Wednesday 20 March 2013

Chop Off Their Hands . . .

President Truman famously called for a one handed economist. The Carolingian kings of France would have accommodated him. They realised that a kingdom required a common currency under the control of the king and well regulated markets to sustain the confidence of the people.

At first mints were established widely, spread across the kingdom. Local barons began to profit from debasing the coinage, undermining confidence in the monetary system. So Charles the Bald established mints under his direct control and regulated the issue of coins:
C.12. Following the custom of our predecessors, just as it is found in their capitularies, we decree that in no other place in all our kingdom shall money be made except in our palace, and in St. Josse and Rouen, which right in the past belonged to St. Josse, and in Rheims, Sens, Paris, Orleans, Chalon-sur-Saone, Melle, and Narbonne.

C.13. And those who have control of the money, with no desire for favor or gain, should select faithful coiners, as if they were seeking our favor and the grace of God. And the coiners should themselves take oaths that they will perform their office faithfully, as well as they know how. And they should not coin a denarius of mixed metal nor one of light weight, nor should they consent to such a thing. And, without any deception or evil disposition towards those whose silver they accept for purifying, they should cleanse the silver, and without practicing any deception in weighing it, they should change the purified silver into denarii. If it be reported that any one has acted contrary to his oath, he will be tried by the judgment of God; and if it be proved that he acted contrary to his oath he will lose his hand just as was decreed for false coiners in book four of the capitularies, chapter thirty-three, and as a sacrilegious person and despoiler of the poor he will be subjected to public penance by order of the bishop;---for he committed no greater fraud if he coined a denarius of mixed metal or of light weight than he would have done by taking the silver of the State, or of the Church, or of the poor, in purging and coining silver with evil intent. In those regions where trials are conducted according to Roman law, he will be tried in accordance with that law.

C.18. And if a false coiner from those places, in which we have decreed that money shall be made, stamps money secretly or offers a false denarius in a business transaction, so that he cannot be caught and punished; he will be seized by our minister, just as has been decreed, if he seeks refuge in our fisc, in any privileged place, or on the estate of any powerful person whatsoever.

C.19. In order that this provision for the non-rejection of good denarii, and concerning the making of false denarii, might be better observed, we wish that every overseer cause the markets of his district to be catalogued, that he report to us what markets there were in the time of our grandfather, and what new ones began in the time of our father, and what were established by his authority, and what markets began to come into existence in our own time, which of them remained in their ancient locations, and, if they had been changed, by whose authority they had been changed.
Modern states gave control of monetary policy and markets to the barons of global finance. The experiment has resulted in the same disasterous outcomes as before. The barons have debased the coinage and corrupted the markets. The state lost control of the currency as central banks allowed the barons in banks and shadow banks to "create" money from securitisation and quantitative easing. The state lost control of markets as the SEC, FSA and others allowed those same barons to set up alternative trading platforms beyond any public scrutiny and to bastardise public exchanges with algorithmic trading and synthetic instruments priced against fraudulent reference rates.

Now that the whole system is falling apart, banks and bondholders - the robber barons and false coiners of our times - want to take more money from depositors and taxpayers to prop it up. The state, the taxpayers and the depositors should not be compelled to protect bank bondholders. Central bankers and market regulators should stop being complicit in debasement of the currency and corruption of the markets - taking the silver of the state and of the poor.

Enough already. Chop off their hands.

Friday 20 July 2012

For Want of a Nail, the Ship Was Lost

Imagine a great ship dominating the skyline on a distant sea. Imagine the complexity of that ship: keel, ribs, planks, masts, spars, and an infinite number of less readily named components. Each component was hand-crafted by a craftsman skilled in his trade, to precise requirements, and secured in position to take the stress and strain of a life at sea.

Now imagine a crew. They didn't build the ship. The crew are told that the one and only purpose of the ship is to realise a profit for every man jack aboard. Any hand not contributing a profit will be turned ashore. Down below in the ship are nails. Thousands and thousands of nails. Nails are useful. Nails are much sought after in every port the ship enters. Nails can be readily sold and never traced.

The crew has been told that their purpose is profit. They have taken the lesson to heart. In every port they assess the value of the nails, and compare it to their function in the ship.

They tell themselves that the lubbers at Admiralty have no idea of ships. They specified too many nails in the regulations for ship procurement and licensing. The ship will be just fine with fewer nails.

So the crew below starts sneaking out the nails and selling them in the ports. They self-certify to their warrant officer, who self-certifies to the midshipman, who self-certifies to the lieutenant, who self-certifies to the captain, who self-certifies to the admiral, who self-certifies to the Sea Lords that every nail is where it should be and the supply of surplus nails remains adequate to meet unexpected reverses. And they turn a profit, so everyone is happy and the crew are given bonuses.

Until there is a leak, no one bothers to check the inventory of nails still in the woodwork. And when there is a leak, it is taken by all involved to be a localised problem that can be solved with a local solution, stemming the flow into the bilges from that one leak.

No broader inventory of nails is ever suggested. The crew are asked to conduct a stress test scenario that confronts a gale, or an enemy warship, and they self-certify that they would remain sound.

When RMBS valuations and ratings were questioned in 2007, it was taken to be a localised leak. Bear Stearns, Lehman and Northern Rock were sunk, but surely the rest of the fleet was still sound with a bit of extra liquidity to keep them afloat.

But a crew that is accustomed to enriching itself selling nails is unlikely to stop just because the Admiralty takes an interest and orders more nails be provided to shore up the creaking woodwork. They will take all the nails Admiralty is generous enough to provide and keep selling them in every port. Their purpose is profit, and profit they must. The ships still creak, the water gets deeper in the well each watch, but the self-reporting of the ships' condition improves in every dispatch to the Admiralty.

This is where we are, and this is what the LIBOR scandal reveals. Self-certified valuations of fixed income, OTC derivatives and other instruments not traded and valued on exchanges should all be suspect. Even the exchange valuations should be suspect, as they are influenced by the OTC positions. Some of those ships are being held together by the collective greed of the crews, unwilling to lose the means of profit at the Admiralty's (and taxpayers') expense.

No one suggests that we can let them all sink to the bottom as a lesson to seamen who follow. The navy is critical to our image of ourselves as strong and resilient. The navy must be saved. But how, when every nail that is sent aboard is sold in the next port to the profit of a man with no loyalty to the crown or the ship?

Tuesday 10 July 2012

Lies, Damn Lies and LIBOR

I've been hesitant to write about the LIBOR scandal because what I want to say goes so much further. We now know that Barclays and other major global banks have been manipulating the calculation of LIBOR through the quotation data they provided to the British Bankers Association. What I suspect is that this is not a flaw but a feature of modern financial markets. And if it was happening in LIBOR for between 5 and 15 years, then the business model has been profitably replicated to many other quotation-based reference prices.

Price discovery is not a sexy function of markets, but it is critical to the efficient allocation of scarce capital and resources, and to the preservation of the long term wealth of investors and the economy as a whole. If price discovery is compromised by manipulation, then we will all be gradually impoverished and the economy will be imbalanced and unstable.

Over the past 25 years the forces of regulatory liberalisation and demutualisation of markets have allowed the largest global banks to set the rules, processes and infrastructure of global markets to their own self-interested requirements. Regulatory complexity and harmonisation benefit the biggest banks disproportionately, eroding the competitive stance of smaller, local banks and market participants. This has led to a very high degree of concentration in a very few banks in most markets that determine global reference rates for interest rates, currencies, commodities and investments. If those few collude with each other - as Adam Smith warned was always the result - then they impoverish us all.

We have allowed markets to evolve in ways that make supervision of markets almost impossible. Many instruments trade off-exchange or in multiple venues, making it nearly impossible for any single investor or regulator to supervise trading to prevent or detect manipulation or abuse. Many financial instruments are now synthetic compilations of underlying assets and derivatives, with multiple pricing components determined by reference to other prices or rates. Demutualisation and regualtory reforms stripped exchanges of the self-regulating interest in preventing manipulation and abuse by their members as mergers, profits and market share came to dominate governance objectives.

Off-exchange trading has been allowed to proliferate, creating massive ill-transparent and largely illiquid markets in almost every sector of finance. Pricing in these markets is based around calculated reference rates which, like LIBOR, are open to abusive quotation and data input practices. Many OTC derivatives are priced and margined using reference rates calculated against quotations unrelated to actual reported transactions. Synthetic securities such as ETFs are another example of an instrument that prices off a reference rate rather than the actual contents of an underlying asset portfolio. These instruments are open to consistent abusive pricing as a means of incrementally impoverishing those market participants who are the krill on which the global banks thrive.

How has it been possible for banks to grow from less than 4 per cent of the global economy to more than 12 per cent of the global economy without impoverishing others? How has it been possible for profits in the financial sector to be consistently higher than profits from other human endeavors with more tangible products or impacts on our daily lives - such as agriculture, transport, health care or utilities? How has it been possible that banks derive their profits not from the protected and regulated activities of deposit-taking and lending, but from the unsupervised and often unknowable escalation of off-balance sheet assets and liabilities? How has it been possible that pension savings have increased while pension returns have declined to the point where only bankers can expect a comfortable old age? Global banks have built the casinos and tilted the odds in the house's favour by rigging the data that determines the outcomes of most of the bets on the table. Every one of us that sits at the table long enough - whether saver, investor, borrower, taxpayer or pensioner - will be a loser. It is not a flaw; it is a feature.

There is a reason that financial infrastructure used to be dominated by mutuals. Mutual gain and mutual liability created a natural discipline on excess and on rogue elements that would impoverish their peers.

There is a reason why trading was restricted to exchanges, and exchanges and clearing houses used to be self-regulating, and even had responsibility for resolution and liquidation of their members. Direct responsibility, authority and financial control meant that they could exert very powerful and immediate consequences on those members identified as abusing the market or investors.

The investigations into market rigging are just beginning. Paul Tucker opened the box yesterday when he admitted that he could not know whether the abuses discovered in setting LIBOR had spread to other synthetically calculated reference rates. As events unfold, it may be that we begin to appreciate just how deeply vulnerable we have become to predation by bankers with no stake in a local economy or in the local quality of life of the people they impoverish. A reckoning is needed, and then a rebalancing toward more local and mutual provision of essential services and market infrastructure that serves markets rather than those few bankers on the board.

As a start, regulators should consider punitive restrictions on the sale of instruments which price on reference rates unrelated to reported market transactions or underlying asset portfolios. Pricing should reflect real market transactions rather than guesstimates talking the banker's book.

We need to rethink as a society what banks are for, what exchanges are for, and what clearing houses are for. If they are for the profit of the few at the expense of the many now, that is because it is the business model we have permitted. If banks, markets and clearing are protected because they have a social function, we should make certain that social function is adding value. If it isn't, then we need some new models and some new rules.

Tuesday 29 May 2012

"Heads I win, tails you lose."

I was at a private lunch in the City some 15 years ago discussing whether hedge fund investments should be considered a new and distinct asset class. A very prominent hedge fund trader was asked his opinion. Surprisingly, he said that hedge funds were less a new method for investment, than a new method for higher remuneration. The appeal of hedge funds was in the outsize fees rewarding the fund managers rather than any superior returns for investors.

I was reminded of that lunch again this morning by two pieces in my inbox. The first referenced a paper from the Bank of England estimating the public subsidy of the UK's largest banks at more than £220 billion during the past couple years. These banks secure a funding premium in wholesale and deposit markets from the implicit state guarantee of obligations attaching to their too big to fail status. The subsidy distorts competition and risk taking, storing up even more future draws on beleaguered taxpayers. The second was a blogpost summarising recent comments of a Bank of England executive to the effect that all the cost savings generated by technology advances and automation in the banking sector had been paid away in increased bonuses and remuneration. IT efficiency gains fund bonus payments. The financial sector's appetite for technology investment is not driven by a desire to provide more efficient services, but to secure ever larger remuneration packages. In fact, rapid financial innovation and technology transformation has led to less efficient intermediation if evaluated on a cost basis.

Regulation has had a pernicious effect in driving technology and complexity. As Chris Skinner observes,
Put another way, in the first iteration of the Basel Accord there were seven risk metrics requiring seven calculations; by the time we get around to implementing Basel III, over 200,000 risk categories will require over 200 million calculations.
At some point policy makers will need to turn their efforts from reinforcing and bailing out the bankers who use any and every opportunity to take public support as private bonuses and instead evaluate much simpler, lower cost models of financial intermediation likely to yield domestic investment in domestic businesses and assets.

I can almost hear the shouts of "socialist" from the usual defenders of banks and markets. I am not advocating state nationalistion of banks, but state withdrawal of explicit and implicit bank subsidies.

It is a conservative principle that the state should intervene when markets fail. If the banking system has failed (and it has) and requires a taxpayer subsidy to continue to operate (which it does), then conservative principles dictate that the state must intervene to secure a resolution in the public interest. More of the same is not a conservative policy, but social welfare for bankers.

We currently have a system of excess regulatory complexity, hidden market distortions and public subsidies. Moving away from the status quo requires state action to identify and reduce subsidy through promotion of business models that are simpler, more transparent and more directly aimed at securing public benefit.

Tuesday 13 March 2012

Your Bank: Fiduciary or Predator?

In the old days when banks were local, and owned either as partnerships or mutuals, bankers had a stake in promoting the prosperity of their clients. They wanted to see their clients do well so that savings in the bank would increase, and then the banker could lend more and do better too. Bankers were meticulous in evaluating the credit quality of local borrowers, because a loss hit their own capital and equity in the business.

Largely as a result of this happy local alignment of depositor/banker/borrower interests, bankers came to be regarded as trusted fiduciaries. Depositors expected the banker to exercise discretion in the lending of capital. Borrowers expected the banker to provide loans on fair and reasonable terms which would help the borrower's business to grow and perform on repayment obligations.

As we know, those days are long past. Banks are rarely partnerships or mutuals. Remuneration models that promote fierce competition and short term bonus mania are unlikely to leave much scope for ethical reflection on the promotion of either depositor protection or borrower prosperity. Modern bank funding models are focused on money markets and shadow banking conduits rather than making depositors secure long term. Their lending models are seeking ever higher margins on transactional speculation, cross-selling and hidden fees. They seek opportunities globally rather than the long duration lending that sustained growth of local businesses. Banks are no longer geographically dependent on the local community for either deposits or borrowers.

We are now forced to re-evaluate the role of banks. They clearly have little interest in performing as fiduciaries. They have a powerful interest in becoming predators.

But if banks are predators, then their beneficial social functions are undermined, and indeed, they become a threat to social welfare, economic growth and non-bank prosperity. If that is true, then they no longer warrant state protections.

It is the depositors and borrowers who now need the protection.

In the UK some banks have threatened to leave if the successor to Mervyn King is not less "hostile" to their predations.

This is like a fox threatening to go elsewhere unless the farmer makes the chicken coop more accessible. Worrying.

UPDATE: Today Greg Smith, head of equity derivatives at Goldman Sachs, very publicly resigned in the pages of the New York Times. It sums up his resignation to say that he preferred the days when he could be a fiduciary to the firm's clients rather than their predator.

Tuesday 6 March 2012

Complexity Costs

I have had to deal with the idiocy of modern financial regulation rather more than I would like lately. The issue involves FSA regulations which create a bias in favour of the TBTF banks. (As almost all FSA regulation is biased in favour of TBTF banks, this isn't much of a clue.) The FSA acknowledges that their rule creates a bias. They acknowledge that the bias was created in error, without principled justification. (They allowed outside counsel retained by the big banks to write the rule for them.) They acknowledge that the restrictive rule is inconsistent with European Union directives on the subject matter, and inconsistent also with UK government objectives of reducing the implicit subsidy to TBTF banks and reintroducing competition to financial services. They acknowledge that a change to the rule could improve sector competition, consumer choice and reduce costs.

Will they change the rule? No. Changing the rule would require an expensive public consultantion and cost-benefit impact assessment that hasn't been budgeted by the relevant division of the FSA for this fiscal year. Additionally, there is no proof of a market demand for the benefits of the rule change, as the existing users of the rule - the TBTF banks - are telling the FSA that existing customers aren't asking for a rule change.

It's a good thing that this is a marginal issue for the business. If it were serious, I'd have to advise doing business elsewhere than the UK. It might be wise to do that anyway, as being subject to a regulator like the FSA will be such a miserable experience based on current observation that locating a business somewhere more sensible would probably help ensure the business succeeds longer term.

The frustration of this one case raises a broader issue. Is it possible to reform a failed regulatory system sufficiently to restore a functioning market?

Regulators operate monopolies and are virtually impossible to discipline for their errors. Being bureaucrats, most regulators do not really have a stake in whether their rules do more harm than good. No one outside the regulator knows or cares who had responsibility for crafting a particular regulation, much less how it promoted or restrained market efficiency in the long run. It's almost always easier and less risky to do what they are asked by powerful incumbents than to attempt to level the playing field in favour of consumer protection or increased competition. Fifteen years of the FSA pretty much proves this point, as complaints to the financial ombudsman were at record levels last year and financial services concentration is consolidating at a very rapid clip leaving consumers very little real choice.

And then there is the complexity of modern regulation. Changing any regulation requires a publication of proposals, a consultation period, a cost-benefit impact assessment, legal consultation to ensure compatibility with EU directives, etc. Consultation responses are more likely to be from TBTF incumbents with a stake in bad regulation, and very unlikely to be from ill-informed consumers or would-be market entrants who might benefit from good regulation.

The FSA is being disbanded for its failure to properly regulate UK banks in the run up to crisis. It will be split into three, with some functions going to the Bank of England, some to a new Prudential Regulatory Authority and some to a new Financial Conduct Authority. A change in structure does not necessarily yield a change in ethos or policy. Sadly, the same bureaucrats will turn up at the same desks and largely follow the same courses that led to failure of the old system. If anything, the added complexity of co-ordinating among the three new regulators will be an additional incentive to make as few changes as possible to regulations going forward.

I am reminded of a friend who went to Eastern Europe just after the Berlin Wall came down in hopes of investing there to modernise the economy. He came back determined never to venture an investment because the same bureaucrats as held office under Communism were still showing up to work in the ministries every day and following the same rules as before.

Tuesday 7 February 2012

Greece - Cutting out the Middle Man

It seems that central bankers and politicians are endlessly resourceful when it comes to innovating ways to profit themselves and bankers at everyone else's expense. Where I had thought Greek default inevitable just two weeks ago, I no longer think so today. It appears that Sarkozy, Merkel and the Troika have decided to prevent a default regardless of what Greek politicians or citizens may choose to do.

The new plan is to take the EUR 130 billion that would have gone to Greece in the second bailout, and put it in an escrow account. The account may be labelled "Greek Government", but Greek politicians will not have any authority over the funds. The funds will be disbursed by a non-Greek overseer to pay holders of Greek debt. Official creditors will receive full payment. Private creditors will receive the new discounted rates agreed with the IIF for restructured debt. I am not sure what private creditors who reject the IIF proposal might receive, but it will not much matter as ISDA will find there is no credit event regardless.

The fear among the creditor states of the eurozone was that irresponsible Greek politicians might use any new money to pay civil servants and pensioners rather than bankers and hedge funds. With funds held in escrow and disbursed by a non-Greek overseer, they needn't worry about such excesses of sovereign generosity.

This plan amounts to cutting out the middle man - the debtor. Bailout funds are used to bail out Greek creditors, without ever passing through Greek hands.

Athens is left with uncertainty about whether any further funding will be forthcoming for actual Greek state expenses. This is intentional. The escrow overseer may withhold funding if Greek politicians do not live up to creditors' reform requirements. As Greece may have run a primary surplus in the fourth quarter of 2011, it is just possible that Greece may be able to manage on its austerity budget if the economy doesn't contract too harshly going forward.

More from the FT's Greek team:

If Greece agrees to the new programme, all the elements agreed in a high-drama October European Union summit will finally be in place: a debt restructuring that will see private bondholders lose half their holdings; €130bn in new bail-out funding; and tough new controls officials hope will ensure Greek reforms are forthcoming.

The question remains whether the restructuring of private debt will achieve the ultimate goal of getting Greece’s debt level down to 120 per cent of economic output by 2020, without calling for bigger public sector contributions.

While this plan solves the immediate problem of a March 20th Greek default, what this means for future repayments of sovereign debt is less clear. Despite never having access to the funds, the Greek government and Greek taxpayers will presumably be obligated to repay their Troika creditors at some point. And the EUR 130 billion will not cover debt payments for ever.

If I were a Greek politician, I could probably live with this deal. While it is humiliating to have the money held and distributed elsewhere, it is still money that forestalls an otherwise certain default. And Greece can always default later anyway, should that prove convenient to avoid repayment of the now even larger debts.

The can is kicked down the road for another quarter, and the bankers can pay themselves their 2011 bonuses.

After all, innovation is the driving force of economic growth, and deserves to be generously remunerated.