The British government has praised the development of the Co-operative Bank, a member-owned institution that looks a little like an old school thrift, but that also provides funeral services, grocery shopping, agriculture - and, we'll let's just agree that it isn't exactly a model of a pre-Glass-Steagal institution.
However, like old-school thrifts, the bank is overcommited to the British housing market, and the result is that this alternative to corporate behemoth banking has had its credit downgraded to junk status (usually the death knell when you're talking about an institution that provides, and depends upon, credit), while the traditional banks start to produce profits.
So sad, too bad, banks die every month - but what if the government has been trying to prop up its golden child with regulatory forbearance? It's everything you worry about when you worry about capital regulation:
Ian Gordon, an analyst at Investec Securities, said it was “curious that the bank was allowed to run with such weak levels of capital,” adding there was “an element of regulatory neglect” that represented a lesson for the new system.
Julia Black, a professor at the London School of Economics, said, “Supervision isn’t a transparent process, but I’m surprised it hasn’t already been required to hive off the bad loans or to set aside more capital.”
The dirty secret of regulatory forbearance - and Congress tries to legislate it away after banking crises, you can see as much in the hand-forcing provisions of both Dodd-Frank and FIRREA - is that it works. Some day Citigroup will be much more profitable than it was during the Latin American debt crisis and the housing crisis, when the government could have shut it down. But not requiring a bank to maintain its capital levels during bad times is also counter to the whole point of safety and soundness supervision. We'll see if the forebearance suspicions save, or destroy, Co-operative.
The titular questions have been swirling in the back of my head for the past month or so. Spoiler alert: I don't have the answer. But Jeff Schwartz' post in the CLS Blue Sky blog on the SEC Advisory Committee on Small and Emerging Companies' proposal to create a separate market for small and emerging companies, open only to accredited investors--more or less a public SecondMarket/SharesPost--has me asking it again.
This strikes me, unlike Jeff, at first blush as a bad idea, but let's ignore the merits of the proposal and focus on one of its premises. One of the arguments the Committee makes in favor of it is that "providing a satisfactory trading venue" for these companies might encourage IPOs of their securities.
First question: Really? Isn't it just as likely that, if a robust market exists for these companies, they're less likely to go public? Isn't obtaining liquidity one big reason for going public in the first place?
Second question: How many is the right number of IPOs, anyway? The WSJ told me yesterday IPOs are set to raise the most cash since 2007. Jay Ritter argued in a recent paper that IPOs have dried up not because of heavy-handed government regulation but because times have changed. Now getting big fast is the way to go, and going public and being a small independent company isn't as attractive to a young firm being acquired by a bigger player.
As Ritter writes, "If the reason that many small companies are not going public is because they will be more profitable as part of a larger organization, then policies designed to encourage companies to remain small and independent have the potential to harm the economy, rather than boost it." Ritter's prescriptions to help IPOs are to encourage auctions over bookbuilding (here's yet more evidence that the underwriter spread is too big), discourage class action lawsuits, and reform the copyright and patent system.
Ritter closes with: "I do not know what the optimal level of IPO activity is in the United States or any other country, nor do I think that it should necessarily be the same now as it one was."
Right now I'm with him.
JPMorgan is far too big to fail - but, then, so is Wells Fargo, Bank of America, and Citigroup. And JPMorgan is generally thought to be the safest and best run of the four of them (or at least better run than BofA and Citi). But this spring, it is JPMorgan that is getting buffeted by the press, regulators, and others. ISS is urging a vote against some directors as a result of the London Whale fiasco. Congress ripped the firm over the same thing on March 15. Mark Roe has been critical. And now the Times is discussing the "full court press of federal investigations."
It is a season of woe for JPMorgan, as it finds itself in a very uncomfortable spotlight. The Times has run 31 headlined stories on JPMorgan between today and March 1 (source). It has run none on Wells Fargo (source), 9 on BofA (source), and 10 on Citi (source) during that time period. And the London Whale trade, and subsequent defenestration of a number of JP executives, happened long ago.
Moreover, while the London Whale trade was terrible, it is by no means clear that JPMorgan has failed to manage the situation. The firm is, admittedly, too big. But it is not alone in that. This is beginning to look to me like the start of something corporations fear most, a singling out scandal, whereby one firm becomes the poster child for the shortcomings of an industry sector - it is a way that Washington works, and one that corporations find difficult to understand. Usually, those firms pay a disporportionate penalty for their celebrity; I can't help but be a little sympathetic for the bankers in this case, if it turns out that that is in their future.
I do international financial regulation, but you really have to turn to others for sovereign debt. Here's Buchheit and Gulati's three page long solution to the Cypriot debt crisis. Here's Felix Salmon on it:
Their plan is simple:
First, leave all deposits under €100,000 untouched. Hitting those deposits was by far the biggest mistake of the Cyprus plan as originally envisaged, and everybody would be extremely happy if guaranteed depositors could be kept whole.
Second, term out everybody else by five years, or ten if they prefer.
That’s it! That’s the whole plan, and it’s kinda genius. If you have bank deposits of more than €100,000, they will be converted into bank CDs, with a maturity of either five years or 10 years — your choice. If you pick the longer maturity, then your CD will be secured by future Cypriot gas revenues, which could amount to hundreds of billions of dollars.
And if you have sovereign bonds, they too will be termed out by five years, giving Cyprus a bit of breathing room to get its act together.
Do that, say Buchheit and Gulati, and you manage to reduce the size of the needed bailout bymore than the €5.8 billion that Cyprus is currently planning to raise with its tax on bank deposits — and you don’t touch anybody’s principal at all. To be sure, the new CDs, which would be tradable, would surely trade at less than par: there would be a present-value haircut on deposits over €100,000. But that’s going to happen anyway. And at least in this case patient depositors will have a chance of getting all their money back in full — with interest. And, most importantly, guaranteed depositors will remain unscathed.
And here's Matt Levine on how the crisis is so strange.
The various reasons to object to this boil down to its violations of absolute priority; the way things are supposed to work is more or less:
- When a bank goes bad its equity holders lose,
- If zeroing the equity holders doesn’t cover the losses, then the bondholders lose,
- If zeroing the bondholders doesn’t cover the losses, then the depositors lose,
- But even there deposits under €100,000 shouldn’t lose, since they’re government guaranteed under the EU deposit insurance scheme.
In Cyprus sort of the opposite happened: equity holders are being diluted but not confiscated,1bondholders weren’t touched (there are essentially no bonds),2 and depositors under €100,000 were haircut in order to limit the damage to depositors over €100,000. The reasoning for this is unclear; a leading theory is that softening the blow on over-€100,000 deposits was viewed as necessary to retain Cyprus’s status as a haven for offshore deposits by tax-dodging Russian oligarchs. This is an odd theory; losing 9.9% of their money is no doubt a more pleasant proposition than losing 15% though it’s not what you’d call absolutely pleasant and they don’t seem particularly pleased with it.
It is strange, but I agree with Andrew Sorkin that haircuts, in this case, aren't supremely terrible to contemplate.
By the way, if you’re wondering why investors left so much money in troubled Cypriot banks, here’s a trivia question: Would you have been better off leaving your money in a bank in the United States or in Cyprus over the last five years?
The answer: You would have been better off in Cyprus, even after the bailout, when your money was “confiscated.” If you had 100,000 euros in a Cypriot bank account over the last five years, where the interest rate has averaged about 5 percent, you would have about 127,600 euros today. Even after the bailout, which would require you to give up 10 percent of your deposit — 12,760 euros — you would be left with 114,840 euros. The American bank? The $100,000 you deposited at Bank of America five years ago is about $105,100, at the going rate of about 1 percent interest a year.
I'm less exercised about the revolving door than most. But this American Banker story on Promontory Financial, the lucrative place where retired regulators go to read the riot act to banks in crisis, in an effort to get them out of the jail that is CAMELS 5, is pretty interesting. It has made Eugene Ludwig, the former Comptroller of the Currency. something like dynastic wealth, and it seems to afford other career bureaucrats, incuding Princeton economist (and Fed vice-chair) Alan Blinder, seven figure sums for post-retirement work.
I don't have problems with either of those things, and Promontory really does seem to salt the private sector with consultants who expect compliance with regualtory edicts. What does surprise me is that I can't think of a similar example of this particular sort of revolving door elsewhere, though one presumably exists for defense contractors. Does EPA have a Promontory? OSHA? It might be that the money for "tell me how I can make this right with the FDIC" sort of advice exists in finance alone. HT: Counterparties
One of the things Europeans have been talking about in the wake of the financial crisis is the "ring fencing" of banks. In theory, you can ring fence lots of parts of a bank, all of which makes the bank a little less of a nexus of contracts and a little more of a nexus-of-contracts-with-some-contracts-blocked. The US could ring fence BNP Paribas' American subsidiary so that if one went bankrupt, the other would be solvent, for example. That's one kind of ring fencing. But what Europe means by ring fencing is the separation of retail banking from investment banking, as Jim Hamilton has observed about Germany's new law:
It is interesting how quickly a continent that never had Glass-Steagal has gotten very interested in it after the financial crisis. The US got rid of the separation of banking and securities partly because its banks complained they wouldn't be able to compete with European and Japanese banks that could do it all. Maybe it will be rethought over here if this sort of legislation becomes the norm abroad.
Still, if S.&P. is singled out for ratings that were matched by the other ratings agencies, the government’s case might look like an exercise favoring certain speakers over others, and that might be a problem. It might even encourage the government to file lawsuits against other ratings agencies.
And one on the new perspective that it may mean the government is taking on settlements:
The S.&P. suit shows that at least part of the government has come around to Judge Rakoff’s way of thinking. If so, we should expect to see fewer settlements and more court cases in the future.
There's more at the link, so do give it a look, and let me hear your own views, either here or over at the Times.
While Americans worry that there isn't enough accountablility being imposed on banks for the financial crisis, the Times observes that European banks are forking over billions in penalties to their regulators. LIBOR is one thing, there's an insurance product that is causing no end of headaches, and:
European banks are expected to pay a total of about $25 billion for settlements and client compensation, so far. HSBC has to write the biggest check, paying $1.9 billion for lapses in its anti-money laundering controls. (A number of banks, however, have made provisions for potentially larger amounts.)
ING Bank, part of the Dutch financial giant ING Group, reached a $619 million settlement for allegation of sanction violations in June. Standard Chartered, based in London, agreed to pay a total of $667 million in two separate money-laundering claim settlements in August and December.
To be sure, American regulators haven't exactly eased off on sanctioning boycott avoiders. But this action in Europe is all worth keeping an eye on, if only for the possibility that financial regulation could go the way of antitrust or accounting, where global standards are set by European regulators. It is too soon to suggest that something like this is happening yet, and there is a great deal of work being done on harmonizing global standards so that European rules do not get applied extraterritorially. But it isn't outside the realm of possibility.
A small sampling of recent legal scholarship on "shadow banking" (a topic of I've written about myself):
- Chrystin Ondersma (Rutgers Newark): Shadow Banking and Financial Distress: The Treatment of 'Money-Claims' in Bankruptcy; and
- Ed Greene & Elizabeth Broomfield (both, Cleary Gottlieb): Promoting Risk Mitigation, not Migration: a Comparative Analysis of Shadow Banking Reforms by the FSB, USA and EU (in the Capital Markets Law Journal)
Steve Schwarcz of Duke also produced a bevy of articles on the topic at the end of last year.
Today, the SEC will convene a much-anticipated roundtable examining the current regime of penny-priced tick sizes on U.S. stock markets. A principal purpose of the roundtable is to explore whether the transition to penny-priced quotations in 2001 (known as “decimalization”) has harmed liquidity in the securities of small and middle-sized companies. The general theory, initially advanced in this Grant Thornton white paper, is that when securities were quoted in sixteenths of a dollar, trading spreads were kept artificially wide given the fact that bid-ask spreads could be no less than $0.0625 per share, creating large profit margins for dealers making markets in U.S. equities. Such market-making profits, so the argument goes, were then used to support trading operations and analyst research in thinly-traded securities and the securities of newly-public firms. In this fashion, the argument continues, the higher trading costs associated with fractional-quoting were actually part of a healthy ecosystem for nurturing the market for IPO stocks and smaller company securities more generally.
According to this theory, one way to bring back the IPO market is to undo the harm decimalization caused this ecosystem by increasing the tick size, or minimum price variation (MPV), when quoting the securities of smaller issuers. It is an argument that has gained considerable support over the past year, as reflected in both Section 106(b) of the JOBS Act (which required the SEC to study the effects of decimalization on the liquidity of smaller firms) and the draft recommendations of the SEC Advisory Committee on Small and Emerging Companies (which recommends a “meaningful increase in tick size as a necessary step toward encouraging the reestablishment of an infrastructure designed to increase liquidity for small public companies.”) And based on the agenda for today’s roundtable, a reasonable bet would be to see some form of pilot study being implemented in which the securities of certain firms must be quoted in an increment greater than $0.01.
While it is heartening to see the SEC take an empirically-driven approach to capital market reform, new research by Justin McCrary and myself underscores the need for the SEC to assess this issue especially carefully and for any policy changes to take place within an incremental framework. In our working paper, Shall We Haggle in Pennies at the Speed of Light or in Nickels in the Dark? How Minimum Price Variation Regulates High Frequency Trading and Dark Liquidity, we document how modification of the penny-based system of stock trading will likely have simultaneous and opposite effects on the incidence of both high frequency trading (HFT) and the trading of undisplayed (or “dark”) liquidity (what we refer to as “trading hidden liquidity” or THL). Specifically, in the event of an increase in the MPV, our research strongly suggests we can expect to see both an increase in off-exchange trading in venues such as dark pools and a decrease in HFT.
Although often conflated within the popular press, HFT and THL reflect two distinct types of trading strategies that have distinct consequences for price discovery and market liquidity. In terms of strategy, traders focusing on HFT typically seek to profit from discrete, short-lived pricing inefficiencies by rapidly bidding on and selling securities, customarily through pre-programmed algorithms. The emergence of so-called “maker/taker” fee structures at stock exchanges—whereby limit order providers are paid a “maker” rebate and traders using market orders are assessed a “taker” fee—creates an additional profit opportunity for such traders provided they can position their limit orders at the top of exchanges’ order books. For firms engaged in HFT, minimizing the latency of processing information and entering orders is therefore of paramount importance to profitability. In contrast, a firm focusing on THL will generally seek to profit by providing liquidity to investors without the necessity of publishing public bids or paying exchange access fees, thus minimizing the price impact and cost of the transaction. Access to investors looking for liquidity—rather than speed of trading per se—is accordingly a primary goal of those engaged in THL.
Despite the recent focus on changing tick sizes, there has been remarkably little focus on how each of these strategies is intimately connected with the rules governing the MPV. As was revealed following decimalization, smaller tick sizes have led to both a surge in market message traffic as prices dispersed across more price points as well as a dramatic reduction in quoted spreads. Both developments favor algorithmic trading strategies capable of processing quickly large flows of order messages, while reducing the costs of rapidly trading in and out of positions. With respect to THL, larger tick sizes create the opportunity for larger spreads and, consequently, larger profits for those firms that can capture them by trading against marketable orders from individuals and institutions seeking immediate liquidity. In this regard, dark pools and broker-dealer internalizers are aided by a technical rule concerning how the penny-pricing requirement is actually implemented: Although it is prohibited for anyone to quote (i.e., post an order) at other than a penny-increment, it is perfectly fine to execute a trade in subpenny increments. Using this flexibility to execute subpenny trades, a dark pool or internalizer can thus offer price improvement over the National Best Bid or Offer (NBBO) available at conventional stock exchanges (even if the improvement is as little as $0.0001 per share). In this fashion, dark pools and broker-dealer internalizers have both the incentive and the means to trade directly with incoming marketable orders rather than route them to exchanges.
To examine empirically how changes in the MPV might have these effects on the incidence of HFT and THL we turned to a peculiar quirk in the ban on sub-penny pricing described in the previous paragraph. In particular, the ban on sub-penny quotations (Rule 612 of Regulation NMS) only applies to equity orders priced at or above $1.00 per share, thus creating a sharp distinction in tick size regulation between those orders priced just above $1.00 per share and those priced just below it. Using a regression discontinuity (RD) research design, we can therefore identify in a clean, parsimonious way how changes in tick size regulations can affect the incidence of these two forms of trading. For our data, we used the NYSE’s Trade and Quote (TAQ) database, focusing on the 300 million trades and the 3 billion updates to exchanges’ best published bids and asks made during 2011 for securities that traded below $2.00 per share at some point in 2011.
Overall, our results are strongly consistent with the hypothesized effect of MPV on both THL and HFT. To measure THL, we examined for each completed trade the market center at which it occurred, using trades reported to a FINRA Trade Reporting Facility (TRF) as our measure for THL. The figure below presents our RD estimates of the effect of subpenny quoting on the incidence of such off-exchange trading. In the figure, the x-axis represents a transaction’s reported trade price truncated to two-decimal places, and the circles represent the fraction of all reported trades reported to a FINRA TRF at each such price. The solid line plots fitted values from a regression of the fraction of TRF trades on a fourth-order polynomial in two-decimal price (the point estimate and standard error are in the legend). As the figure indicates, trades executed at prices immediately above $1.00 per share revealed a sharp increase of 8 percentage points in the percent of trades reported to a TRF facility. Because all other market centers reflect stock exchanges, this translates to a corresponding decrease of 8 percentage points in the incidence of transactions on the public exchanges.
With respect to HFT, we examined (among other things) the incidence of “strategic runs” within the quotation data at each price point truncated to two-decimal places. Notably, the TAQ data does not permit tracking individual orders since it covers only updates to each exchange’s best bid or offer (BBO), but evidence of such strategic runs nevertheless appears in the TAQ data to the extent they affect an exchange’s BBO, which is continually updated by the exchanges to reflect the new orders that change it. Accordingly, we measure for each second of the trading day the rate of BBO updates for each security in our sample (a “security-second”). As might be expected in the (for modern financial markets) relatively quiet corner of penny stocks, the vast majority of security-seconds experienced no update of an exchange’s BBO. In particular, over 90% of the security-seconds in the sample showed no BBO updates, with higher-priced orders generally being more likely to have at least one BBO update per second. As shown in the figure below, RD analysis of security-seconds having at least one BBO update by two-decimal order price reveals that this trend was generally continuous at the $1.00 cut-off.
In contrast, analysis of those security-seconds where a BBO was updated with significant frequency reveals a sharp increase in the incidence of such strategic runs below the cut-off. The next figure, for instance, provides our RD estimates for the incidence of security-seconds where the BBO was updated at least fifty times per second. Consistent with the previous figure, the rate of these strategic runs generally declines from $2.00 to $1.00 where it reveals a discontinuous upward jump from .02% of all security-seconds to .1% of all security seconds, highlighting the negative relationship between the size of the MPV and the incidence of HFT.
In sum, these findings suggest that current proposals to increase the MPV may very well entail significant, unanticipated structural changes in the nature of how equity trading occurs on U.S. markets. To be sure, many of these changes in trading such as the higher incidence of THL would actually be consistent with a core objective of Section 106(b) of the JOBS Act insofar as they would increase the profitability of market-making in affected stocks. However, our finding that these market-making profits are generally captured by dark pools and internalizers causes us to question how these enhanced profits will translate into additional analyst coverage and sales support for emerging growth companies. For instance, most dark pools and the two largest internalizers by volume—Citadel Investments and Knight Capital—do not offer sell-side analysis or advisory services. Moreover, the new retail price improvement (RPI) programs at major U.S. stock exchanges—which seek to allow exchanges to compete with internalizers through establishing de facto dark pools to capture trading spreads—only further undermine the theorized benefits for IPO firms of larger tick sizes given that the beneficiaries of such programs (i.e., stock exchanges and RPI participants) are also not known to provide market support for emerging growth companies. To the extent the SEC chooses to implement a pilot program modifying tick sizes, coupling such a program with increased disclosures concerning which broker-dealers are reporting trades to a FINRA TRF could help ascertain whether the appropriate market participants are benefiting from the wider spreads.
The Post says that international financial regulatory reform is grinding to a halt, and Mark Carney, who, as Bank of Canada supremo got so active in the subject that the Bank of England hired him to be its supremo, filed a report to the G-20 that was positive, but observed that only 8 of 27 rich jurisdictions have issued final Basel III regulations.
Dan Drezner concludes that travail and intermittent progress is all you can expect from IFR, and most things, presumably. I only sort of agree. Carney's report to the G-20 is way better than the sort of mealy-mouthed declarations that characterize much international missive-writing. Europe is going to implement something substantially stronger than Basel III - call it Basel III plus a Tobin tax - and that will add a bunch more jurisdictions to the total. And anyway, the deadline for the accord is not yet upon us.
But nobody promised you a rose garden. If you put your trust in international process, as financial regulators must, you expect backsliding, inconsistency, and progress at extremely ponderous speeds. You might even characterize is as the worst way to regulate - except for all the others that have been tried.
- This podcast of Joseph Grundfest on the SAC insider trading investigation is admirably clear.
- Should Goldman really be seeking restitution from Gupta? Here's their restitution memo opp, and here's Gupta's.
- And here's Frontline on the lack of criminal proseuctions in the wake of the financial crisis.
In the recent edition of The Atlantic, Frank Partnoy (law & finance professor at the Univ. of San Diego who recently wrote Wait: The Art and Science of Delay) and Jesse Eisinger (a journalist with ProPublica and columnist for the New York Times DealBook) authored What’s Inside America’s Banks?. They present an extensive analysis of the public disclosures made by major banks. The centerpiece of the article was an effort by Partnoy and Eisinger to unpack and understand the annual statement of Wells Fargo, a large bank that has been less associated with complex derivatives and trading activities than firms such as JP Morgan, Citi, and Goldman Sachs. They conclude that the public securities disclosure makes it impossible to understand adequately the risk-taking of even a more “traditional” large bank.
Frank agreed to engage in the following e-mail q&a on the article:
Q: You paint a pretty bleak picture of opaque disclosure and potential hidden time bombs lurking in the balance sheets of big banks. How does this problem compare to the toxic assets hidden in Japan’s zombie banks in the 1990s after their real estate bubble collapsed?
A: It’s a great comparison, and the degree and type of opacity are very similar. For example, I wrote in F.I.A.S.C.O. about the AMIT deals we were selling to Japanese banks back then, and looking back from today I think that the games played during the real estate bubble echo the games played in Japan during the 1990s. (And the zombie point is also a good one; we actually used that word in an early draft of the piece.)
Q: Is this a post-crisis phenomenon? Is it a function of banks trying to hide bad assets from before the bubble burst? Did the problem start there?
A: Yes, and I think it’s a friendly amendment to Charles Kindleberger’s work on crises, or even Hyman Minsky’s. As the bubble builds, credit expands, and risk increases, and inevitably the banks at the center of the expansion increasingly hide their risky assets. The assets aren’t necessarily bad – at least not at first – but they are hidden because they are risky. Then there is a dislocation and a panic as the assets “become” bad and ultimately the losses are disclosed.
Q: Is the opaque disclosure a sign that the United States runs the risk of a zombified banking sector like Japan’s?
A: That remains unclear. Bank stocks have performed well recently, in part because of the faith in the implicit U.S. government guarantee. Japanese banks weren’t as fortunate. But we think the risk is a real one, and it was a major reason why we wanted to write the piece. I don’t know if the right metaphor is zombie or rot or something else, but historically opacity has been at the center of major financial problems, especially over the long term.
Q: Do you have a sense whether the problem is as acute for large banks overseas – the Barclays, UBSs, and Deutsche Banks of Europe?
A: The gap between disclosure and reality is not nearly as wide in Europe, though banks there have plenty of other problems. For example, European regulators and bankers continue to rely heavily on credit ratings; that is a huge ongoing problem and will almost certainly result in massive misallocation of capital and future crises.
Q: You don’t seem to have much confidence in the ability of regulators or even bank management to understand the risks these banks are taking despite having nonpublic information. Is there other evidence of this besides the London Whale tale of JP Morgan?
A: Oh, there are so many. Regulators have failed to comprehend the risks at banks over and over during the previous two decades. My book Infectious Greed documents many of those incidents from the 1980s through 2003. As for more recent examples, the recent revelations about what Fed officials thought in 2007 is notable. So are the regulators’ positions about risks at Citigroup in late 2007 and early 2008. I attended several conferences with regulators during 2007-08 and was surprised by how little they knew about Structured Investment Vehicles. And so on. Kids, you really need to get out more.
Q: Why did Warren Buffett invest in banks after the crisis? What could he figure out that you (or other investment fund managers you interviewed) couldn’t? Did he have special access? Why is Berskshire Hathaway still invested in Wells Fargo if the disclosure is so opaque?
A: Buffett obviously has special access and his bet turned out to be a good one last year. He’s experienced investing in companies with opaque derivatives exposure, going back to General Re, and while sometimes he is warning that derivatives are financial weapons of mass destruction he is also often profiting from them. The key to Buffett’s investing style has always been timing – he is a genius at managing delay, waiting for the “fat pitch,” and I suspect he’ll know when it’s the right time to unload bank stocks so that he doesn’t get burned again. He understands that just because something is a black box doesn’t necessarily mean you should avoid it. Even buying into a pyramid scheme can be very profitable if you get the timing right.
Q: Why wouldn’t the market address this? Wouldn’t one large bank collect new investors and be able to sell equity above book value by offering better disclosure?
A: Oh, you’re right – how silly of me. The market addresses all such problems. Never mind.
(But seriously, imagine what our economy would look like today if the markets actually had worked. What if all of the major banks had failed in 2008 and Google, Microsoft, Amazon, and Walmart had stepped in to provide basic financial functions?)
Q: If this opacity scares away equity investors, why isn’t it also scaring away the creditors and derivative counterparties of these big banks? Why aren’t they demanding more margin or collateral or higher effective interest rates? Do these counterparties assume that the problem would have to be large enough to threaten the big bank?
A: Implicit government guarantees. And even so, they are demanding more collateral and clearer contractual arrangements, which are creating another set of problems. Also, there is some truth to the notion that the banks are so large and diversified today that creditors and counterparties probably aren’t at huge risk of failure. Catastrophe yes, but maybe nothing so big to cause insolvency. JPMorgan’s $6 billion loss was a nit.
Q: You offer a detailed indictment of Levels 2 and 3 of fair value accounting. What did you make of the outcry during the financial crisis that mark-to-market accounting was exacerbating the crisis by causing fire sales? Might some of the reforms you suggest, including improving fair value disclosure, have nasty procyclical effects?
A: No, quite the opposite. The outcry during the crisis was about marking down assets to more realistic levels – obviously bank managers didn’t want to do that. But if managers had understood they would be required to mark assets down immediately when they declined in value, they would have been less likely to buy them during a bubble – hence, an anti-cyclical effect. The smartest investors and managers say that if you can’t mark something every day, you shouldn’t buy it. Period.
Q: Your analysis of Wells Fargo’s “customer accommodation” trading focuses on some of the fudged language in the disclosure, namely that this trading might not be driven by actual customer demands, but “expected” customer order flow. You also write that
“Some traders can disguise speculative positions as “hedges” and claim their purpose is to reduce risk, when in fact the traders are purposely taking on more risk to make a profit.”
Does this mean that you are skeptical of the Volcker rule’s effectiveness in reducing risk-taking because the built-in statutory exceptions to proprietary trading are too easily manipulable?
A: Absolutely. I use the metaphor of a piece of Swiss cheese with holes that get bigger and bigger – until it is gone.
Q: Are you really limiting your proposed fixes to better disclosure and more vigorous securities enforcement? Or are you saying, as Felix Salmon blogged, that banks need to become much simpler? Do you agree with his assessment that moving back to a simpler age of banking or a simpler age of disclosure is quixotic?
A: I think getting simpler would be a result of better disclosure and enforcement. And I have very little confidence that regulators could draft a set of “simplicity rules” to pare down what banks are permitted to do and what they are not, especially in the face of the financial services lobby. I don’t think ex post adjudication in a principles-based regime is quixotic. If anything it’s a more sophisticated way of impounding market information in regulatory decisions. But good use of the word “quixotic.”
Q: Doesn’t disclosure still have the “you can lead a horse to water…” problem? Would even sophisticated investors demand or make use of the disclosure you envision? How do you know?
A: True. Some of the reception to our piece has made me wonder whether some supposedly “sophisticated” investors are in fact not wearing any clothes. On the Wells Fargo earnings call after our piece was published, one person asked about it, but the various investors and analysts seemed placated by the CEO’s response that Wells Fargo is “pretty plain vanilla” and “I’ve never seen us be more transparent.” There’s been virtually no follow-up about the bank’s Variable Interest Entity disclosures, for example. But I think there are enough truly sophisticated investors out there, and they have huge amounts of wealth under management – as long as they drink, the other horses eventually should come along. And the most sophisticated investors tend to pile on very effectively once even one of their ilk has made a good case. Which is why managers hate (and fear) them so much.
Q: Are you coming out in favor of principles in the old rules vs. principles debate on accounting standards? Aren’t simple, broad standards also subject to gamesmanship?
A: Yes, I am. It is much more difficult to game broad standards when they are adjudicated ex post. This after-the-fact element is just as important as rules vs. principles.
Q: How much promise do you think technology offers in improving the quality of disclosure (for example, the SEC’s XBRL initiative)? [Editorial note: this is my latest research project]
A: It’s a fantastic project, and I wish you the best with it. In theory, technology can vastly improve the quality of disclosure. But one problem with systematizing disclosure is that you can miss crucial angles that are “outside-the-box” or more like narrative. What would XBRL have done with Enron’s footnote 16?
Q: If you were to offer a few concrete suggestions for the new SEC Chair on improving disclosure and enforcement, what would they be?
A: Keep it simple and be willing to be vague. Single out financial firm disclosure as a hot topic, and make it clear that banks must make better disclosures of risks and worst-case scenarios, or face consequences. Get the board members of the major banks to sign on to these initiatives, through a series of early meetings and then a highly-publicized roundtable. Keep trying to win “should have known” cases, especially against employees of financial firms. Good luck!
The Basel Committee just put out some core principles with the un-earth-shaking but nonetheless important goal "to strengthen banks' risk data aggregation capabilities and internal risk reporting practices." Who helped them come up with the principles? You might begin to answer that question by looking at the comment process. Who wrote in once the committee completed a draft of the principles and sent it around? It turns out that Basel kept a list:
|British Bankers Association||39kb|
|Canadian Bankers Association||368kb|
|French Banking Federation||204kb|
|Independent Data Professionals Group||788kb|
|International Banking Federation||250kb|
|Japanese Bankers Association||74kb|
|Polish Financial Sepervision Authority||443kb|
Prefontaine is a Canadian professor, and JWG a beltway bandit/think tank. So, in other words, other than the Poles, this is a comment process dominated by banking industry groups. Basel has not in the past radically changed its rules during the comment process (though it changes them some), and I'm glad the committee is no longer operating entirely in secret. But it does show that the new openness in international financial regulation isn't being exploited by everyone.
One doesn't always think about the national security implications of a secure financial system, but Iran appears to be engaged in an odd demonstration project designed to remind us about it. As Stewart Baker observes over at Volokh:
One thing is sure, they’re the opposite of the cyber Pearl Harbor everyone’s talked about. Unless Adm. Yamamoto called up the Navy on December 7, 1941, and said, “We’ll be attacking Pearl Harbor for an hour and then the Philippines for an hour, but only on Tuesdays, Wednesdays, and Thursdays.” Because that’s pretty much how the bank attacks are going – short duration, scheduled disruptions.
That raises a couple of questions. First, why would a country launch such a limited attack? It could be a demonstration designed to show capability without actually provoking a response — sort of like sending an aircraft carrier to a trouble spot but staying in international waters. Indeed, some of the details of these DDOS attacks do show surprising sophistication, and there’s no doubt the actual impact of the attacks could be greatly ramped up if the attacker wanted to. Second, if that’s the case, the best response would be to demonstrate that our defense can counter the attacker’s offense – sort of like surfacing an undetected submarine alongside the carrier.