Liquidity, Bank Capital and Market Reform

A friend forwarded some thoughts on liquidity that are worth sharing here, as liquidity is central to the utility of assets as bank capital and to stabilising markets under stress. My friend's points are in bold, with my commentary below.

Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.

Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.

Liquidity means you can generate cash from a physical asset or paper claim.

If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.

Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.

Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.

When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.

Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.

This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.

Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.

Liquidity means that proceeds of sale will be paid as funds to your account in a currency you can use widely to meet obligations.

If you can only sell your asset into a market denominated in a currency which itself is not liquid and not legal tender for meeting your obligations, then you haven't got liquidity vested in the asset. A lot of investors in emerging markets are probably going to find that liquidity in those markets is a lot less than they might think, despite advances in exchange trading of emerging market assets, and the currencies might be less liquid too in a falling market. If they require funding in their home currency, they risk taking a big hit on sale and FX spreads when they realise the asset under stress.

Liquidity is measured by size, speed and spread - not by price levels.

Whatever the market price, a market isn't liquid if those holding assets in size cannot deal in size. A market is not liquid if those holding assets cannot sell at the time the sell decision is made, but must wait to identify or attract sufficient buyers. A market is not liquid if the spread between the bid and ask is so wide that buyers will be deterred from the market by the risk of never recovering the spread in appreciation or returns. The way that markets have levitated on minimal volumes in 2010 and 2011 is no indication that the markets are liquid. As we've seen in August, even mild selling can have a massive effect on prices in an illiquid market.

Short sales are an attribute of liquid markets. If a market can't be shorted, then the market will fail as prices fall.

Short sellers will come in to buy assets in a falling market to realise a profit. They provide liquidity when everyone else is too scared to deal.

Securities markets regulators and central bankers need to think through liquidity as an attribute of market structure in the public interest. Idiosyncratic, illiquid, ill-transparent deals and instruments which have dominated market growth for the past two decades are behind the weakness of bank capital and market recovery. The regulatory incentives should be toward standardisation of securities terms and offering documents, much larger issues of securities and series of bonds, and fungibility of asset types within a class. Exchange trading should be encouraged, fragmentation discouraged. Exchanges should provide rigorous listing rules, timely reporting of market relevant information, full price transparency and two-way quote obligations on market makers. If we got that right, then much of the misrepresentation, mispricing, inefficiency and fraud of the past would become impossible in future.

Basel Accords: "Tissue paper over a mountain range"

In 1987 I used the title of this post to describe the brand new Basel Capital Accords. I was a young and novice central banker, but as soon as I looked at the proposed accords, I knew they were sowing the seeds of a great misallocation of capital. The principal flaw was the uniform weighting of assets:
- zero weight for OECD government debt and all other government debt with less than one year maturity;
- 20 percent weight for debt of OECD banks;
- 50 percent weight for mortgage debt.

Young as I was, I had the confidence to express to my elders and betters that they were making a mistake treating a French bank - with unlimited state support - exactly the same as a Italian bank - where state support would be subject to greater political and currency risk. Given the massive differences in yield and liquidity, how could an Italian government bond be just as good as a US Treasury held as bank capital?

The enthusiasm of my colleagues did not convince me. I knew that by drawing these clumsy rules we were telling banks that they no longer had individual, direct responsibility for assessment of the creditworthiness of their assets or their bank counterparties. The banks could use the uniform weightings of Basel to justify bad judgement and lend to Italian banks just as if they were French. Worse, the zero weighting of all OECD government debt would make Italian bonds just as good as Gilts or Treasuries as capital assets, despite more volatile liquidity and the obvious credit risks. [Italian governments changed almost weekly back then.] If the bank regulators slapped a label of capital adequacy on a bank, they would keep on lending unto disaster.

"But no!", my colleagues declaimed, "We are making the world safe for capitalism. With level playing fields from here to West Germany, American and British banks can grow internationally in every market because competition will favour more efficient international banks." [At the time the Soviet Union was still a bar to capitalist extremism in Eastern Europe and we were all devoted to Chicago School free markets elsewhere.]

Basel Capital Accords did promote global competition, and so the concentration of global banking into a very few global banks by punishing smaller banks with higher capital requirements. And to that extent, the plan worked to favour Wall Street and the City. The plan also worked in favour of the Italians, who could issue copious government debt to capitalise their banks at the zero risk weighting and flog that debt to American, British and German banks who carried it at zero risk too.

But as the American, British and German banks were relieved of the onerous responsibility for due diligence, they took sillier and sillier risks. For example, they bought lots of Italian government bonds. They spread the emergent model of securitisation far past any productive reinvestment of capital to the point of wasting each nation's decades of accumulated wealth to finance excess consumption. They bought ratings from willing rating agencies to justify more and more leverage with less and less capital. They used derivatives to make their balance sheets and accounting impenetrable and misleading, and then got governments to adopt the same techniques in the public sector to support increasing government debt. And all the time the bias of Basel made them more and more powerful.

Basel II cemented big banks' control of both regulators and markets. They could use ratings to justify investments in structured products that seemed to have no economic rationale for either investors or intermediaries, but were magically profitable for everyone in theory. They could use internal models to book profits now and defer losses indefinitely, so ensuring wonderful bonus growth. Ah, glory days!

It is all starting to unravel now. Despite a commitment to Basel III - to be implemented far in the future - I doubt Basel II will last much longer. This week saw Portugese and Irish government bonds downrated to junk. Even the mighty US Treasury is on creditwatch for downrating given the rising risk of default.

Junk rating means risk. Recognition of an asset as capital implies that it can be priced in a liquid market when cash is required. When sovereign debt is junk rated and only good for collateral at the ECB or Fed, then it should not be eligible for bank capital. And so, zero weighting of these bonds as bank capital assets is no longer defensible. The banks holding Irish and Portugese debt as zero weighted for regulatory capital will have to supplement their capital at a time when bond markets are already dysfunctional and becoming downright illiquid for new issues. Huge maturity mismatch and refinancing overhangs were already threatening banks over the next few years, and now it will be much, much worse.

The ECB has ripped up its liquidity facilities rulebook this week to permit Portugese government debt to remain eligible as collateral despite the downgrades. That just tells the banks that there is no longer any rulebook that will not be ripped up as the occasion requires. And that inevitably includes Basel II and Basel III. The ECB has doubled down on moral hazard.

Watch the banks use the next crisis to ensure that no rules apply to them at all. Basel II will be suspended as regulators come under pressure to agree to continue to zero weight even junk bonds, despite high risks of sovereign defaults. You won't hear the Portugese, Irish, Italians or Spanish - or likely even the Germans - object to that when the time comes and the alternative is recognition of widespread capital deficits and bank failures.

But if the Basel II rulebook gets ripped up, that will also destroy the means by which the banks suborned regulators, central banks and governments to their service, chasing ever higher yields and ever bigger marketshare. I'm not sure what will come after that, but it probably won't have zero weight and certainly not zero risk.

Related posts:
More on the lunacy of the Basel Accords
Basel Faulty: Sovereign defaults and bank capital

Protect the Bondholders?

The latest twists and turns in the Greek bailout fiasco have combined with a disturbing insight into FSA attitudes here in the UK to make me concerned that the system may now be distorted beyond peaceful reform. In fact, the danger of harmful destabilisation may be much worse because supervisor actions reinforce poor outcomes.

I am told that the primary objective of the ECB in Greece and the FSA in the UK is the same: Protect the bondholders.

Perhaps I am naive, but I did not realise that the FSA saw this as its primary mission until someone at the FSA bluntly told me so and someone in the markets confirmed it independently as only just and proper that this should be so.

If protecting bondholders from bad debt really is the primary objective of the supervisors, then the supervisors have become the problem. Capitalism does not work when capitalists are shielded from the economic risks that they freely undertake for profit when they enter into private contracts for debt finance. If bondholders know that they can get the ECB and the FSA to tilt the field in their direction, they have no incentive to balance yield against risk. They should just go for yield wherever they find it, and trust the ECB and FSA to ensure that they get their money whatever happens to the company, the depositor, the employee or the taxpayer who foots the ultimate bill for their yield.

If the objective of current official interaction with the markets is to prevent market determined outcomes, then we are in for a very ugly period of instability. The market is going to force a market outcome. The officials standing in the way can influence who profits from the market clearing, but the market is going to clear. If the officials have decided that the bondholders always win, then the rest of us will always lose. And once the rest of us - the companies, depositors, employees and taxpayers - remember that we have political power, then we will change the system.

This is what we are seeing in Greece on the streets. The Greek people have realised that the government works for the bondholders; the ECB works for the bondholders; the IMF works for the bondholders. They now understand what was not clear before: No one works for the people.

Strangely, this is also the realisation taking hold in Germany too. People are waking up to the fact that their national economic self-interest is subordinate to the claims of the bondholders. The German government's priority is to protect the bondholders. Germans should know better than most that stuffing the bondholders is sometimes the best policy - having defaulted three times in the last century to lay the ground in each case for economic resurgence.

What scares me is that I naively believed the UK was different. I believed that the FSA was a market regulator that understood market operations. I am now under no such illusion. They have told me their job is to protect the bondholders. If that is true, then the UK is no different than Greece, just slightly behind Greece on the arc of history.

It used to be that the role of the state in financial market regulation was to ensure efficient market operations, promote transparency of prices and liquidity, protect consumers from abusive practices, and to resolve failed companies according to principles of equitable distribution of assets among like classes of creditors. If the role of the state now is to shield HFT, dark pool and OTC markets from transparency, provide liquidity where the market fails, oversee the orderly fleecing of consumers, and to ensure that some creditors of failing firms always win while others always lose, then we no longer have a market economy. And as virtually all these regulatory policies have evolved in the absence of public debate and legislative scrutiny, we also no longer have democratic governance of markets.

Perhaps this is what tiny Iceland realised when it determined that it would default rather than protect the bondholders. Perhaps in a small country in a big ocean it is easier to perceive a common interest in economic and political adaptation to protect the future of your children and your neighbours, rejecting the claims of the faceless, pitiless and stateless bondholders.

I suddenly have a lot more sympathy for the Greek people than I did a fortnight ago. Come the revolution here, I may be in the streets too.

Some will say that the Greeks are hard line communists pining for generous state benefits and pensions they haven't earned. Maybe so. But there is more economic justice in such a system with such objectives determined in a democratic process than in any system with a secret primary imperative to Protect the Bondholders.

The FSA is being broken up as institutional punishment for its many failings in the run up to the financial crisis. I was skeptical of breaking the FSA along prudential supervision and consumer protection lines, but now think that may be a good thing. It may draw a sharp distinction between maintaining resilient banks and tilting the playing field toward institutional players like bondholders. A consumer protection authority will have a more direct interest in countering the Protect the Bondholders mindset where it robs the consumers or risks the taxpayers to achieve its ends.

As many long time readers know, I try to remain optimistic. There is hard work to be done, but the ground is fertile for those who will make the effort to seed and nurture the reforms required. The Vickers/Indepdendent Commission on Banking review and various efforts by HM Treasury and the Bank of England are all moving in the right direction: toward getting the state out of private financial transactions except as regards the setting and enforcing of reasonable rules. Hopefully they will succeed and the bondholder bias will be curbed with the break up of the FSA and long before we Britons hit the streets under the weight of an unsustainable debt.

Anomie

I came across a new word today playing Scrabble:

Anomie: a collapse of the social structures governing a given society.

Now that is one very useful word! It could usefully describe the slow motion collapse of the financial markets as investors and consumers realise that their interests are no longer protected by fiduciary, exchange, monetary and regulatory structures that once engendered confidence. Or maybe it captures the loss of patriotism and social cohesion in a globalised economy dominated by stateless corporations, their executive elites and their political puppets who are all determined to loot the public treasury while paying no taxes.

One word. So much potential. I will be finding all kinds of appropriate contexts to use it, I expect.

Concentration, Manipulation and Margin Calls

Over the past 25 years the financial markets of the world have become highly concentrated in the intermediation of a handful of firms, and regulation has been harmonised in the interests of these few firms. As Adam Smith - that great proponent of free markets - cogently observed:

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Sadly, these few global firms have been for some time in "a conspiracy against the public", and have subverted the organs of public governance and the infrastructure of the financial markets to their purposes. Regulators and legislatures have done what they were asked to do in rubber stamping the policies that promoted further concentration, assured the whole time that it would result in "efficient markets", when the reality has been entirely otherwise. Exchanges were demutualised, and their new owners installed electronic trading systems to a common design, with provision for co-located HFT servers right next to the exchange's boxes to better front run their client orders. Clearinghouses were demutualised, and their new owners installed common margin algorithms and collateral rules that created a liquidity bias in their favour, reinforcing their control of global liquidity. Regulators liberalised over-the-counter markets, off-exchange trading and shadow banking so that the real trade flows that drive global markets occur well out of sight or supervision.

Four global banks are intermediaries in 85 percent of OTC derivatives transactions. The same banks dominate prime brokerage. The same banks own large equity interests in the now demutualised exchanges, clearinghouses and even warehouses of the global markets. Naturally, the same banks dominated underwriting of securitised assets. The implications have scarcely been grasped of what this portends in terms of the information asymmetries and the opportunity to manipulate markets without risk.

Each of these roles gives these few banks a view into the positions of market investors. They know who owns what, using what leverage, under what terms, and trading in which markets. Knowing that, the manipulation of prices to impoverish investors and enrich the ruling banks is child's play with a bit of ill-transparent HFT through proprietary dealing desks and connected hedge funds aligned with the firms.

These banks will protest that there are Chinese walls between their trading desks and the market infrastructure they own. The problem with Chinese walls is that they have chinks in them. (Apologies to PC crowd, but it is an old Wall Street joke I'm quoting.) We have seen from what is now reported about securitisations, that these banks structured products to trade against their clients, often colluding with hedge funds to share the profits. Is it likely that when they balance the public interest in market integrity against next year's bonus they become much more altruistic?

In October 2008 the global financial markets crashed. The story in the media is that it was a panic caused by the insolvency of Lehman Brothers. This is not the truth - or at least not all of it. The crash actually followed a $2 trillion margin call by these four global banks on their prime brokerage clients and OTC counterparties - effectively a 30 per cent increase in required margin. It was the margin call that forced liquidation of global portfolios of all asset classes - and particularly the high quality, most liquid asset classes.

Eligible margin is defined by bilateral agreement for both prime brokerage and OTC derivatives. According to the ISDA Margin Survey for 2009, the eligible collateral at the time of the crash was predominantly US dollar cash, euro cash and US Treasury securities.

Bilateral agreements are not made public, and neither are the margin calls. This is why the $2 trillion dollar margin call did not make the news. Each prime brokerge client and each OTC counterparty dealt with their margin call as a bilateral obligation, despite it being systemically the most important event in the history of financial markets.

As the markets crashed, the US Congress was threatened with chaos and martial law if it did not pass the Paulson Plan to grant $700 billion to Wall Street banks without any formal process or review. The Federal Reserve in parallel innovated a series of secret, extra-legal measures to give money to the same banks in exchange for assets which would never be disclosed, publicly valued or audited. The need to raise dollar liquidity globally to meet margin calls in US dollar led to the innovation of central bank dollar swaps - to preferred central banks only, of course.

After all the global liquidity had been sucked into the hands of these few global banks, and the dollar surged to strength along with US Treasuries, the game of increasing leverage started all over. The firms sitting on all the margin cash and global liquidity bought up all the quality assets lying about the crashed global markets at deep discount, then they started lending again. They have been reporting huge profits consistently ever since as their clients and counterparties take the assets and exposures in this "recovery" on terms very profitable to those running the markets and liqudity business.

And remember, these few firms see all your positions and know all your clearing balances better than you can. And they chair all the margin committees at all your clearinghouses and exchanges too. And they even own the warehouses where you believe your gold, silver and other hedges against financial chaos are supposed to be stored.

We are now nearing the same global levels of leverage as prevailed in summer 2008. The political situations in the US and in Europe are unstable, and China is slowing. There is money to be made in instability.

It isn't the leverage that causes a crisis, but the margin call.

In the past few months we have seen a pattern of increased margin calls in exchange traded derivatives. It makes me wonder what is happening unseen in the OTC markets. The dollar is strengthening from its lows, indicating flows back to US counterparties. Perhaps another round in the game of liquidity manipulation has begun.

Leaving that aside, how would Adam Smith recommend that we protect ourselves from the well-entrenched tyranny of a global elite of manipulators? The only resilient solution is local, transparent markets with disintermediation of the controlling banks. Eliminating the information asymetries which allow them to see everyone's positions, leverage and trading activity - and trade and ration liquidity accordingly - would go a long way to preventing further concentration.

How to do this? Would the co-opted regulators allow markets that disintermediated reliable paymasters? Those are the questions we will grapple with after the next crash I suppose.

UPDATE: A timely example of the public spirit of exchange executives:

SEC -- Antonia Chion, Associate Director of the SEC’s Division of Enforcement, added, “Johnson brazenly stole nonpublic information from NASDAQ and its listed companies in breach of his duties of confidentiality to his employer and clients. Johnson assured at least one corporate official that she could share material nonpublic information with him because he was obligated as a NASDAQ employee to hold such information in confidence, and then he illegally traded on it.”

Quote of the Day: Greenspan's reputation dead as a parrot

“Greenspan is an ex-Maestro; his reputation is pushing up the daisies, it’s gone to meet its maker, it’s joined the choir invisible.

He’s no longer the Man Who Knows; he’s the man who presided over an economy careening to the worst economic crisis since the Great Depression — and who saw no evil, heard no evil, refused to do anything about subprime, insisted that derivatives made the financial system more stable, denied not only that there was a national housing bubble but that such a bubble was even possible.”

- Paul Krugman

Hat tip: Barry Ritholtz

"You can't build a car with 97% of the parts"

The title statement summarises the challenge for the global manufacturing sector with Japan's industry and logistics disrupted for an unknown span of time.

Power shortages threaten global supply chain

Ford Motor Co., Samsung and The Boeing Co. are waiting for suppliers in quake-stricken Japan to increase one key export: information.

A top supplier of high-end components for the global technology and auto industries, Japan may need weeks to recover output lost as a result of the country's strongest earthquake on record, according to a forecast by Barclays Capital. . . .

“Our production won't be affected this week, but then we'll see,” Volvo spokesman Per-Ake Froberg said.

Supply of batteries, Blu-ray compact discs and magnetic heads used in hard drives also may be affected by the quake and power shortages, according to a report by Taipei research company TrendForce Corp.

“The reality is, the companies don't know the full extent of what's happened,” said economist Kim Hill at the Center for Automotive Research. “You can't build a car with 97% of the parts.”

Damage to ports, railroads, and factories in northern Japan has yet to be fully assessed - not least because engineers, corporate management and insurance claims adjusters have been kept at bay by radiation leaks from the Fukushima crisis-hit nuclear complex. Fuel shortages, power blackouts and disrupted land and mobile communications further stymie any effort to document damage or predict reopening schedules for stalled manufacturing plants. Rolling blackouts occasioned by damage to power generation and electricity grids mean even undamaged industries across the nation are producing less than expected. The scale of human tragedy - with half a million displaced refugees and 21,000 lives lost - mean many workers will be unable to report to work, or too concerned with rebuilding their homes and comforting their families to work more than regular shifts.

We have a highly interdependent, global manufacturing sector for modern goods, particularly high end electronics and automobiles. Japan may only account for 3 percent of the modern product, but it is usually the high value components that will be very difficult to source elsewhere. And as the title suggests, a failure to supply the 3 percent might result in halting production for the rest of the supply chain.

As this week rolls on, and the scale of disruption becomes better understood, I expect a lot of companies worldwide will start evaluating the implications for their operations of a disrupted supply chain. Without more precise information from Japanese suppliers on the expected scale of the disruption, few businesses elsewhere have been able to issue statements on the implications. As the information begins to flow, we can expect more than a few negative shocks about Q2 and Q3 earnings as inventories of parts run down globally.

So far as the media has noticed the issue, concern has been limited to supplies of the iPad 2. We may find that the implications are more serious for our economies than delayed gratification of Apple fans.

Intererestingly, the Japanese companies most directly affected are the only ones likely to be able to claim insurance for business interruption. Companies elsewhere reliant on Japanese-sourced components might have comparable losses, or even greater losses, but have no recourse except their reserves and such corporate finance as might be available in already tight markets.

Magnitude of insurance claims still almost impossible to measure

While analysts and risk modellers are daily raising their estimates of the economic damage, with the latest Barclays Capital estimate coming in at $US185 billion, many insurance experts believe it will be well over $US200 billion.

In terms of insured losses, risk modeller AIR Worldwide estimates it at $US15 billion to $US35 billion.

But some big-name brokers are quietly suggesting it could be $US70 billion, making it one of the biggest losses to the insurance and reinsurance industry.

Claims adjusters have poured into Japan in the past few days trying to grapple with the size of the damages and their clients' exposure, but cannot get near the radiation-affected area. Japanese insurance companies are also being hampered by power cuts in Tokyo that make it virtually impossible for them to appraise the damage.

A growing concern is how the tsunami is covered by general insurance policies. For example, AIR's estimates for insured losses do not factor in tsunami-related damage, business interruption costs or potential losses from nuclear damage.

Adding to the uncertainty of losses and disruption is the likelihood that insurers may contest coverage for some damage or disruption. After Katrina, many hurricane insurers asserted that their policies did not cover flood damage to properties. Similar disputes may arise in Japan where a trifecta of catastrophe has complicated claims assessment. The longer companies are kept from rebuilding and restarting production, the longer and deeper will be the losses for the industries dependent on them for their own operations, production lines and profits.