is also calling for new rules on liquidity to ensure firms can better ride out problems. It believes regulators should widen the net to include stricter supervision of private equity firms and hedge funds when they have the potential to cause systemic disruption to the financial system.

Lord Turner, the chairman of the FSA, admitted mistakes had been made as a cocktail of six interlocking factors had led to the crisis that began in mid-2007, but said the action taken by policymakers would prevent recession turning into a 1930s-style slump.

"I have always believed that while we are not able to avoid a recession, we do have the tools available to make sure the recession is not endlessly self-reinforcing," Turner said.

The report highlighted the risk that banks would lack the credit to keep the economy going – even after the money poured into them by the government. "A major process of deleveraging is now in hand with potentially deflationary effects.

"Without effective policy responses, the banking system and the real economy are in danger of being caught in a self-reinforcing cycle, where constrained lending leads to falling property prices, troubled corporates and credit losses which further impairs banks' ability to lend."

The FSA's Financial Risk Outlook said the six factors that caused the crisis were a rapid extension of credit and falling credit standards; a property boom; an under-estimation of bank and market liquidity risk; the increased complexity of the securitised credit market; increased leverage in the banking and shadow banking system; and a self-reinforcing cycle of irrational exuberance.

Matters came to a head last autumn, the FSA said, when the bankruptcy of Lehman Brothers brought the entire financial system to the point of collapse. "In hindsight, it had become apparent that by mid-October 2008 the fall of confidence in the core banking system was more severe than any since the Great Depression of the 1930s."

It added the rescue package announced by the government had stabilised the situation, largely halting runs on banks and leading to a narrowing of spreads in the credit and interbank markets, "however, the banking system is still in a weakened state and the wider financial system is under significant strain".

Turner said he would cover pay and bonuses at banks in a review for Alistair Darling due by the end of next month. He said, however, the FSA was less concerned about the level of bonuses than whether their structure encouraged excessively risky behaviour. The government, he added, had a "legitimate right and duty" to have a view on pay at the banks where it was a major shareholder, but it was not an issue on which the FSA was focused.

The FSA said it would need to co-operate more effectively with the Bank of England to identify the build-up of risks to the financial system so that pre-emptive action could be taken. It said an average of the forecasts by outside economists suggested the UK would contract by 2.2% this year, but that the risks for developed countries were "on the downside". Turner said that, in the past three or four months, the consensus had moved "in a more negative direction"."

Me:

DonthelibertDem

09 Feb 09, 4:14pm (2 minutes ago)

"The FSA's Financial Risk Outlook said the six factors that caused the crisis were a rapid extension of credit and falling credit standards; a property boom; an under-estimation of bank and market liquidity risk; the increased complexity of the securitised credit market; increased leverage in the banking and shadow banking system; and a self-reinforcing cycle of irrational exuberance."

I notice that the following were missing:
1) Implicit government guarantees to intervene in a financial crisis, leading to excessive risk at banks or concerns "Too Big To Fail".
2) Fraud, Collusion, Negligence, and Fiduciary Mismanagement.
3) Effective Lobbying by the Financial Sector.

There seems a willful attempt to blame actual human beings."

DonthelibertDem

09 Feb 09, 4:15pm (1 minute ago)

Pardon me:

There seems a willful attempt to not blame actual human beings.

"But this turns out to be dangerous hysteria, disconnected from the trading facts. "

Peston on BBC:

"When the ban on short-selling( ASININE ) was introduced last year, the chancellor basked in the general approbation of this crackdown on financial speculation that was supposedly destroying confidence in our banks.

The impression was created that the Treasury was in part responsible for the prohibition on the practice of borrowing bank shares to sell them (with the speculator hoping to buy them back later at a lower price to trouser the difference).

Which now puts the government in something of a pickle. Because it's very unhappy that the City watchdog, the Financial Services Authority, lifted the ban last Friday on these transactions that generate profits from falling share prices.

But ministers can't easily express their disapproval in public - to do so would imply that they didn't really have much say in the imposition of the ban in the first place.

The thing is that the FSA is an independent regulatory body. And at least part of its role is to promote liquid markets that set prices in an efficient way.( YES )

The FSA believes that short-selling enhances the process of setting prices, by capturing the available supply and demand for securities and also relevant information.( I AGREE )

As we surely must now appreciate, as we live with the bitter consequences of the popping of the debt bubble, the euphoric buying of assets by manic investors is highly dangerous - so it can be very helpful that the market contains short-sellers expressing a contrary, negative view.( YES )

So the FSA would only ban short-selling, or any other similar orthodox and longstanding trading practice, when it detected palpable, significant damage to companies or to the economy that outweighed the market benefits.

There was evidence of such damage last spring and summer. A vicious interaction of malicious rumour and speculative sales was devastating bank share prices, and this in turn affected the confidence of banks' creditors and depositors.

When these creditors and depositors withdrew their funds, banks came perilously close to collapse, which transformed the rumours into self-fulfilling propositions.( BUT THE CALLING RUN WAS ENTIRELY SEPARATE )

The ban on short-selling was therefore a circuit-breaker between rumour and the undermining of banks' ability to fund themselves in the wholesale money markets and from retail deposits.

However, since the ban was imposed last autumn, the funding of banks - their borrowing - has become much more stable, thanks to the forced largesse of taxpayers.( YES )

The Treasury has committed around £800bn of taxpayers' money to underpin banks' ability to borrow what they need. A run on a bank that would bring it down is almost impossible today, because banks can secure what they need from us, the taxpayers.( YES )

Which is why the FSA felt comfortable about allowing short-selling to re-commence.

To put it in stark terms, thanks to taxpayers' largesse, short-selling bank stocks is no longer a potentially lethal activity.

Even so, many - including ministers - argue that the FSA was crackers to allow short-selling to start again.

They point to the collapse in the share prices of Royal Bank of Scotland, Lloyds Banking Group and Barclays as evidence that hedge funds and other short-sellers are up to their old tricks of destroying the infrastructure of the British economy for private profit.

There's only one problem with this thesis: it's not supported by the facts.( TRUE )

Since the ban was lifted, there has been a negligible amount of short selling.

And although some will be revolted by the disclosure in this morning's Guardian that Landsdowne has made a few millions in profit from shorting Barclays, it's laughable to think that Landsdowne's miniscule short position could have contributed to the billions wiped off Barclays' value since last Friday.( SILLY )

Most of the share price movements in the big banks have been caused by conventional selling of shares by the normal gamut of investment institutions.( YES )

Some of these investors may have sold because of their conviction that the shorts were selling the stock down to zero. In fact a number have told me precisely that. But this turns out to be dangerous hysteria( YES ), disconnected from the trading facts.

There is an argument that the FSA should have anticipated this irrational depression( TRUE ) on the part of pension funds and others - and should have delayed the lifting of the ban until a bit more common-sense( MAYBE ) returned to the market.

But the main cause of the recent falls in bank shares was the Treasury's massive new package to stimulate lending - which spooked the City for reasons discussed in earlier notes - and a worldwide escalation in fears about the health of banks.( YES )

The short-sellers are the convenient whipping boys, not the prime malefactors (if you think it's a crime that the share prices have fallen, which is moot).

As of now, no irredeemable damage appears to have been done. And although it may jar to say so, shares can rise as well as fall - even bank shares. "

I think that the short selling ban was a mistake, which might have helped calcify the market.

The question, in truth, is not only whether the measures will work, but whether the UK can afford them.

From the FT:

"Are UK banks too big to rescue?

By Martin Wolf

Published: January 22 2009 19:55 | Last updated: January 22 2009 19:55

Is the British government on the right path with its recent package of measures to help the banking sector or, as Mervyn King, governor of the Bank of England, put it this week, “to protect the economy from the banks”? The question, in truth, is not only whether the measures will work, but whether the UK can afford them.( BLIMEY )

Here are two frightening statistics: over the past five years, the balance sheets of many of the world’s largest banks more than doubled; and, according to the Bank, the median ratio of debt to equity in big UK banks is more than 30 to one.

The government faces two challenges: it must eliminate the consequences of these past errors and prevent new ones. These errors go in opposite directions: the past one was lending too much; the present one is lending too little. The legacy of the former is destroyed balance sheets; that of the latter is collapsing lending. ( A SPOT OF BOTHER )

So what should the government be doing in dealing with the legacy of past excesses? The first action must be a brutal worst-case evaluation of balance sheets. The government cannot safely guarantee any conceivable losses( ACTUALLY, IT NEEDS TO. ). The big banks are deemed too big, too interconnected and too important to fail. Yet might they not also be too big to rescue( YOU'D BETTER HOPE NOT )?

This last is the spectre that Willem Buiter has been raising for the UK in his Maverecon blog. He notes that, with balance sheets equal to 440 per cent of gross domestic product, these institutions might imperil the fiscal soundness of the UK itself. I suspect this danger is exaggerated( LET'S HOPE SO. ). A recent analysis from Goldman Sachs suggests that the cost to the state should not exceed 8 per cent of GDP. But it is also true that we do not know what would happen to the value of the global assets of UK banks in a depression. Moreover, we have to add in the costly impact of what are likely to be huge ongoing fiscal deficits over many years.

The government’s policies for dealing with the overhang of bad loans had been recapitalisation. Now we have what Alistair Darling, chancellor of the exchequer, told the House of Commons would be “a new scheme under which the Treasury will insure( REMEMBER PESTON'S POST. ) certain bank assets, for a commercial fee, against losses on banks’ existing loans”.

Meanwhile, the problem for new lending is the departure of foreign financial institutions and capital. The government estimates that about 30 per cent of lending capacity has consequently been lost.

The proposals announced this week include three measures to address the capacity reduction: a £50bn Bank of England fund, financed by the Treasury, aimed at buying corporate assets; a decision to let Northern Rock maintain its loan book, to “support prudent lending to creditworthy customers”; and conversion of the preference shares in Royal Bank of Scotland into ordinary shares.

In addition, “we intend,” said the chancellor, “to negotiate with each bank a lending agreement,” which would be “binding and externally audited”. In return, new support measures are offered: an extension of the credit guarantee scheme introduced in October, which already covers £100bn in loans; an additional £50bn of guarantees, initially on new mortgage lending and eventually on other assets; and, finally, a plan for the Financial Services Authority to adjust capital requirements, to encourage lending in the downturn.( NOTICE THE GUARANTEES )

So what are we to make of these proposals? I have three big worries.( THAT'S IT. AN OPTIMIST. )

My first concerns the potential cost to the taxpayers of guarantees, particularly on past loans. Guarantees on new loans may now be unavoidable. Old loans are a different matter. The idea of offering insurance against extreme outcomes is a superior alternative to buying bad assets at inflated prices( YES ). Yet these loans are bygones – sunk costs. The only question is: who bears the losses? The dangers of letting some losses fall on creditors, via debt-for-equity swaps, are evident. Yet there may be no responsible alternative, particularly in view of the UK’s vast ongoing fiscal deficits.( YES )

My second worry is management. The chancellor says that “we have a clear view that British banks are best managed and owned commercially and not by the government”. Recent performance hardly suggests banks are well managed( TRUE ). Above all, who is taking the risk and deciding what the banks should do? The answer to the former question is taxpayers; the answer to the latter is government. Private management of socialised risks is dangerous( TRUE ). This is why temporary nationalisation is logical. I suspect it is where we will end up.( YES )

My third concern is over the apparent hope of recreating securitised financial markets. I understand the appeal of such markets. But, by offering guarantees( YES ), the government could be subsidising the recreation of a market in lemons.

With international confidence in the UK weak and weakening, the government has to take a realistic view of what it can and must do. It has to come clean on the possible fiscal costs and, in the last resort, it has to focus its limited resources on the future instead."

Too true.

"That turned out to be spectacularly wrong. "

Peston on BBC:

"The Governor of the Bank of England didn't pull out the stops to cheer us up in his speech last night.

What was particularly striking were his closing remarks, when he said that he was sure an economic recovery would come and that there would certainly be a positive outcome from all those interest rate cuts and the hundreds of billions of taxpayers' cash allocated to pumping up the wilting banking system and stimulating demand.

But - and it's an important qualification - he couldn't be sure when the economy would turn. He said: "No one can know at what point the impact of all this stimulus will have a visible effect on activity; the lags in economy policy are notoriously long and unpredictable".

Oh dear. If the economists we trust to steer us through this mess ever had a torch, the battery appears to be flat.

Nor did I feel particularly reassured by his assessment of when the great cause of our woes will be fixed, the reduction in borrowing and lending by banks and other financial institutions.

To remind those who don't live and breathe bankers' jargon, when Mervyn King talks about "leverage ratios" he means the relationship between a bank's debts and its capital resources. He said that the "leverage ratios of large banks remain at remarkably high levels and the required adjustment will not happen quickly... With fresh capital from the private sector difficult to obtain, banks have opted to reduce their lending and that is why the flow of credit to all parts of the economy, here and abroad, has been heavily disrupted."

It's that stress on the leverage ratios of banks still being "remarkably high" that slightly surprises me. Not because it's wrong. But the Treasury and the Financial Services Authority have frantically been trying to reassure the banks that they have ample capital resources to finance their balance sheets - and Mr King does seem to be saying something different( TRUE ).

Mr King went on to say that "banks are encouraged to run down their capital to enable them to absorb losses while continuing to lend, but in the long run they will need more capital".

Again, this is not quite what the FSA is saying. The City watchdog's message - which it repeated loudly on Monday - is that our banks currently have enough capital to absorb the losses they'll incur as the recession causes increasing difficulties for borrowers. It says that their capital ratios will still be at acceptable levels even after the losses have been absorbed.

But if the Governor is right that banks have inadequate capital for the long term, the markets will price that in today, in the form of lower share prices for banks and much more demanding terms for the credit they require( TRUE ).

Considering the mullering of bank share prices in the past couple of days, it looks as though the Governor is right. But I doubt the Treasury or the FSA will thank him for pointing it out.

It's not all gloomy news, according to King. He says that because so much of banks' excessive lending and borrowing has been with other financial institutions, there is "scope for a reduction in the leverage of banks without restricting lending to the 'real' economy".

There are two things to say about this.

First, as John Gieve, the Deputy Governor of the Bank of England, told me in an interview for my Panorama documentary before Christmas, the Bank of England was too sanguine during the boom years that there was some kind of cordon sanitaire around the debt and asset bubble, such that when the bubble was pricked it wouldn't infect the real economy too much.( TRUE )

That turned out to be spectacularly wrong. It's therefore reasonable to question whether the non-financial sector (that's you and me, and "real" businesses) can be protected from the massive reduction of lending between financial institutions.( A FAIR POINT )

Also, the way the Treasury is trying to protect the non-financial sector is by imposing formal quantitative targets for lending to businesses and households on those banks in receipt of financial support from taxpayers. As you've noticed, it's instructing the banks to lend considerably more to all of us.

Which is all very well.

But as I've pointed out before, if all countries forced their banks to concentrate their lending on domestic markets, that would lead to an even sharper fall in cross-border flows of funds and capital than is already taking place.

It would amount to a kind of financial protectionism, a beggar-my-neighbour policy, that could impoverish us a lot more than would otherwise be the case.( ANOTHER GOOD POINT )

So the Treasury should tread a little warily, I think, before forcing all our banks to do nothing but their patriotic duty.

PS: Mervyn King is at pains to point out that he hasn't run out of all tools to revive lending and the economy.

He confirmed that we're probably about to enter the relatively uncharted wilderness of "unconventional measures" to stimulate the flow of credit and money: what's called quantitative easing, or the creation of reserves at commercial banks by the Bank of England buying all manner of financial assets, in the hope that the banks won't just sit on these reserves but will convert them into loans to the private sector.

It's reasonable to see this as the creation of new money. The big question is whether it would circulate and stimulate transactions - which is what the Bank of England would want - or would be hoarded.( YES )

In fact, within a matter of weeks, we'll see the Bank take an imaginative first step in that direction, when it starts to buy up corporate debt (not for cash, but in exchange for Treasury Bills), in the hope that the liquidity of the market for corporate debt will be significantly improved and thus make it cheaper and easier for big companies to borrow.

This may sound tediously technical. But it is big stuff. It represents the public sector, us as taxpayers, lending directly to companies( TRUE ) (even though the Bank will be buying this stuff on the secondary market). "

It's wonderful capturing these moments of clarity and truthfulness by bankers. It has an almost sexual pleasure to it. Almost I said. Don't get carried away.

"to stem the remorseless contraction of credit that's caused our awful recession.

Peston on BBC:

"A bank insurer, not a toxic bank

• Robert Peston
• 17 Jan 09, 12:04 PM

I don't know why the Government hasn't knocked on the head the idea that it's working on the creation of a bad or toxic bank that would buy our biggest banks' dodgy loans and investments.

What I expect it to announce on Monday (although the timetable could slip a day or so) is the creation of the mother-of-all bank insurance schemes.( GOVERNMENT MUST STEP IN AND GUARANTEE EVERYTHING IN A CALLING RUN. )

By the way, the Treasury is also considering making an offer to Lloyds/HBOS and RBS to convert the expensive preference shares they've sold to the Government into ordinary shares.( GOOD )

If this happens, I would expect RBS to say yes and Lloyds to say no. And the conversion would see the state's holding in Royal Bank rising from 57.9 per cent to around 70 per cent, or a good step nearer full nationalisation( GOOD ) (see below for more on this).

But back to this insurance scheme to give banks and their investors a bit more certainty( A GUARANTEE ) about the losses they would face as the recession undermines the ability of many borrowers to repay their debts.

Our biggest banks would identify their bad( CORRECT ) loans and foolish( CORRECT ) investments. And they would then pay a fee to a new state-backed insurer to protect themselves from losses over a certain level on these stinky assets. ( A PROPOSAL PUT FORWARD IN THE US AS WELL. )

But the banks would retain these bad assets on their balance sheets. They would not be transferred to a new toxic bank. We as taxpayers wouldn't own the stinky loans - though we would be liable for losses on them over a certain level.( TRUE )

Why the urgency of doing this?

Well in just a few weeks we'll see results for 2008 from our biggest banks. As I've already pointed out, Royal Bank of Scotland and HBOS will announce unprecedented, horrible losses.

And the HBOS losses would represent a massive drain on its new owner, Lloyds TSB.

There's a fear that unless the Government has developed some kind of safety net for them by then( A FULL GUARANTEE ), there could be an alarming loss of confidence in the banking system of the sort we witnessed in September and October.( A CALLING RUN )

So next week we'll get the announcement that just such a safety net, in the form of the insurance scheme for toxic loans, is in the process of being designed and built.

In a way, it can be seen as a way of getting capital into RBS and Lloyds/HBOS in particular without fully nationalising them.( THAT'S IT )

That said, the scheme will be open to all( IT HAS TO BE TO STOP THE CALLING RUN ) our very biggest banks. So Barclays too could insure away future losses on certain of its loans and investments if that suited it - although on Friday night it insisted that it had made stonking profits of well over £5.3bn in 2008.

However I don't expect a long and detailed statement on the institutional mechanism by which we as taxpayers will pick up part of the bill for the longest banking blow-out in history.

Nor do I expect, as this stage, the Government to put a number on the likely cost to all of us as taxpayers of putting a floor under banks' losses - although the potential liability would run to tens of billions.( TRUE )

Of course it's entirely possible( TRUE ) that if the new state insurer values the assets properly( THIS IS THE REAL PROBLEM ), taxpayers could end up over the years of the scheme with a profit.

But it seems unlikely that this will be a very popular policy. Readers of this blog have repeatedly asked why we as taxpayers should bail out the banks for the consequences of their greed and recklessness( BECAUSE THE CALLING RUN HAS LED TO A PROACTIVITY RUN ). The question I'm always asked is whatever happened to the old-fashioned idea that we should pay for our mistakes?( NATIONALIZING THEM WOULD DO THIS.)

For those working around the clock this weekend at the Treasury, in Downing Street, at the Bank of England and at the Financial Services Authority, the priority is to restore the strength of the banking and financial systems, to stem the remorseless( MANY PEOPLE ACTUALLY ADVOCATE LETTING THIS GO ON! ) contraction of credit( A CALLING RUN, WHERE CAPITAL MUST BE HOARDED FOR CALLS. ) that's caused our awful recession.

In that context, the Treasury and UK Financial Investments (the institution created by the Treasury to manage its investments in banks) have been preparing to make an offer to Lloyds/HBOS and Royal Bank, to convert £9bn of their preference shares (owned by the Treasury) into ordinary shares.

The reason for doing this would be to remove from them the heavy financial burden of paying the 12 per cent dividend of the preference shares.

In the case of RBS for example, the dividend represents an annual cash outflow of £600m and for Lloyds/HBOS the outflow is £480m.

In theory, if the two banks didn't have to pay this dividend they could lend £27bn more every year (because under FSA guidelines, if the £1080m of dividends were retained by the banks as equity capital, the banks would be able to lend a multiple of that core Tier 1 capital).

My strong sense is that RBS would love to convert the prefs, which it regards as costly debt, into ordinary shares - even though that would see it owned 70 per cent or so by the state.

However Lloyds TSB is less keen, because it's 43.4 per cent owned by the public sector and doesn't want to see state-ownership rising above 50 per cent, which would be the result of converting the prefs.

It will be interesting to see whether Lloyds' shareholders would agree that its worth paying out £480m of cash each year to taxpayers to prevent that creeping nationalisation of the bank.

Anyway, as readers of this blog know, there'll be plenty of other initiatives announced next week by the Treasury, most of which can be seen as deploying taxpayers' resources to encourage lending.( THE ONLY WAY )

One of these will be an extension of the timetable for Northern Rock, the fully nationalised mortgage bank, to repay what it's borrowed from the Bank of England and the Treasury. This would put less pressure on the Rock to shrink the amount that it is prepared to lend.

Which at a time when the problem for the economy is a shortage of credit sounds a bit like an outbreak of common sense at the Treasury."

Sorry Bob, this is the only way. Frankly, nationalization would be better. I'm surprised that you don't see that.

"The line between private sector and public sector, which became blurred in 2008, may become almost impossible to see in 2009."

Peston sums the situation up, as per usual on BBC:

"The past 18 months was a story about the collapse of lending to banks and by banks - and about how we as taxpayers came to the rescue by providing £600bn of loans, guarantees and capital to the banks, to keep them afloat.( WE WERE ALWAYS ON THE HOOK WITH A SYSTEM OF IMPLICIT AND EXPLICIT GOVERNMENT GUARANTEES TO INTERVENE IN A CRISIS )

The story of the next year will be about the implications of this continued shrinkage in the availability of credit and about the implications of this massive, unprecedented support given to banks by taxpayers( LET'S NOT DO IT AGAIN ).

As a nation, our fortunes in 2009 will be conspicuously tied to the fortunes of our banks as never before. ( I'M NOT SURE I FEEL COMFORTABLE WITH THAT, GIVEN THEIR RECENT PERFORMANCE )

First, an economic recovery rests on the ability of banks to support viable businesses during what increasingly looks like a severe recession. ( TRUE )

Second, and as important, the balance sheet of the British public sector can be seen as the aggregated balance sheet of some substantial banks - because the state now controls three banks, Northern Rock, Bradford & Bingley and Royal Bank of Scotland, and will have a huge stake in a soon-to-be created fourth, LloydsTSB/HBOS. ( TRUE )

It means that if the perceived credit-worthiness of our banks - with their trillions of pounds of assets and liabilities - were to deteriorate further, that would have an impact on the perceived credit-worthiness of the state( YES ).

As never before, it matters to all of us that the banks run themselves in a prudent way( HEAR HEAR ). In an extreme and highly unlikely case, if the markets viewed our banks as recklessly managed basket-cases, that would have an impact on the value of sterling and on the ability of the government itself to borrow( TRUE ).

So our prospects and welfare depend to a huge extent on an institution that was created a few weeks ago by the Treasury to manage its investments in the banks, UK Financial Investments (UKFI). ( GOOD LUCK BRITS )

It's probably no exaggeration to say that - for the coming year or two at least - UKFI will be as important to all of us as the Treasury, or the Bank of England or the City watchdog, the Financial Services Authority.

UKFI's primary aim is to "protect and create value for the taxpayer as shareholder"( I AGREE WITH THIS POLICY ) - while also making sure that the banks we own provide "competitively priced" loans to small businesses and homeowners "at 2007 levels"( TRUE ).

Those objectives are not quite irreconcilable( IN THE US THEY ARE ) - in that the banks over which it has sway should be capable of providing substantial credit to the housing and small-company markets without chucking good money after bad, even though this is a dire period of economic contraction and proliferating bankruptcies( I AGREE ).

But, for the avoidance of doubt, UKFI has no ability to increase the supply of credit in the economy as a whole.

Remember that the ability of banks to lend is anyway being undermined by losses on the stupid loans they made in the boom years and also by the collapse in the price of houses, property and shares, which slashes the value of vital collateral that backs loans( VERY TRUE ).

So many banks are lending less to big companies, they are lending less for commercial property transactions, they are lending less to City institutions, they are lending less in the form of unsecured personal loans( TRUE. IT MAKES SENSE. ).

Lots of overseas institutions are cutting back significantly on the bounteous credit they provided directly to the real economy in the UK during the preceding few years( TRUE ).

Also many bigger companies that borrow directly on wholesale markets by selling bonds and other securities are finding it much harder and more expensive to raise money( VERY TRUE. A BIG PROBLEM ).

And credit provided between companies that buy and sell to each other is being massively restricted, by a collapse in the availability of insurance for such credit( TRUE ).

All of which can be summed up as "ouch" for businesses and households - and is the primary reason why some companies are going bust, and why those that will survive are reducing investment and cutting jobs( I WOULD ADD FEAR AND AVERSION TO RISK, SINCE THE "OUCH" SEEMS TO BE UTTERED IN TOO HIGH A VOICE ).

So even with £600bn and rising of support for banks from taxpayers, our banks simply don't have the resources to keep afloat real companies - manufacturers, exporters - that are vital to the future of the British economy( SOME WILL FAIL ).

Which is why early in the new year, the Treasury will announce details of yet more taxpayer lending, this time to ensure that credit is provided to viable and strategically important companies - such as the more efficient carmakers( THAT'S ABOUT IT. JOBS.)

The line between private sector and public sector, which became blurred in 2008, may become almost impossible to see in 2009."

I disagree. We both have Hybrid Systems, in which the public and private commingle. All that's changed is the mix of the mingling, so to speak.

"Matt Apuzzo's excellent article on how the goverment failed to reign back subprime mortgage lenders paints a picture of deregulation run amok"

Felix Salmon considers the story about the Bush Administration's objections to regulation, which I considered interesting, but not of particularly cogent value:

"This is worth underlining. Even if the OCC, the FDIC, the Fed, and the OTS had miraculously managed to come to unanimous agreement on curtailing subprime lending, it still wouldn't have helped much -- because between them, they only had regulatory control over banks. Any subprime lenders which didn't take deposits -- and there were hundreds of them cropping up all over the country, originating loans and selling them on to investment banks to be packaged into bonds -- would have remained outside the regulatory reach.

In other words, without major regulatory consolidation, nothing effective was going to happen in any event. There's a general consensus in Washington now that we need a super-regulator with teeth, and the US might be able to learn from the UK's lessons in setting up the FSA. Once we have that, doing things like clamping down on subprime lending might become a great deal easier."

This is extremely important. Regulations need to be simple and easily enforced. This tangled web of regulations and regulators is, among other things, a breeding ground of lobbying and regulator shopping, as well as of confusion and legal complexity. We need to rationalize many of these agencies, and, just as I wrote that , I became very weary. What's the point?

Here's my comment, for what it's worth:

Posted: Dec 02 2008 5:07pm ET

"These mortgages have been considered more safe and sound for portfolio lenders than many fixed-rate mortgages," "David Schneider, home loan president of Washington Mutual, told federal regulators in early 2006. Two years later, WaMu became the largest bank failure in U.S. history."

The shocking thing in that story was the ignorance and negligence of the industry representatives quoted, who assured everyone that everything was coming up roses. Too bad that they didn't warn us that they meant a thicket of thorns were included.

By DonthelibertarianDemocrat

"The outlook for the bond insurance industry is, flatly, bleak"

Wow. From Stacy-Marie Ishmael On Alphaville:

The death throes of the bond insurers

Ambac’s share price hit an all-time low on Wednesday, falling below $1 a share for the first time in the company’s history as a public company.

Why? A rather savage downgrade from S&P, which cut the bond insurer’s financial strength rating to A from AA, The outlook on the ratings is negative, meaning further cuts are likely in the medium term.

S&P’s rationale (emphasis FT Alphaville’s):

The rating action on Ambac reflects our view that the company’s exposures in the U.S. residential mortgage sector and particularly the related collateralized debt obligation (CDO) structures have been a source of significant and comparatively greater-than-competitor losses and will continue to expose the company to the potential for further adverse loss development.

These losses have slightly more than offset the benefits to the company of lower capital requirements that result from a declining book of business.

In addition, to support funding needs at affiliate Ambac Capital Funding Inc., a provider of investment agreements, to meet increased collateralization and termination requirements, Ambac has purchased assets from and made loans to the affiliate that have lowered slightly the credit quality of Ambac’s investment portfolio and increased the gap between the book value and fair market value of the assets in the portfolio.

Nevertheless, in our opinion, the company still exhibits sound claims-paying ability at its current rating and adequate liquidity levels…

The negative outlook reflects our view that Ambac’s exposure to domestic nonprime mortgages and related exposures to CDO of ABS have likely damaged its franchise and that the company faces extremely limited new business flow.

The move comes two weeks after Moody’s cut Ambac to Baa1, which is two notches lower than S&P’s rating. The Moody’s downgrade required the insurer to post collateral and to move money from its financial guarantee arm to its investment unit.

The outlook for the bond insurance industry is, flatly, bleak. Per RBS analyst Michael Cox this morning:

Several of the protagonists in the monoline story are experiencing death-throes. Syncora was only a reserve release away from breaching minimum statutory capital requirements. FGIC is barely better. Ambac and MBIA continue to see their ratings hacked at by the rating agencies. Even FSA, previously viewed as the safest of the major names, has had to fall into the arms of a rival in an attempt to prevent being subjected to the same treatment.

A moment of silence, please…

Related links:

Ambac and MBIA suffer major losses - FT

Bond insurers try to tap Treasury plan - Bloomberg

This entry was posted by Stacy-Marie Ishmael on Wednesday, November 19th, 2008

Now, I had to ask the following:

Posted by Don the libertarian Democrat [report]

It looks like these particular bond insurers are in bad shape. Are you saying that the whole business model is now unworkable?

Here's her answer, which was quite nice of her to do:

Posted by Stacy-Marie Ishmael [report]

Don - yes.

Here's my response:

Posted by Don the libertarian Democrat [report]

Thank You, Stacy-Marie. I love Alphaville. Cheers, Don

Now, I'm having a hard time wrapping my head around this. I can certainly see why no one would to sell insurance on bonds right now, but a whole investment and insurance mode destroyed. How can that be?

Was This Panic Dealmaking By Barclay's?

Today, a fascinating post by Robert Peston on BBC. First, a refresher:

"Wednesday, October 29, 2008

"Barclays non-governmental recapitalisation efforts don’t exactly appear to be thundering forward."

Interesting post on Alphaville about banks not taking bailout money and how they're doing in getting investment:

"To bailout or not to bailout…

Barclays non-governmental recapitalisation efforts don’t exactly appear to be thundering forward. In the US, meanwhile, as observed by footnoted, banks’ are exhibiting some peculiarly similar recap-PR lines:

NorthernTrust put out a press release yesterday to announce its $1.5 billion infusion because it “fully supports the U.S. government’s efforts to strengthen our nation’s financial system.” There’s also this one from Valley National: “Although Valley is a well-capitalized organization, we believe such a program provides an excellent opportunity for healthy strong banks like Valley to participate in and support the recovery of the U.S. economy”. Even relatively small banks seem to be on message, like First Niagara which said in its press release yesterday, “We are supportive of the Treasury Department’s efforts and remain strongly committed to supporting the economy in Upstate New York.”

Banks’ boards, indeed, face quite a tough call when it comes to using government money. The below has been sent to us from Hilary Winter - a partner at Orrick:"

Do read the whole post."

So, Barclays is attempting to weather this turmoil without government largess, but was having a rough time of it. Next:

"Monday, November 3, 2008

"But governments were implicitly underwriting the financial system all along. They still are."

Here's another interesting post on the FT:

"Not exactly a private solution. Indeed, even if Barclays is not owned in some part by the UK government, it will still be guaranteed by it – and that matters.

Last month, the UK government asked banks to fortify themselves against further financial shocks by increasing their capital cushions, in return for which it would offer new guarantees on inter-bank lending. To help the banks to raise new capital, the Treasury offered to buy preference shares, albeit only on onerous terms; some hoped that the banks would seek alternatives. This is what Barclays has done."

The British plan is:

1) Banks must increase capital ( The big problem )

2) Government guarantees inter-bank lending ( The resulting problem )

3) Government buys shares in banks ( Seems reasonable to me. Better deal for taxpayers )

4) Terms of loan to be onerous ( Absolutely necessary )

5) Would prefer private solution ( Absolutely )

So, in the U.K., the terms on the loans from the government were thought to be onerous. Really:

"It is striking that these investors are charging more than the UK government’s punitive rate. Given that sovereign wealth funds’ earlier investment in financial institutions have resulted in heavy paper losses, it is hardly surprising that the Gulf royals have driven a hard bargain.

Ultimately, it is for shareholders to decide whether to back this deal. There can be no doubt Barclays is paying a heavy price for a measure of independence."

Now note this:

"The bank, however, is still not entirely independent. One of the great fictions of recent years was that large banks could be allowed to fail and had no state guarantees. But governments were implicitly underwriting the financial system all along. They still are. Regardless of who owns the shares, the UK Treasury must make sure that its large banks are stable – and it has a duty to intervene if they are not.

The Gulf deal has reduced risk for the UK government; in the event of problems, new shareholders will lose out before the exchequer. But Barclays is much too big to fail, and the government would be forced into a rescue if the bank were seriously to stumble. The government may not be in the boardroom but it must keep a watchful eye."

Absolutely. This fiction has been the main point on this blog since the beginning of this crisis. The guarantees are still there. I've already explained what we can do going forward, but it's at least becoming clear to everyone that these guarantees were in place. It only remains to examine how they factored into this crisis."

So, Barclays found outside investment, even though, as my post claims, their ultimate guarantor is the government. But they paid more for the private deal than the government deal would have cost. Once again, they paid a premium to remain independent. But, did they act prudently in this deal, or rush to get it done to stay out of the government's clutches? You tell me. From Peston:

"Here's what you need to know.

When Barclays only 19 days ago sold £3bn of these Reserve Capital Instruments (RCIs) to Qatar and Abu Dhabi, it threw in warrants to purchase 1.5bn new Barclays shares at any time in the next five years at a price of 197.775p each.

According to Sandy Chen of Panmure Gordon, each of these warrants is worth around 16p, which would value the lot at just under £250m (and, by the way, some analysts have argued that the warrants are worth a good deal more than this).

They were apparently an important sweetener to persuade Qatar and Abu Dhabi to buy the RCIs. What's more, Qatar and Abu Dhabi were also paid a £60m commission in cash for taking the RCIs.

In other words, Qatar and Abu Dhabi were paid a bit more than £300m for buying £3bn of securities - and these securities pay a stonking 14% rate of interest until June 2019 (many of us would love a bank to pay us that kind of interest).

So, Qatar and Abu Dhabi got a good deal. So what?

"Here's the thing.

Other investors yesterday bought £500m of the RCIs without the inducement of the warrants or the cash commission.

Perhaps unsurprisingly, although Qatar and Abu Dhabi were prepared to release £500m of the warrants for sale to other investors - following complaints from British investors that they should have been offered these in the first place - the Gulf investors didn't give back any of the commission or warrants.

Qatar and Abu Dhabi therefore ended up being paid over £300m for taking even less risk on their investment in Barclays.

It's worked out very nicely for them indeed. Now there's a proven appetite for these RCIs, they could presumably sell the rest on the open market, should that be appealing to them. In which case, the £300m would become pure profit attached to zero investment risk.

So why on earth did Barclays less than three weeks ago feel it had to pay so much money to Qatar and Abu Dhabi, to persuade them to buy these securities?

Well, it points out that market conditions were fraught at the time.

But there was no urgent rush to raise the money. As Barclays told me back then, the Financial Services Authority had given it till early next year to raise the capital it needed.

Arguably therefore Barclays has needlessly given away £300m."

That doesn't sound good.

"Could the board make amends? Well Barclays' four executive directors have volunteered to forego their bonuses.

But they would probably have to do without bonuses for around 10 years to compensate for the shareholder wealth given away in this transaction.

Which means that the decision by the board to offer itself up for re-election may turn out to be more than a symbolic gesture.

In particular, there is likely to be pressure on the chairman, Marcus Agius, to explain why he and the non-executives permitted the deal with Qatar and Abu Dhabi to be transacted on such generous terms."

I should hope that they are called to account. But, I also want to file this one, unless otherwise informed, under panic selling or dealmaking. I simply wonder how much, in retrospect, of this kind of panic will turn up.