Thursday, February 26, 2009


RBS (CEO Stephen Hester) reports today an annual loss for 2008 of £8.13bn before goodwill write-offs of £16.6bn (giving a £24bn loss from a gross statutory loss of $40bn), and restructuring of about a third of the bank's £2.2 trillion balance sheet (my calculation), by placing roughly 10% in a non-core division, another 10% in the UK Government 'bad bank' Asset Protection Scheme (announced today) plus another 10% likely to be swapped at the Bank of England liquidity window in 2009. Part of the cost/benefit of this is Government buying a further £6bn of B-shares (at the option of nationalised, UKFI-owned, RBS). Government funding and related measures will be very profitable for taxpayers (a promise in the RBS annual report). See also:
These shares will attract dividends but only have voting rights in certain circumstances? This matches the fee RBS would pay of £6.5bn plus other coupon and haircut. The fee is funded through the issue of B-shares, to cover the “first loss” of up to £19.5bn as part of the government’s asset guarantee scheme. As part of the scheme RBS agreed to waive some UK tax allowances, which is obviously another form of fee bartering, although if I recall there was already some 20 year dispensation for spreading tax liabilities into the distant long grass. The AP Scheme was agreed in the early hours of this morning, the corridors of power echoing to the midnight taps in HMT of laptops, maybe the Credit-Suisse boys at it again, keying their risk-accounting spreadsheets, calculating RBS's agreement to put £325bn of its assets into the scheme. Further losses after a first loss of 6% retained by RBS would be split between the Treasury, taking 90%, and RBS taking the remaining 10%. This is a super-SIV deal. It requires shareholder approval, not hard with UK Gov holding 68%, soon to be 75% (the government’s voting stake will be capped at 75%), and with the Government's economic interest “significantly” above that. Hester said participation in the scheme would help assist the bank to reduce risk for shareholders (mainly the Government at present) and provide for increased lending to UK customers. Its annual report for 2008 says it will centre its focus on the UK, which might raise some eyebrows in the USA? The share issue would be further dilutive to ordinary shareholders who won't get any dividend not even in shares in 2009, but Mr Hester insisted it represented capital on terms that would not be available from private markets and would count towards the group’s core capital. RBS Core capital will then be among the world's highest. Referring to spossible stress-testing results, Hester said, ”In all scenarios this is cheap insurance and the right thing for us to do... But that is quite different from saying it is a shareholder bonanza – it is not.”
Lloyds Banking Group – 43% state-owned – confirmed today it is in talks with the Treasury to participate in the scheme, “These discussions are ongoing and no terms have been agreed.” It is not certain that Lloyds’ participation would be on the same terms as those announced by RBS, but for fear of accusations of self-serving bias, equitable terms should be expected.
RBS promised to increase lending to UK homeowners and businesses by £25bn over the year, of which £9bn would be in new net mortgage lending, plus a further £25bn the following year. The Government loans would be made on “arm’s-length” pricing and credit criteria. Details of the fresh capital raising came as RBS reported pre-tax losses for 2008 on a statutory basis were £40.7bn giving a net loss of £24.1bn, biggest in UK corporate history. Goodwill write-offs were £16.2bn, due in large part (probably almost all of its £10bn share of the ABN AMRO purchase price). In the annual report the bank says it will 'centre' its core business on the UK, which may be an eybrow raiser for the Americans where RBS-owned Citizens Bank is in the top 10, possibly no.6 and where there is also a duty of responsibility not to behave proc-cyclically. Over there, after all, there is the Citizen's Bank Baseball Park. Shares in RBS were 17.75% up at just over half of one first class postage stamp, 27.2p in afternoon London trading, having earlier risen as much as 22% first thing. Alex Potter, banking analyst at Collins Stewart, reported by the FT, said the bank is in effect conducting a £19.5bn rights issue, but at a price (50p) well above the stock market level, through the issue of shares to the government, while the APS is larger and cheaper than had been expected. The bank’s asset quality trends, he says, are “appalling” and the recession is beginning to hit earnings. I beg to differ here in that the default retaes reported are well below those of the Bank of England's latest reports. But it does look worrying that RBS appears to planning withdrawel from, little or no growth in, property development and project finance? Potter predicted RBS would only break even this year, after further impairment charges, and there was “little chance of a dividend before 2012”, which is absurdly self-confident forecasting about a bank with over £2 trillions in assets (in ratio equal almost to all of UK GDP)!
Speaking of the possibility of future losses on insured assets, Hester said: ”All of us have our eyes open but we can’t foresee the future. I don’t think any of us have any ability to ascribe a sensible probability of where the loss will occur, or at what pace.” The bank's results coincide with a growing political row of useful news-displacement noise about the £16m pension pot awarded to Sir Fred Goodwin, the former chief executive of RBS. This agreed with RBS’s board and approved by the government, gives Sir Fred the Shred £650,000 a year with immediate effect. The figure – double previously reports – undermines claims that executives of failed banks will not be rewarded.
Under the RBS strategic review led by Mr Hester, RBS plans to shrink its global banking and markets division GBMD that expanded under Sir Fred’s leadership, by taking out 45% of the capital employed there i.e. over £900bn in derivatives that Mr hester told the Treasury Committee was only £400bn hedged, a remark that raised eyebrows through the roof. It seemed highly imporbable that the bank could have £500bn in one-way bets or net exposure especially in view of its stated RWA (risk-weighted assets) figures?
The FT reports that the bank aims to cut £2.5bn from its cost base and centre its business on the UK, and pledged to “drive major changes to management , processes and culture.” Mr Hester said the move could involve 20,000 job cuts but no definitive figure had been set. The strategic plan would take three to five years to execute, he added. ”We are not building on sand here,we are building on rock. What we need to do is sweep away the sand that is covering that rock.” Sir Philip Hampton, the new chairman, said the bank had been through “an exceptionally difficult period... confident that we can, must and will restore RBS to standalone financial strength.” The bank also announced the appointment of Nathan Bostock, chief financial officer of Abbey National, part of Santander bank, to be head of restructuring and risk. Gordon Pell, head of RBS’ regional markets division, is to be deputy chief executive.

Wednesday, February 25, 2009

“De Larosiere Report” - IN THE NAME OF THE ROSE

Looking at regulatory restructuring of the world's finances, the metaphor of the Titanic and rearranging deckshairs comes to mind, but when considering the policy institutions of Europe, US the rest of the world, a certain film seems more appropriate. When all else is up in the air and being restructured with the whole world on the floor, this is the time for the men of big ideas to make their career-defining moves, as is happening with all financial regulatory organisations. The past-masters at this are undoubtedly the pragmatic ironic British and the paradoxical French alongside dutiful 'can do' Americans followed some way back by others like the baroque Italians, and the theoretically-thorough Germans. As a regulatory risk expert and Cambridge-educated I have much empathy with the political-economy diplomats in international organisations from the Grand Ecole mandarinate of France, among whom I count many friends in various pan-European and global networks, a few shadow versions of which I've helped in over the years. We macro-political-economists luxuriate in the big numbers of that seem a most sublime power, that of ideas, intellectual, academic, vicarious and virtual, therefore of the morally cleanest sort, well-filtered. For us, the power of ideas is status and influence, but not money-wealth - that appeals to me, but as an outsider, and so I identify more with the William de Baskerville character or maybe his junior sidekick Adso de Melk, in the film and Umberto Eco's book The Name of the Rose. Following on from my last blog into the monastic corriders of geo-euro-political power-grabbing for the financial heights of the world's economics, I can now report the latest discovered scroll issued today to be approved by the European Commission on March 4th - regulatory reform at lightning speed before the April G20.
The “DeLarosiere” Report will be published by the EU Commission today at noon CET, it’s the call for the European Super Regulator shrouded in rosicrucian titles like “reforming / strengthening regulation in Europe”. As I expected, the ECB made a bid to the Commission's ECFIN DG to take this euro super-regulator under its wing and locate it in Strasbourg, that remote monastery of the European Parliament that has drifted away inexorably, like evaporating share value, to the heart of strife-torn Brussels where the real action is.
But, two theological objections are countervailing upon that bid, not unlike how IMF's political power is represented by its voting structure, in this case to do with the ECB structure; its plenary authority being of two brotherhoods: a), national representatives who are ‘CEOs etc’ of each member-state's central bank, and b), members appointed by DG ECFIN. The former group have apparently (for various reasons in this fast-moving crisis) completely lost the short-term faith in the ECB, or at least become seriously doubting Thomases. They feel the dualism restriction of the ECB's current structure, it's now outmoded constitution and its tight control of open money market operations etc. Countering the ECB itself as super-regulator pontificate is the argument from the Banque de France that there is a conflict of interest between the ECB being the lender of last resort and the super-regulator at the same time (not neglecting the anaemic C-ebs). This is not to undermine Jean-Claude Trichet whose term in office remains secure, but there is general disbelief in the ECB's ability to truly see or to effectively respond with the rapidity required given how fast circumstamnces are changing. Days and weeks have rarely been such a long time in geo-political-economy. Let us be absolutely clear, the Euro-Super-Regulator would emasculate national regulators who are all collectively in the dungeons reviewing their testimonies and confessions and awaiting their fate, like the FSA in the UK, the IFRSA in Ireland, CBFA in Belgium, NDB in the Netherlands, and others, not least the BIS whose crime appears to include among other offences that it resides in tax-evader haven Switzerland, though why that should be a factor I can't understand. And there are those in the various national finance ministries and even within the regulators who would support a new super-regulator as a good thing, at least good enough to deal forcefully with Europe's top 45 cross-border bank holding companies that (until the credit crunch knocked them over like pins in a bowling alley) were not just too big to fail, but too big and financial-market-powerful to be beholden to national interests and Europe's winder communitaire interests. Like central banks whose task was to defend the currency regardless of politics, the biggest banks considered one of their tasks to be to attack currencies and related financial interests regardless of politics, arrogantly above all that. The Euro is testimony to political anger at the financial markets. In fact the Euro cost the banks about half a € trillion in lost trading profit over 5 years plus lower than necessary Euro Area GDP growth and in part is what propelled the banks to seek faster growth through asset backed securities and other derivatives and structured finance. Now that the banks and financial markets have imploded, lost their ammunition train, where the Euro was Europe's defence, now comes Europe's counter-attack against the big banks. This de Laroisiere Report is the alternative to nationalisation of the banks by offering multi-national, coordinated regulatory oversight. There will be nowhere else to hide. Of course, the big banks who are nationalised will not be subject to regulatory laws and this new super-regulator of 3committees etc. Government agencies are not subject to regulatory-supervisory laws. Police is another matter. The police raided the offices of Anglo_irish bank yesterday thanks to a new law permitting criminal arrests, despite the bank now being nationalises. Where The US has led in police-action against bankers, over 250 FBI arrests, Ireland now follows and the rest of Europe will also follow.
Gordon Brown and Barack Obama have declared an end to the era of irresponsibility. By that they both mean the irresponsibility of international and global banks, of the big banks and securities houses trading with customers' deposits and high-risk leveraging directly for their own profits, and through unregulated financial markets, letting unqualified so-called 'bankers' with maths degrees and one year MBAs cause mayhem to the world's economies for their get-rich-quick bonus rewards.
It is now the era of responsibility and that means the Politicians' revenge on the big banks who are the targets of all this. For at least twenty years the financial markets and the top bankers have terrorised governments, been financially more powerful than elected governments when they wanted to be (not unlike the great monasteries and religious oprders of the middle ages). There is the same cleaning of the Augean Stables idea, of hypocrisy and greed, pluas some payback for all the chaos and effort. They who have to be cut down by size and deprived long term of their arrogant, undemocratic, irresponsible, self-aggrandizing, profit-seeking, Gordon Gekko greed-is-good, financial power, each to be cut back, beginning with by a quarter to a third of their assets, principally all of their own trading books and toxic assets.
The Euro and the Eurozone, let's not forget was a necessity born of desperate defence of Europe from international banks who deemed it their perfect right to arbitrage and short-sell Europe's currencies and rattle the cages of governments and whole economies whenever they decided to conspire to do so! Given all this emotion and righteous anger, what chance has the ramrod ECB with its history of monetary rectitude and politically-neutered constitutional role.
The Eurozone member-states desperately need their money-market operations back, back under some political control, under the political direction that the ECB sorely lacks. All might be different of course if the EU had got its constitution voted hrough and could have established a permanent presidency with a new voting structure. The Irish insistence on democratic voting scuppered that and its voters don't look like changing their vote anytime soon. Notwithstanding that the Dutch and French electorates voted No, and probably the British electorate would have too given the chance. I understand that President Sarkozy wants the Euro-Super-Regulator somewhere near INSEAD (and the fine libations of the Cote du Rhone). I cannot imagine the Germans or the British not wanting that for the pleasurable aspects, but politically and practically this remains a matter of London is where the Anglo-Saxon financial markets are including half of the EU's banking assets, while Germany is where the image of monetary rectiude is part of its national culture and vital brand-image. But as discussed yesterday, Brown will grant Sarkozy the Euro-super-regulator (shortly to be re-named the new finance-super-collider en pays de CERN?) as the bargaining chip on his way to getting the world's super-regulator agreed to be vested in the IMF in Washington, although actually located in NY City near the UN complex.
What is happening here is a well-programmed set of dominoes falling to plan, managed between the mandarinates of the UK FCO & the French Foreign Ministry, with the EU handled in a high-stakes geopolitical game, which has been à gout sournoise invisible to the 4th estate as usual asleep at the bar! One reason the British (Anglo-American-French) can succeed with this is the Czech Presidency of the EU until June. The British and the French (and why not the Italians, Spanish and irish too) want this done before the Swedish Ministries take over in July since all are aware that the Swedes have alternative plans in this domain, and after all of the famous Swedish Banking Crisis they believe they do know something about it. The Czech government is as you are aware I am sure, profoundly grateful to the American in loco parentis!
The authors are a high-level group led by ex-IMF MD, ex-Bank of France Governor Jacques de Larosiere, and ex-BNPP. They seek reform of cross-border financial supervision in the EU to remedy flaws in the network of national based supervisors, which is directly taking on the job of C-ebs! For loss of local regulatory sovereignty, the report suggests changes over 4 years and "stops short of introducing an all-powerful, pan-EU regulator", according to a draft copy. But, this is somewhat bizarre as C-ebs already exists as a supra-national supervisor overseeing all national supervisory-regulators in implementing Bsael II and Solvency II (EU CRD law), and which only in recent months has sharply narrowed any differences between national standards orptions? The report offers a 2-tier reform - new oversight of systemic risks and a beefing-up of coordination among national supervisors in day-to-day oversight. That is certainly a difference. C-ebs does not exert a day-to-day oversight. Of course, this all really only is focused on the top 45 banks. Both tiers are closely linked.
The report's main recommendations are focused on Pillar II of the CRD, although that is not the direct expression used. The idea seems o be o give C-ebs more political power via the ECB. But, this may not be enough when political backing is needed as we have seen has been essential in all the major bank failures in the last year?
Systemic risk is part of CRD PIllar II and requires stress-testing of banks' economic capital models (as has been initiated vy the Fed and US Treasury to be done today in the US for the top 100 major banks). The De LaRosiere Report proposes:
- A "European Systemic Risk Council" (ESRC) to be chaired by the ECB President and composed of members of the general council of ECB, a member of the European Commission and the chairs of the 3 existing pan-EU committees of banking, insurance and securities supervisors i.e. from C-ebs. - A risk warning system by the ESRC and the Economic and Financial Committee made up of national treasury officials. If the ESRC thinks a local supervisor is taking inadequate action, it can take action.
- Improvements in how a bank crisis is handled e.g. EU states to agree detailed criteria for burden-sharing with whoever bails out a failed cross-border bank.
- Creating a European System of Financial Supervisors and a decentralised network, with existing national supervisors continuing day to day supervision.
- 3 new EU authorities will replace 3 pan-EU committees of banking, insurance and securities supervisors (C-ebs, CEIOPS and CESR). - Colleges of Supervisors would set up for each major cross-border insitutions (of which 45 have been identified).
In a deference to the legacy of depoliticised central banking, the report proposes that ESFS should be independent of political authorities but be accountable to them. Is this logical? Moreover, is it any longer practical?
ESFS should rely on a common set of core harmonised rules. We have these already in the CRD. It is hard to see what this is adding other than elevating the systemic risk aspect that had been overlooked by banks for practical difficulty reasons that are intellectually immense. There are very few people who know how to make sense of this. It is hoped that the committees will make more headway here.
Other reforms proposed:
- fundamental review of globally-agreed Basel II rules on capital requirements for banks, such as stricter rules for treatment of off balance sheet items. This is not new insofar as accounting stajndards and incremental additions to Basel II are proceeding.
- A common EU definition of regulatory capital should be adopted. Hard to see that there has been a problem here, if regulatory capital means Tier 1 capital. If the total of reserve capital is implied then the issue is undoubtedly the economic capital buffers. - National supervisors should collectively be responsible for registering and supervising credit rating agencies.
- A wider reflection on mark-to-market accounting standards, blamed by some for exacerbating the impact of the credit crunch. Oversight and governance of the IASB, which sets accounting standards used in the EU, should be strengthened.
What is really likely to be needed here is auditors have more of a risk audit scope based on IFRS.
- Draft EU insurance industry rules known as Solvency II must be adopted and include a binding mediation process between supervisors and the setting up of harmonised insurance guarantee schemes.
- Regulation should be extended to the so-called parallel (shadow) banking system, and there should be registration and information requirements on all major hedge funds. There should be capital requirements on banks owning or operating a hedge fund or engaged significantly with a hedge fund (for which read Altrnative Investment and Private Equity Funds). - Supervisors will oversee suitability of compensation at financial institutions.
NOTE: hedge funds and corporate bonds: Jean-Claude Trichet has on Monday backed his bid with a strong call on Monday that hedge funds, credit rating agencies and all other important market players should be subject to regulation based on a global approach, that the worst financial crisis in over 80 years has sparked a rethink of how markets should be supervised to cut excessive risk-taking by banks. This would be strong if not for the fact that he is pushing at an open door. Next day in London, The Alternative Investment Management Association, a hedge fund body threw its weight behind regular disclosure of large holdings and risks to regulators. And, in the US where financial regulation is at state level as well as federal level, Connecticut legislators, a state home to hundreds of hedge fund firms, are proposing tougher oversight for the industry ending the state's longstanding hands-off approach that attracted so many financial firms and banks there in the first place. Dublin's financial services centre became to the City of London what Connecticut is to Wall Street.
The hedge fund industry can survive the credit crisis according to the chairman of the Hedge Funds Standards Body told the CESR conference on Monday. One way it is doing so is feeding the desertion of private investors abandoning bank bonds for corporate bonds, especially big brand names that are thought to be too big brands to fail and paying 8-9% coupon, which in any book should be a high-risk, junk-bond signal! Private investors are in for a switch-back ride as hedge funds dump corporate bonds assets on the market; default rates have not yet peaked. When they do yields will rise dramatically. default rates are currently north of 6% and 10% on sub-investment grade, which S&P expects to exceed 23% at peak sometime this year. That will be another MADOFF plus Stanford scale loss to HNW wealth-classes. There is rising interest from private equity and hedge funds to scoop up debt in secondary markets once the peak has passed and the surviving paper will book them double-digit profits.

Monday, February 23, 2009


A proud achievement of Monetarism was political independence for central banks. This has especially been so in Europe, notably the EU's Maastricht Criteria, the UK granting of independence to the Bank of England in 1997 and the formation of the European Central Bank to support the Euro Area. Independence of various kinds has been granted the world over from North America to S.Africa and Japan. The financial crisis and worldwide recession and dramatic changes to world trade and payments flows has ended all that! Contrast the International Monetary Fund (IMF) with the Bank of International Settlements (BIS), and ask yourself why it is that the former and not the latter is the G20 choice for the new global financial regulator and custodian of the new 'financial world order' that G20 is working on with immense urgency? The IMF was established after WW2 and has 187 members and is doubling its capital to $500bn. The BIS was established in 1930 and has only 55 members. The IMF has powerful political profile and is HQ'd in Washington. BIS has failed to play up a politically important profile. It believes in the anaemic world of staying in the shadows, the world of 'shadow-central banking'. It is HQ'd in Basel, Switzerland. It is not without transatlantic and global influence. It has a full quota of Anglo-saxon bankers. It has far deeper expertise in banking regulation and central bank coordination than the IMF! BIS also already has over $500bn in funds and has had twice this in the recent past. But, combining the IMF with the BIS does not yet appear to be on the G20 political agenda; it is either or? And here we get into what is a spaghetti dish of global issues that I shall endeavour to fork out some key strands. The US Treasury, The Federal Reserve, FDIC, and The Comptroller of the Currency, Fannie Mae and Freddy Mac none of these have an ounce of political independence any longer. The European central banks and regulators, BoE, FSA, IFRSA, DNB, BoG, CBFA, and most, but not all, of the rest are no longer politically independent for any practically useful purposes. 'Independence' for now and the forseeable future is just a fashion statement that's so over, a passing fad, gone, buried, but not buried forever! Central Banks that stick out as behind this curve are the European Central Bank (ECB), the European Bank of Reconstruction & Development (EBRD), and BIS. They better wake up and get with the new global G20 political-economy agenda! The figures below are the optimistic estimates from October 2008. Now it looks as if even China may dive into recession in 2009, in which case the other emerging market economies may possibly do so too! The estimates for the OECD countries already look high for 2009. But, with fiscal stimulus policies in place, there is a chance of recovery starting by or just before 2010. It is the worsening of global figures in recent months that is concentrating European minds to agree with the fiscal policy priorities of the G20 agenda, even if it is unpalatably Anglo-American? BIS has a new Chairman, Guillermo Ortiz, Governor of the Bank of Mexico (which with the Central Bank of China joined BIS in 2006). Mexico's banking crisis is useful experience. Ortiz's term is for a period of three years, commencing on 1 March. he should see out the worst of the present crisis.
Europe. the EU, of course to be expected of 25 nations, is flummoxed and jostling between where the weight of new political-economy thinking and cross-border banking regulations should reside? Should it be the ECB if given more political-backing by the European Council (EC) or by the European Parliament (EP), or by the European Commission (backed by the EC and or EP), and or the Committee of European Banking Supervisors (C-ebs), and or BIS (author of Basel I and Basel II and producer of the world's cross-border financial statistics) that also convened the Financial Stability Forum (SFS). There is no clear answer possible, not even within Europe, hence the default choice will be the US/UK one of the IMF.
Also, highly important and usually least discussed, is the Group of Thirty which shares many senior figures with BIS and IMF and is also based in Washington. It is pursuing work programmes in many of the same areas including standards, see
One issue of the IMF structure is voting power. That is what China and other new members want if they are to donate some of their sovereign funds. The board members of the IMF representing all members have votes proportionate to their economic size e.g. roughly USA 17%, Japan 6%, Germany 5%, UK 4%, France 4%, Italy 3% and so on. China will want 5-6%, even if the true size of its economy justifies 4%. But, there are $5-6tn of bank balances in China as well as $2tn foreign currency reserves. What the crisis has rediscovered is the political importance of central bank functions - undoing what monetarists did by officially evacuating politics out of Central Banks. Monetarism sought to depoliticise not only monetary policy but also fiscal policy e.g. Europe's Mastricht Criteria. Now, if ECB, BIS or any other can't play along to the political tunes of how to regain financial normalcy and economic recovery then they're useless - hence the US/UK leading the G20 agenda to the IMF! As soon as Government politicians realise they must grab back responsibility for finance, as essential to political-economy, central bank political independence has dead! Germany and France and others have fought against this re-politicisation, but they are outgunned and undermined by their own fast deteriorating economic problems.
In Europe, the view is that stepping over, around or away from BIS is stupid and wrong, except that there are some undoubted strengths of the IMF that the BIS simply is not yet matching, and arguably never has. Critical to the G20 agenda is 'Third World Countries' (3WC) support, UN /GATT DOHA Round's 194 (also called emerging markets, especially BRIC countries, and poor developing countries) and the IMF appears best positioned for this, to get 3W countries support for global prudential regulation and who will 'buy in' if they are not seen taking orders from an IMF that merely speaks for the USA/UK/EU, or not unless there is money attached. The IMF is currently seeking to double its funds to $500bn, which should suffice for the next 6 months and then it needs more. BIS has $500bn already, but this is tied up in supporting blobal balance of payments tranfers, something the IMF was also originally set up to support.
From the US point of view a big issue is the IMF role world hotspots (hot wars) and the global credit crunch is feared as a generator of many more such hotspots. The G20 agenda is focused on prudential regulation of banking as emphasised by the EU's Berlin conference on Sunday in preparation for the G20 London Summit in April. But, hard currency trade payments payments and Debt Relief are even more urgent. This has been masterfully picked up by the IMF's Dominique Strauss Kahn. He has positioned the IMF by what BIS, the ECB and EBRD relative to Eastern Europe and N.Africa should have done but didn't.
The IMF got involved in the FSF and became the supporting bureaucracy for G20 and studied 122 banking crises around world and found (no surprises here), that banks' balance sheets must be cleaned up for real recovery to begin, and banking sector can start distributing credit only once it has shrunk and it's been cleaned up. This is frightening to Governments who fear their domestic bank lenders deleveraging by 10-30%, easily enough to turn a crisis into stagnation.
The IMF also looks like a place to invite Sov.Funds into, to address intra-3WC transfers, to attract some investment by Soverign Funds' and to take on some of their holdings of US ABS that otherwise might be dumped back into the USA? The US can call what it lends to IMF as fundings when really they can be $ treasuries swaps for US ABS via the IMF and best done while the $ exchange rate is riding high. The
IMF unlike BIS or ECB or the World Bank can speak out with political authority and politically-attuned economic forecasts. The IMF might have a role in stopping some wars by mitigating crisis or funding reconstruction. The BIS doesn't have any of that political profile. It is too much like a global regulator and too little like a global central bank. The IMF believes in a combination of 4 set of measures to get the world back on track: 1. action by many governments to stabilize fin. markets to get credit flowing again. The IMF does not have a clear analysis of what this entails. I supply that. This is a combination of capitalisation measures, replacing 100% of banks' reserve capital (in US & Europe about $2.5tn), and central banks stepping in to provide wholesale market funding to fund banks' 'funding gaps'. (In the USA, the funding gap is up to $8tn, in Euro Area, $4.5tn, in UK $1tn and in Central and Eastern Europe, including Russia, $1.5tn. In China and Japan and India the 'funding gap' is another $4tn or so = $18tn worldwide). US, UK and Euro central banks have so far financed about 20% of what is required over 3 years. This role, displacing private sources from what had been a highly profitable business by banks and near-banks, should be medium term very profitable to governments and a serious loss of income to banks, while at the same time saving their hides. 2. Fiscal stimulus by higher government borrowing and spending. The IMF conservatively prefers to say higher government spending & tax cuts to revive economic consumtion (mainly consumer demand) and world trade. The IMF's emphasis on tax cuts is its hat-doffing to the monetarist orthodoxy of the past 30 years, including its last November package for the Ukraine, of which it has been a passionate supporter (sometimes notoriously so in Africa and S.America). The US and UK are aiming at 8% fiscal stance, which may translate into 4-5% GDP boosts, but 5% is the least needed to get back to 2003 financial balances of banks and onto a palpable recovery path. The EU is dithering around a more minimalist 2.5% but edging upwards to 5%. The fiscal stimulus rule should be that it is better and safer to do too much than too little. Monetarists in the wings worry traditionally about the inflation consequences of higher government indebtedness and spending. This view has however ignored the consequences of far faster growth of private sector debts that are also a concern of monetarist theory if only most monetarists were that versed in their own theories? 3. The IMF is rightly very concerned about supplying liquidity to Emerging Market Countries from where there has been a fall-off in Foreign Direct Investment, severe drop in export volumes, stock market and other financial outflows because of the financial crisis, repatriation of funds to the USA and 'safe-haven' panic into US dollars, Yen and Euros. The context of this is also very much that of hard currency reserve balances which in 3WCs are, along with minerals and cash-crop future exports, what supports 3W central bank domestic money supply. 3WCs lack domestic bond markets alongside lacking 'tradeable currencies' - something the World Bank has become keen to address but has so far not achieved much publically. 4. The IMF wants to help Low-Income Countries harmed by the financial crisis and the legacy from the price spiked in 2008 in food & energy prices, now followed by total insecurity about 2009-11 trade. The global trade pattern is entiely up-in-the-air and falling in volume and value, and no-one has predicted how it will settle. All we can be sure of is that all economies have to look harder at domestic growth impulses and realise that they will be less reliant for some years on their external account. All we know is that energy will remain half od all world trade. The IMF proposes governments in a position to do so should together inject a global fiscal stimulus (presumably to poor Cs) equivalent to 2% of world GDP = $1.2 trillion, which is four times the IMF's current balances and a third of the true GDP of China. A million jobs less in the EU or the USA each supports twenty millions of jobs in China. IMF head, Dominique Strauss-Kahn, former French finance minister, who along with Gordon Brown got President Sarkozy on-side in G20, telling him to hold back on his Europhile objections, by both telling him that the world avoided a total meltdown of the financial system only as a result of coordinated intervention by major central banks last October, as led by the US and UK. "We were very close in September to a total collapse of the world economy." Strauss-kahn defends the IMF's different prescriptions for different economies, arguing that while major advanced economies could afford to boost spending and run up larger deficits to help get out of the recession, other crisis-hit countries, particularly emerging markets of E.Europe, do not have the same budgetary room of maneouvre because inflows of capital dried up and their currencies were under pressure. The irony of this is that similar problems arise even in the most rich Euro Area!
When the Euro was launched (replacing 10 currencies, now 15) the ECB was set up to back the currency including the central money market operations on behalf of the Euro. This meant that Euro-member states' central banks lost the flexibility to issue their own treasury-bills (government bonds with less than 1 year maturity). T-bills have the advantage of being off-balance sheet of government budgets and national debt. It was through treasury bills more than any other measure that both the US and the UK were able to respond quickly and powerfully to relieve the liquidity crises hittin the banks. The ECB has followed suit, but less quickly and proportionately less. The ECB's liquidity window ran into political problems e.g. why did the Irish get so much relative to their economy; answer, because they have a disproportionately large banking sector? The ECB is also least able to take on political direction and least comfortable with more of a fiscal than a monetary intervention. It has been constitutionally set up entirely to implement monetary policy and to use Euro-bills for that, not to save banks or save economies by in effect acting fiscally. The fear of expanding ECB bills issue from €800bn to €5tn is he fear that this would undermine the creditrowthiness of the Euro. But, the choice of not doing so means Euro Area countries busting through their budget deficit and National debt limits as defined by the Maastricht Criteria - and that would politically be even more of a threat to Euro currency integrity! It may be best for the economy of Europe and ultimately of the Euro system for the ECB to delegate back to national central banks the right to issue treasury bills and operate their own liquidity windows for domestic systemically important banks, only limited by the current funding gaps. This could be a very important innovation, but I know of no-one else suggesting this, except myself!
Strength of the dollar is proving to be a boon to the $2.5tn or half of US asset backed toxic securities bought by foreignors, but not in the Euro Area. The high US$ is also a big factor in the low oil price. But, IMF and US criticism of the ECB as not being a real central bank with real political backing and not operating a sufficiently large liquidity window or forcing European banks to write-down their toxic assets far enough ($250bn too little) is all conjoining with bad economic news to pull down the Euro (good thing too). The UK is pulling the EU leaders in the direction of debating fiscal measures and financial bailouts. Germany and France have sought to pull the debate as they achieved in Berlin more in the direction of reguylatory cures for excessive financial risk, seen as essentially the curse of the Anglo-American or Anglo-saxon economic system and culture. Dominique Strauss-Kahn sits comfortably astride this divide, and can say that even though the financial crisis had started in the United States, the recent strength of the dollar showed that people around the world still had confidence in the U.S. economy. He seems thereby to be saying that US recovery has to be the engine that needs to start pulling before everyone else's recovery can get ging and that is quite right. As long as that confidence remained, the United States would be able to finance its large deficit. Even though the Chinese and other BRIC economies were on the rise (with a true GDP in China's case one third less than measured officially), even with reflaion packages of some size being possible as in China, the United States remains overwhelmingly formidable as the main counterparty economy and by far the major trade currency to the whole of the rest of the world. But, all economies remain dependent on the rest of the world. Therefore, the IMF takes the sensible view (and the UN also) that recovery measures cannot be merely domestic and must include how to fix the serious imbalances in the global economy. How big a part new global banking risk management regulation can play is uncertain. My view is that it is dangerous to throw regulatory authority pieces up in the air to create a new jigsaw. We should work with what we've got and create a new system when recovery is certain. Member governments expect the Group of 20 industrialized and emerging market economies to make significant progress in boosting transparency and tightening supervision in the financial sector when they meet in London in April. The London meeting follows the meeting in Washington last November when leaders first agreed an action plan to combat the growing crisis that places global financial regulation at the top of the agenda.
For final confirmation that central bank political independence is now passed and the focus is not longer on monetary aggregates and inflation only, we have only to consider Monday's statement below from The Fed, Tuesday's Ben Bernanke testimony before Congressional Committee (see 2nd of comments here below), and Wednesday's launch of C.A.P. "Capital Assistance Program." The U.S. Department of the Treasury, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve Board on Monday, Feb 23rd issued the following joint statement:
"A strong, resilient financial system is necessary to facilitate a broad and sustainable economic recovery. The U.S. government stands firmly behind the banking system during this period of financial strain to ensure it will be able to perform its key function of providing credit to households and businesses. The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth. Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.
"We announced on February 10, 2009, a Capital Assistance Program to ensure that our banking institutions are appropriately capitalized, with high-quality capital. Under this program, which will be initiated on February 25, the capital needs of the major U.S. banking institutions will be evaluated under a more challenging economic environment. Should that assessment indicate that an additional capital buffer is warranted, institutions will have an opportunity to turn first to private sources of capital. Otherwise, the temporary capital buffer will be made available from the government. This additional capital does not imply a new capital standard and it is not expected to be maintained on an ongoing basis. Instead, it is available to provide a cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers. Any government capital will be in the form of mandatory convertible preferred shares, which would be converted into common equity shares only as needed over time to keep banks in a well-capitalized position and can be retired under improved financial conditions before the conversion becomes mandatory. Previous capital injections under the Troubled Asset Relief Program will also be eligible to be exchanged for the mandatory convertible preferred shares. The conversion feature will enable institutions to maintain or enhance the quality of their capital.
"Currently, the major U.S. banking institutions have capital in excess of the amounts required to be considered well capitalized. This program is designed to ensure that these major banking institutions have sufficient capital to perform their critical role in our financial system on an ongoing basis and can support economic recovery, even under an economic environment that is more challenging than is currently anticipated. The customers and the providers of capital and funding can be assured that as a result of this program participating banks will be able to move forward to provide the credit necessary for the stabilization and recovery of the U.S. economy. Because our economy functions better when financial institutions are well managed in the private sector, the strong presumption of the Capital Assistance Program is that banks should remain in private hands."

The financial authorities have provided funding assistance variously to replace that part of banks' reserve capital that has been lost due to the credit crunch. TALF and other measures will provide Government supported and private undewritten funding of banks' 'funding gaps'. Now CAP: this is the authorities offering to underwrite and supply on an assessed-needs basis the additional reserve capital cushion that banks should have in place to absorb capital reserve losses caused by credit risk and market risk losses caused by recession. All the banks know is that how they have correlated their economic capital model risks to what is currently happening has been woefully inadequate and they must now do this more intelligently, more globally and more severely. The boards of the biggest banks are all directly involved in this and the best brains and systems are being mustered urgently this week to do so in all banks' headquarters working round the clock. They have to do the work in days that normall would take a team of PH.Ds months to complete. They will do the best they can. It won't be very good, but it's a start and certainly is concentrating top minds. I've got the answers already sufficient to predict the rough outcome. The correct result should be $1 trillion of capital reserve cushion as the 'economic buffer'.
The next blog will explain this and in the context of stress-testing by the US banks that will be followed in UK and the rest of Europe. Failures by banks to know how to stress-test and failure to stress test severely enough is considered by many to be a root cause of the present crisis. Hardly anyone seems to know how to do this properly, including BIS, The Fed and other regiulatory and supervisory aiuthorities. In and elsewhere myself and colleagues are providing detailed advice on how to do this work realistically, comprehensively and successfully.

Monday, February 16, 2009


Long before the credit crunch, most customers hated most banks. They had not always done so. It is a phenomenon of the past quarter century of computerising customer relations. It is something everyone knows that computers have no feelings and limited ability to emulate empathy to "put the customer first". The automation of banking delivered conveniences like credit cards, ATMs and internet banking (for a few) but otherwise took negotiable human judgement out of banking relationships at the same time as banks covered their shop-fronts with the rhetoric of customer service mission statements. What was less apparent was how this did the same in financial markets. This technological revolution in retail finance was also accompanied by computerisation of financial markets pricing and trading i.e. the mathematical miscellany of credit-scoring, crude ratio-driven ratings models and poorly-tested algorithms ruled, but are now so discredited the only reason they survive is it is too early to have designed replacements. The derivative and stock markets too will have to change to do more, but more for quality and less for volume, more about regulation and less for commercial profit. Now that all can see just how hypocritical banks risk management has been, the fact and fiction of banks, the 'emperor's clothes', and all the other derision heaped upon them of hubris and imagining the only way is up and so on, essentially that of all the risk factors banks should have been assessing the biggest single risk factor was themselves; they could risk assess anything except their own business! Banking appears to be the single biggest risk factor in our economies when, except for Governments, it should have been the least risky. There is no bottom to how angry the general public is about such enormous hypocrisy, and if they are not careful to be seen to be on the side of the general public the next for the guillotine will be the politicians! Those bankers who ask themselves why politicians are giving them such a hard time over taxpayer bailouts need to consider this carefully and look hard in the mirror. Even when the smoke has cleared how and when will banks be able to restore customer trust and loyalty? There are exceptions, but not many. Most banks follow a bovine herding instinct, which has its good but also its bad aspects. Among the world's biggest banks apparently HSBC stands out from the crowd, hopefully more will follow suit and hopefully too HSBC won't lose its present state of grace.
Mutuals and trustee savings banks, any that make a virtue of ethical values such as the Co-op Bank (where I was proud to be Head of Credit Risk) or those who stuck to traditional values in banking and mortgage business such as Nationwide or the many regional and local banks in the USA and savings banks in Europe that did not let themselves get caught up in structured finance - though the truth is that hardly any were totally free of this. In Ireland, Belgium, '68 style riots in France, street protests in Greece, Iceland, where next will public anger break-out demanding not only the heads of the bankers, but also the central bank regulators and even Government ministers? Governments are being unseated and even a country potentially sundered such as Belgium. In Ireland, a new law is brought in today to allow the parliamentary finance committee to subpoena bankers who if accused of wrong-doing will be arrested by the police. But the general public appear to want to hang some of them from the giant spike in O'Connel Street, that high-minded heavenward symbol of progress and success, now popularly known as the "binge syringe". In France, as to some extent in all countries the governments are being targeted for some if not all of the blame. In the USA, the FBI have made over 200 arrests of senior managers of financial firms and there are countless lawsuits and official inquiries that will undoubtedly lead to more. At the weekend in the UK the media reported that legal actions by shareholders of the banks are being considered. But it will be some time yet before European authorities see the advantage of arresting bankers as a necessary step to restoring confidence. When the time comes for governments to return bailed out banks and those that were part- or wholly- nationalised to the private sector, there will not be a single exec or non-exec Director left on the boards who was there before the credit crunch! And, for extra good measure to evidence just how cleaned up the banks are not a few of these directors will be doing jail time. If the Americans can do this so too will the Europeans. There will be no choice in the matter! Regulatory supervision has been weak when it came to enforcement of the laws and rules - that latitude given to banks to take a hint and fix their own mess will end. Other dramatic changes will include the following:
1. banks prohibited from trading their own books in the financial markets for profit
2. restrictions to ensure clearing banks stick to traditional 'transition-mechanism' banking
3. ratings agencies gone and replaced with econometrics-based financial risk modeling
4. money, bond and credit markets operating in regulated markets only, maybe FX trading too
5. stricter training and licensing of bankers and more regulatory enforcement
6. structured financial products, securitisations, will continue but in basic 'plain vanilla' mode 7. funding gaps between loans and deposits will continue subject to capital reserves (regulatory tax on shareholders capital and on cost of loans)
8. banks expanding their assets will have simultaneously to expand their capital
9. Tier 1 reserves for the banking book, Tier 2 for the trading book and economic capital for the the total of economic and systemic risk = probably 8% ratio to gross assets!
10. 'Shadow-banking' will be dragged into the light and investment banking separately licensed 11. Bancassurance will be similarly split
12. Laws and rules pertaining to shareholder voting rights will become more 'democratic' and ballots become 'secret ballots' and all subject to tighter legal and regulatory scrutiny
13. Working capital statements and liquidity risk (funding accounts and liabilities breakdown) will become more rigorous and more transparent
14. Auditors via IFRS7 will also audit risk statements and capital reserves and economic capital models will become as central as balance sheet summary statements
15. New risk accounting systems will replace legacy general ledgers
16. Economists will have seats on bank boards and top executives will lose the power to choose non-execs, this going to regulators and shareholders
17. customer-service will be 'rediscovered' in new ways that smack of 'old style' banking and less like filling stations 18. much of wealth management and business banking will be restored to branch banking and banks will look less like shops, hotel receptions, or clinics and more like art galleries or grand chapels again, anything to restore some sense of moral and ethical superiority that was so needlessly and foolishly squandered in the last quarter century.
19. Intermediation for up-front fees like up-front bonuses and customer bribes will all be severely cut back. Mickey mouse investment products will have to go.
20. It won't be quite like an imposition of Sharia law to western banking or abolition of usury, but for many of today's big money movers and shakers it will feel like that.
21. My days of signing off a $2.5bn securitisation deal or a £100m political loan without a second signature and a committee approval are gone!

Sunday, February 15, 2009

FSA shoulders some of the blame

Lord Adair Turner, head of the Financial Services Authority (FSA) has admitted that the regulatory supervisor did not focus enough on excessive risks by banks. By this he is referring to the speed at which banks grew their assets (loans) many times faster than customer deposits. This causes a burgeoning 'funding gap' and mis-matches between loans and funding (all part of 'liquidity risk'). He also means 'concentration risk' where banks may be over-exposed to certain borrowers or particular assets. Banks should seek diversity across all kinds of business. "We didn't focus enough on that," Lord Turner said on the BBC's Andrew Marr Show, referring to the fact that by 2004 "the whole system was risky". He stressed that other regulators around the world had also failed to notice the problem.
Public anger and dismay at the FSA being half-asleep on the job is immense, almost as virulent as the anger at the banks. What Turner is talking about however is Basel II Pillar II where banks have to carry out economic scenario stress tests, with forecasts and assessment of worst case shocks, and also combine all risks into a comprehensive analysis of 'economic capital models'. See, even tried and tested, risk-aware, bankers glaze over at this point! The Daily Mail, used this picture to illustrate the typical mortgage seeker baffled by the problem of a £30 billions funding gap between the £90 billions borrowers want and the £60 billions banks can afford? A year ago it seemed plausible to discuss liquidity risk and bank funding in terms of frustrations for mortgage borrowers and the housing market.
What is the 'credit crunch'? By another name it is 'liquidity risk' or 'funding risk', as the name suggests a drying up of lending to banks by other banks. How banks fund what they lend out is basic boot-camp training for bankers, but that does not make it easy to compute.This was discussed before the Treasury Committee in January, Here is an excerpt:
Dr Danielsson: There is a tendency in all modelling to model what you see and not model what you should be modelling,.. focus on the observable. Liquidity is one ...that everybody seems to know ...but nobody has been able to properly define it... trying to model liquidity in a statistical decision-making model has been until now impossible, and therefore, as a consequence... because you could not model it and you could not put it into a decision-making process... it sort of got brushed under the table and now all of these proposals on liquidity do not focus on modeling, they focus on management. This is the biggest criticism of the FSA.It had so parcelled out the issues and details of risk supervision that sight was becoming lost of the overall reality. But, arguably the systemic dimension was the responsibility of the Bank of England and not the FSA? Professor Goodhart: ... lack of concern with liquidity that had been shown previously, particularly by regulators, was out of a belief that the wholesale markets, where most banks went to get their marginal funding, were very efficient and would work and would be open under all circumstances as long as the banks had sufficient capital, and it was that belief that wholesale markets will always work efficiently, subject to the banks abiding by the capital requirements, which was shown not to succeed from August 2007 onwards, and those wholesale markets are still not working properly. The banks' search for liquidity has consistently shifted from holding liquid assets to the belief that they could obtain additional funding by going to these wholesale markets. It was the failure of these wholesale markets that brought concern about liquidity back to the centre of the stage.
Q14 Mr Todd: So what should a regulatory system for liquidity look like?
Professor Goodhart: Well, there very nearly was such a system introduced in fact in the 1980s. At the same time as the Basle Committee was introducing an accord on capital they were searching for an accord on liquidity, but that search ran into difficulties, and effectively got dropped in the 1980s, it became too difficult for them to proceed, and the process went on then continuously whereby the banks turned for their additional funding, their liquidity, to the wholesale markets and more and more got rid of their lower yielding but highly liquid public sector debt, to the point where the British banks entered the crisis in 2007 holding a really minimal amount of highly liquid British government debt... We would need to go back to look at an appropriate regime for liquidity.
Q16 Mr Todd: And Basel II - back to the drawing board?
Professor Goodhart: Basel II has got a lot of good features. I think it is the best system that I know for trying to ensure the adequacy and the constraint on risk-taking of the individual system. Where it fell down completely was in looking at the systemic risk, the macro-credentials, compared to the micro-credential risk. It is not that Basel II is wrong or bad; it is just totally and completely insufficient in that it did not look appropriately at the systemic issues.
To the systems wonks Liquidity risk just looked like another one to be looked at later. And banks' finance and risk accountants were fully focused on just trying to calculate the present and the past, not the future. The detailed requirements of accurately accounting for credit risk and market risk were alone all-absorbing.
Lord Turner only became FSA chairman in September 2008. His deputy, Sir James Crosby, his deputy, resigned last week, following criticism of decisions he had taken when he was chief executive of HBOS. There was also criticism of the decision to appoint Sir James at the FSA, when the watchdog had previously warned about the risk regime he set up at HBOS. Lord Turner stressed that the appointment had been the Treasury's decision. He also said warnings about risk at HBOS had been routine and related more to processes and reporting structures not major warnings about the risks being taken. But he conceded that the FSA's focus had been a failing. "The FSA at that time was more focused on the processes, the structures, the reporting lines, rather than simply saying 'when I look at this whole business model... it's all too risky'." Referring to the news on Friday that HBOS expected an annual loss of £10bn, he said: "The losses that have been revealed this week, I would point out, are not huge surprises to the FSA" He said the authority had predicted such losses when carrying out stress-testing in October.
Just as there was a review after the Northern Rock debacle, so will there be another one now. Lord Turner is reviewing financial sector regulation and will publish his findings on 18 March. His review will make "very major changes" to how banks are regulated, such as how much cash they have to hold in reserve, and changes to rules on credit rating agencies and how bankers are paid.
Lord Turner defended the decision to pay bonuses to the FSA's staff, adding that the FSA's chief executive Hector Sants would not be taking a bonus. The rest of staff, by not getting bonuses means average pay cuts of 15%. This is at a time when many are saying the FSA needs more and much better staff and therefore needs to pay much higher salaries.

Saturday, February 14, 2009


UK Financial Investments Ltd. (UKFI) already owns 100% of Bradford & Bingley and Northern Rock, and 68% of Royal Bank of Scotland (RBS) and 43% of Lloyds Banking Group (LBG), the merged Lloyds TSB and Halifax Bank of Scotland (HBOS). The total commercial banking assets this represents exceeds about $4 trillions and is therefore the biggest financial services group in the world! By virtue of being a government agency, UKFI and those parts of its conglomerate that are nationalised - all this by law now stands outside of regulatory supervision of the FSA and other national financial regulators in Europe including C-ebs at the EU level. Now the opportunity has arisen, following the LBG interim trading statement, to complete the entity neatly by increasing the government share of LBG to more than 50%.
If this is what Eric Daniels, CEO of LBG, wants to have happen, then fine. He told the Treasury Select Committee that except for the takeover of HBOS his bank would not have been in need of a government shareholding (liquidity infusions via the Bank of England is another matter). If it is not what he wants to happen, then I suggest heads should role for the cack-handed way in which the interim trading statement was drafted and announced. As argued in the my blogs in the figures have been misrepresented giving a false impression of the underlying profitability and soundness of HBOS.
Speculation is mounting in the UK media that the Government may be preparing to increase its stake in LBG, after Chancellor Alistair Darling declined to rule out the option of nationalisation, having previouslysaid it is undesirable. The group stunned the City by warning of £10 billion in annual losses at HBOS, which it rescued with direct Government backing, involvement and approval when Lehman Bothers collpased on 15 September 2008. The takeover completed on 16 January 2009. LBG may have thought that results for the period preceding the takeover completion would not have had a dramatic effect on its shares and other bank shares. If so, that was a foolish assumption, not least now that short-selling is again unconstrained.
UKFI owns 43% of LBG after the government pumped £17bn into the two banks, and was left with paper losses of more than £2.5bn at a low point yesterday when Lloyds' shares had fallen 40%.
The Chancellor, Alistai Darling has defended the Government decision to broker the merger of Lloyds and HBOS and offer financial backing, saying that failure to do so would have brought down HBOS and potentially collapsed the whole UK banking system.
Speaking from the G7 finance ministers summit in Rome, he said the immediate priority was to identify banks' bad assets and "put them out of the system", warning that without this step normal lending to businesses and individuals cannot resume. The official reason for the merger was funding (liquidity risk) which means inability to fund the gap between loans and deposits. This lies more essentially at the heart of the problems of the banks - wholesale funding so that the banks will not have to dramatically call in loans and reduce their loanbooks by up to 30% at worst. The funding gap in UK banks is about £800bn to be reinanced over 3 years and £185bn has been supplied by the Bank of England's SLS in 2008, and another £200bn or so will follow in 2009. So, arguably, this is all being taken care of via the Bank of England.
Asked on two occasions during an interview with BBC2's Newsnight whether he could rule out nationalisation of LBG, Mr Darling did not do so. Instead, he responded: "I said in January there is a range of options that we will be deploying, a range of levers that can be pulled to help all banks, because I have made it very, very clear that the integrity of the banking system is very, very important. What we are focusing on at the moment is making sure that we can identify these bad assets and then deal with that problem. That's our focus at the moment and that will continue not just here but it will continue across the world as well."
Liberal Democrat Treasury spokesman Vince Cable, who has become an always available ever-ready gloomy crtic of the government, said: "It looks increasingly as if Lloyds is being dragged under by the dead weight of HBOS, a financial disaster created by Andy Hornby and his predecessor, Sir James Crosby. Obviously we need to digest the detail, but it looks increasingly as if Lloyds HBOS will now go into majority public ownership, followed inevitably by nationalisation." Ken Clarke, for the Conservatives, is in catch-up mode and finds himself echoing the Cable.
Eric Daniels who undoubtedly felt he had the trust of the government and therefore may have believed they would take his opinion on the matter, may now find that he has no more freedom for manoeuvre than he gave HBOS and his bank is now firmly in political hands and what happens to it will be determined by the Treasury.
The Conservatives have been most anxious that the Government's control should be arm's length and temporary.
This was transparently not so in facilitating the Lloyds TSB, HBOS takeover/merger. Eric had insisted on no reference to the Competition Commission. The Government complied, but found that this was roundly resented. There was a lot of popular and even institutional tacit support for the action by the Merger Action Group before the Competition Appeals Tribunal to make the case for referral to the Competition Commission as recommended by the OFT. Eric wanted the freedom to determine himself what parts of HBOS to keep and what to sell. Now all of that commercial latitude may be taken away and will be decided by the Treasury's UKFI board. How it operates and decides matters is not subject to FSA approval or Companies Act or Code of Conduct.
The remaining private shareholders are along for the ride, very much on the tiger's back. Some of the major institutional investors may have envisaged no more share value dilution and opportunities to cherry-pick in the HBOS carcass. One law that will not apply, however, is that if LBG is nationalised whatever is sold out of HBOS parts or Lloyds TSB parts will be subject to full EU competitive tender and the decisions will be by UKFI board, not the LBG board. The commercial freedom to exploit the merger that Eric Daniels so ravenously desired will be lost to him!

£30bn Gap of Gloom?

Shouldn't this be weeds in the picture, thistles and cowslips especially?
The lack of attention given to the Bank of England’s forecast for the economy is bizarre, according to the FT and other organs.
Mervyn 'Midas' King basically said the recession, from peak to trough, will be two times worse than the Treasury expects. Given that the BoE is showing a narrow V form to the recession and recovery, not a U or L shape, this is not at all so? The BoE chart is extremely optimistic, surely? I hate these fan-tail monte-carlo style forecast charts. They just tell me there is too much loose analysis in the modelling. Look at the range of possible GDP growth in 2010. That is shameful economic forecasting, especially if the central projection is merely the median of such a wide range of possible outcomes. I cannot believe this vouches for credibility in the BoE's or the Treasury's macro-economic models!
Anyway, the forecast knocks about £30bn to £40bn off official GDP forecasts, hits the Government tax take we are told by up to £20bn and raises the deficit from 8 to closer to 10 per cent of national income. You have to wonder why David Cameron decided to raise the 2% VAT cut in the Commons on Wednesday PM Questions and ignored the big “gloom gap” between Gordon Brown and the Bank of England. he got short shrift on VAT by being told that the IFS said it was effective - to the tune of about £12bn.
But, when it comes to Government Revenues where is the income from £185bn in treasury bills at 1% offset by $245bn in ABS received paying LIBOR plus say 25bp. That alone means £6.7bn. Add to this £57bn paying 9% worth another £5bn. On February 12 (Bllomberg), “Prime Minister Gordon Brown said bank shares bought by the British government as part of his rescue packages will ultimately make money for the taxpayer. ’I believe over time that the value of these shares will rise,’ Brown told a panel of lawmakers today.” let's assume the banks share rise 20% this year, which from their low base is feasible, that's another £10bn. A further £250bn in BoE swaps are likely, worth another £7bn. Total £28bn, repeatable in 2010 and 2011.
For those who are interested, the BoE calculations are based on this Bank fan chart and not a straight comparison with the Treasury forecasts, so the figures were put into a spreadsheet by Chris Giles, FT economics editor, who did the sums to find that, "The Bank’s forecast, after taking account of “downside” risks, suggested the economy would shrink by more than 3.5% in 2009 with only anaemic growth in 2010, ... far worse than the Treasury’s expectation of a 0.75% to 1.25% contraction in 2009 and 1.75% growth in 2010. From peak to trough, the risk-adjusted estimate from the Bank predicts a 4.6% economic contraction, about twice the latest Treasury forecast. The Bank’s prediction is that we are living through a period that is worse than the 1990s recession and on a par with the 1974 recession, but not quite as bad as the early 1980s. What is really terrifying is the Bank putting more than a 10% probability on Britain seeing no growth until 2013."
I suppose that to be a more than 10% probability that banks will not maintain their 2007 UK lending levels? What does this mean politically? According to the FT, "Brown and Darling’s PBR estimates were far too rosy". But, are they. This depends a lot on the effect of an 8% fiscal impulse. And that surely is the basis for the very sharp recovery.
Compared to all 20th C recessions, recovery averages 5-6 years to get back to pre-crash peak. The BoE fant tail media shows it could happen far quicker!
The FT says "the budget will be grim". No it won't, not for tax-payers, this is a borrow now, pay later maybe or maybe not? Also an 8% fiscal impulse is exactly becoming the international norm. If everyone does it then everyone benefits - no beggar-thy-neighbour strategies.
The FT says, "The chances of a noticeable upturn before the election are tiny." Not according to the BoE chart they're not!
See comment for more on 2nd Treasury Select Committee questionming of the banks.

Wednesday, February 11, 2009


John McFall MP for Dunbarton East, Labour, Chairman of the House of Commons Treasury Select Committee: Hearings Tuesday and Wednesday 10th and 11th February 2009
Introduction by John A Morrison (
"The Thatcher Room in Portcullis House, Westminster; became the Court of the Star Chamber for British banking this week. One of the MPs actually wondered aloud what Henry the VIIIth might have done in these circumstances; “Off with his Head”. This was “The Spanish Inquisition”.
One crucial conclusion is that the letter to the Treasury Select Committee by one Paul Moore (an ex-Risk Manager of the parish); which letter being the basis for the resignation of Sir James Crosby from the FSA and much huffin' and puffin' at Prime Minister’s Question Time; is a chimera, a journalistic running up the flag pole. “Moore's letter is an effective distraction. It makes some good points, but ultimately it diverts attention from more truly serious matters,” (even if it has led to the resignation as deputy Chaiman of the FSA of James Crosby.)
Now we have that out of the way, Robert’s notes on the details of the conversations point to the substance of the issues debated and where we can learn lessons for the future;- Sir Fred actually nailed it early in the debate; the issue was Stress Testing and the inadequacy of historic accounting values in alerting a board as to what risk was likely to look like even 3-months ahead on alternate scenarios.
Lord Stevenson referred repeatedly to Basel II and to HBOS’ elaborate committee structure underpinning risk management but those of us who follow agile techniques understand completely that committees just obfuscate and create “delay worry and expense” to use the Edinburgh phrase.
Buying ABN Amro's investment banking business was a disaster for RBS, a pig in a poke (I thought someone was actually going to use that phrase) again mainly because RBS personnel had followed good old fashioned due diligence techniques of the “wee Scottish CA”! (including 18 board meetings when ABN AMRO was on the agenda). No consideration was given to exploring downside risk using quantitative techniques (to allow the board to examine the interdependence of a multivariate equation, which is what risk really is - not a topic which can be managed in committee). As a senior Scottish banker once remarked to one of his committees; “we are running a bank here, not a philosophy department!”
J.A.M. by Robert MCDowell:
With financial journalist Ian Fraser, I watched the Treasuring Select Committee questioning of 4 top bankers for 4 hours while being filmed and interviewed by BBC Scotland's Raymong Buchanen. Next day we were interviewed by South German television, Bayerische Rundfunk, and there will be an upcoming Channel 4 film too about HBOS.
First, to make it absolutely clear - to borrow the favourite politician's phrase - the banks did not collapse because of their simple hubris and belief in asset values forever rising; they failed because of the loss of confidence in the banks ability to refinance their wholesale funding and this resulted from complete failure at stress-testing of economic scenarios as legally required by the CRD (Basel II Pillar II) and inability to imbed the new Basel II risk culture fully and properly. This failure had typically a lot to do with the status of risk professionals and the inevitable clash between finance and risk and of risk and finance with structured products divisions. Above, there was a failure to integrate economics modeling and forecasting into risk management and business strategy, despite the undoubted resources available to the banks to do this well. This biggest failure may therefore have been the sidelining of economists by top bankers in favour of mathematical engineering as the intellectual basis for risk valuations.
Eric Daniels of Lloyds TSB as well as Andy Hornby ex-HBOS CEO and Fred Goodwin ex-CEO of RBS have each emphasised their problem was funding (liquidity risk) and not credit risk. Stephen Hester, Goodwin's replacement said RBS purchase of ABN AMRO's investment banking doubled the bank's exposure to structured products.
Treasury Committee Hearing
On 10 feb the 4 bankers questioned: Sir Fred Goodwin (FG) ex-CEO of RBS (nearly $3tn assets, 40 million customer accounts); his ex-Chairman Tom Killop (TK); Andy Hornby (AH) ex-CEO of HBOS (over $1tn assets, 22 million customer accounts) and his ex-Chaiman Lord Dennis Stevenson (DS).
The 4 bankers and the questions (Feb 10) put to them did give clues to what went wrong, but a coherent explanation did not emerge; this was clouded over by the interest to find how these men are personally guilty, despite this not being the purpose of the hearing or the motive of the Treasury Select Committee (TSC), but everyone knew this to be what the public & media wanted to know? The smoking gun that has now animated media comment is Paul Moore's letter to the TSC. He was the GRR (Head of Group Regulatory Risk at HBOS) 2002-05. What he says seems important.
But it is also a distraction. I know very well how typical it is of what happened to many risk managers, but I could tell over a dozen similar and more important stories. It does point to key governance matters addressed in the CRD (Basel II) legislation that were ignored by ignorant executives. But, what Moore has to say does not go to the real problem. (for discussion of the letter and how it exonerates Hornby and Stevenson see Note 2 below)
The other important points arising are:
- all said sorry to whomsoever, to everyone and anyone, but they passed the
- blame on to unexpected "wholesale crash of the wholesale markets" and
- FG emphasised the 2 weeks following Lehman Bros. collapse (15 Sept.)
- both banks admitted to growing too fast (but only in hindsight)
- none of the 4 bankers had banking qualifications (only high-level experience)
- all claimed to have sufficient banking expertise around them
- AH and FG both claimed to preside over a collegiate collective of experts
- with regular involvement with FSA that approved their strategies
- questions as to how it was they claimed solid performance up to and including 16 Sept. got no admission of having made false or misleading statements to shareholders and markets, or of market abuse!
- DS came close to saying they'd used gloss to calm the markets, but stopped himself
- Jim Cousins MP asked TK if he'd consulted legal advice on criminality; answer: no!
- Cousins said UK banks had lost £120bn in securitised assets & got no clear answers!
(This was from page 16 of BoE Stability Review - see link below)
- no clear answer to why UK taxpayers are supporting non-UK loans (e.g.Citizens Bank owned by RBS, the 6th largest in the USA)?
(Note that only 15% of RBS loans are to UK borrowers, and several £billions of Bradford & Bingley assets are GMAC US mortgages and US car loans. Hence £tens of billions of UK Government funds are supporting US loanbooks.) Halifax Bank of Scotland HBOS - over £600 billions of assets Lord Dennis Stevenson ex-Chairman (DS) Andy Hornby (AH)
- AH blamed funding but agreed the bank's takeover was a commercial decision!
(implication is then that it should have been referred to Competition Comission!)
- AH said he felt no personal blame (clearly minded to blame the Crosby inheritance, even if he was 7 years responsible for retail on the Crosby board before becoming CEO for the last 2 years)?
- he also blamed bonuses rewarding wrong kind of behaviour, and
- failure of risk systems in "banks all round the world"
(Failure of markets are a systemic and global matter, but there is no excuse for inadequate or failing risk management systems given the years of renewing regulations and accounting standards other than foot-dragging or incompetence. The failures of banks are shared not only collectively but individually, especially in the case of those banks who found themselves exceptionally exposed to the largest 'funding gaps' which is clear sign of irresponsible and excessive growth in risk exposures, of seeking to grab maket share when others were behaving more prudently!) - because of the Paul Moore issue, AH was able to shift blame to James Crosby!
- he said takeover (by Lloyds TSB at a small fraction of book value and after 90% share price collapse) was good for shareholders, employees and the bank's continuation (possible interpretation: little or no analysis was attepted on how the bank could survive independently, especially when Government and Bank of England intervention measures became stronger and more comprehensive?)
- DS said no other bank offered to buy the group, which was
- no answer to what if bank could've stayed independent? even if meant becoming temporarily nationalised?
- he said his bank's scenario stress-testing was totally inadequate and said this was serious! (This is like an 757 pasenger aircraft pilot admitting to flying blind in fog without a properly functioning instrument panel!)
- he was only the one to mention Basel II, but said little further of substance about it
- he admitted over-exposure to property developers, but
- he mitigated this by saying the bank decided to stand by its long term customers
- on governance they claimed to have excellent non-execs and
- that every risk cmte had a non-exec to report to (trashing Moore on that point)
- that means bank risks were considered in disaggregated ways, not holistically!
- Crosby sacked head of risk who whistleblew in '05, replaced by a sales-banker!
- FSA approved and KPMG investigated (so Crosby has paper defences on this!) Royal Bank of Scotland RBS - over £2 trillions assets (most of its outside UK) Tom Killop ex-Chairman (TK) Fred Goodwin ex-CEO (FG)
- Cmte assumption was bank's failure was20buying ABN AMRO
- but the reasons for buying it were not elicited (e.g. to get hold of more ABS)
- questioned on 27 takeovers, FG said most asset growth was actually organic!
(This can be challenged e.g. most profits coming from derivatives & struct. products?)
- the scale of US sub-prime exposures of Citizens and Greenwich not elicited
- FG said Greenwich only intermediated and Citizens did not do sub-prime loans
- asked about sufficient capital for Greenwich, FG fudged his answers
- asked about Greenwich's leading role in structured product markets in US, ditto
(can of worms, 85% of loans ex-UK according to HoC Banking Bill debate same day!)
- TK couldn't say what % of £20bn write-off was ABN AMRO or what the rest is?
- but later admitted the £10bn cost of ABN AMRO purchase was totally lost!
- FG said blaming him would not explain anything.
- he also said his integrity should not be doubted.
- he, remarkably, couldn't be clear on value of, & loss from, ABN AMRO
- he tried to say this investment could "still come good"?
- he said his leverage (funding gap) was medium rank (absolutely not)
- all knew HBOS was highest, higher than RBS (and both above others)
- he excused funding gap/ leverage as being so much less than that of hedge funds
- FG said he'd raised £24bn Jan-Aug '08 (+£12bn rights) - (but this is far too little!)
- TK&FG admitted reserve capital ratio was too low at time of ABN AMRO deal
(half of the minimum - so what did FG think he was buying in ABN AMRO, a solution to his reserve capital problem? - not asked? In fact, the deal meant doubling RBS exposure to structured product assets, including especially toxic CDO2 and unique CDOs, roughly in my guesstimation from about $90bn to $200bn!)
- TK&FG were not quizzed re. too little capital for the bank's general growth
(I suspect RBS tried to take some kind of advantage of Basel II not yet being firm law in USA?)
- ironically TK admitted that ABN AMRO's sale of Bank LaSalle greatly improved the deal for RBS (yet at the time the opposite was vehemently stated, and the sale was an attempt by ABN AMRO to fend off the RBS-led consortium bid. RBS FG showed zero compunction about offending the Dutch Regulator DNB, whose Chairman Nout Wellinck was also Chairman of the BIS BCBS author of Basel II, which indicated disrespect for regulatory laws and prudential standards, and not least for serious matters of a national concern; he and his board clearly believed global banks like RBS to be above national concerns and thereby also above matters such as customer loyalty including corporate clients. ABN AMRO shareholders are also to blame, however, for holding out for €3bn more and in cash in a €68bn responsible and sensitive 'merger' bid by Barclays that would not have meant the dangerous break-up of ABN-AMRO!)
- motives for buying ABN AMRO were questioned but not as to precise reasons?
- FG attempted to describe securitisation tranches & that banks surprisingly latterly sold even the highest risk equity tranches (in trying to explain why fundamental high-rated values had been traduced by market panic - but his line on this was cut short! It was clear, however, that FG did not accept market prices and did not understand the economics behind of market prices! His mentality is that of a book-value accountant only! He was cut off - not today's issue - & anyway he can't teach the Trsy Cmte anything on this that they do not already know a lot about.)
- FG nevertheless extolled the rating of ABS and CDOs as triple-A and double-A! (He might have gone on to state that defaults rates gave no warning until it was too late, but that is precisely the point of scenario stress-testing, because shocks are sudden and unexpected and have to be accounted for nevertheless. This was not a California earth-quake, but what there is past experience for even if it means going back 80 years). - he only admitted to first doubting values after March '08 when Bear Stearns failed!
(after 6 months of ratings downgrades had already been coming thick & fast and half of all CDOs defaulted and much ABS collateral had been sold at 80% discount to face!)
- he was shocked by rapidity of market collapse (This shows the worst economics naivete given that the solid average period for market and economic collapses are sub-1 year and recoveryies are 5-6 years i.e. FG had no cyclical awareness, which is a primary concern of all regulators, to ensure all board members personally understand this and to determine if they are professionally competent to accept regulatory fiduciary responsibilities!), and not just because of government shareholdings, but as an international legal reposibility. OUR FINDINGS:
- I suspect that in 2007, FG focused far too much on ABN AMRO & lost the plot on everything else going on. TK said the board had 18 meetings after April that year that discussed ABN AMRO, more than one a fortnight. This is far more than normal, hence most of the meetings may have only discussed ABN AMRO. This will be checked by the Trsy Cmte. TK offered the Trsy Cmte list of all the meeting agendas. That should be taken up to see whether the Credit Crunch was given at least equal consideration at this time!
- There was not enough searching detail on both banks 'funding gaps' (RBS £168bn, HBOS £193bn, each greater than several other important banks combined). This is the most important aspect of the iceberg that is 'the credit crunch'. This is probably obvious to the Trsy Cmte that both banks had striven to grow too fast using off-balance sheet securitisations, but that the 2004-2007 timing of their assets growth had the result of a ballooning of refunding requirements in 2008/2009 just when the wholesale markets closed down (some say entirely aftr Lehman Brothers failed on 15 Sept. and AIG was nationalised i.e. both banks grossly failed to adequately understand their liquidity risk - basic concerns of properly trained bankers, which these 4 guys are not! (see NOTE 1 below)
- Media comment and some of the Trsy Cmte comments focused on the obviously absurd expectation among the banks that property values would always rise. That was not the big problem! The really important (irresponsible) assumption was that wholesale interbank funding (to fill the funding gap) would always be available, and even when property values would fall and markets go through whatever corrections! The bankers mistakenly assumed the credit crunch would be a temporary blip, not prolonged! This again shows indifferent or careless ignorance of 'credit cycle' economics.
- In none of their replies did the bankers refer to risks by their proper name e.g. liquidity risk or market risk or credit risk etc. Neither did they refer to "economics", not even when asked about qualities needed on their boards did they think to mention 'economists'! (This is a widespread penemonen where bankers fear to have economists on board, preferring mathematicians and accountants only)
- The MPs failed to question is any of the bankers if they understood economics? In fact, the biggest excuse they are hiding behind is the 'black swan' get-out-of-jail free card of "we faced totally unexpected shocks from circumstances beyond our control that hit all banks not just us" etc. What is really clear, however, is that the banks were the 'black swans', and only from the neck up, the South American variety? - DS's point about the failure of his bank's stress-testing should have been put to RBS also, and was almost, then not? The Trsy Cmte thought better of going there as soon as TK (a Pharma maths expert with a lot of boardroom banking experience) indicated he was ready to explain in exhaustive opaque detail just how complex the analysis of all this is including all the ways of doing risk stress-testing. (Given how Pharma companies do this he would have explained monte-carlo analysis which is actually almost wholly irrelevant to medium and long term risk economics.)
- But, the Trsy Cmte could have asked what importance and resource did they commit to this and did it fail in RBS, and as DS said it failed in HBOS? What analyses did they do is only marginally less important than what were the results?
- And in this context the Trsy Cmte could have asked the 4 bankers for their understanding of how their banks managed their funding gaps and the scale of these? But, it was clear from the start that this is precisely where the 4 expected questions to go to and were prepared with answers about the worldwide collapse of wholesale money markets, of interbank lending following first Bear Stearns and later Lehman brothers collapse, such as when FG tried to talk about CDS and monoline insureres, and blame it all on a general loss of confidence in banks.
- A key question, however, would have been, did any of the 4 directors ever see any analyses showing how their respective banks capital reserve could be 100% or 200% wiped out, and when they say no, ask why not, and then ask is it because they did not understand the vital importance and fragility of their capital reserves that taxpayers money has had to be committed, and that is really why their banks shares crashed?
- Another question should have been to ask the bankers if their past vows to protect shareholder value was mere rhetoric?
- Was it not so that when wholesale funding became expensive they refused to pay the price and fooled themselves that this problem was temporary?
- And when it was not temporary they resorted to Bank of England and Government support?
- Had they sacrificed £150bn of shareholder value for the sake of saving 200-300bp on top of LIBOR (falling) on interbank funding costing i.e. to save a mere £6bn?
The question of UK Financial Stability (systemic risk)
The 4 bankers interviewed on Tuesday were not asked about this aspect, although it was the reason (officially)for the takeover of HBOS by Lloyds TSB and for pumping government capitalisation funding and guarantees into the banks (in return for certain conditions such as maintaining 2007 lending levels - to which Hester, new RBS CEO reported on 11 Feb, his bank had increased retail lending by 10%?
They were asked about the warnings given by the Bank of England (stability reports) and why they had not heeded these warnings? FG said they had heeded these warnings. But this matter needed more enquiry as this answer was of doubtful quality. What did the bankers recall of those warnings, what precisely the warnings told them, and how did they comply with them? What did they understand of their responsibility in the economy and to the wholefinancial system?
Just as one of the media highlighted findings from this hearing is that none of the 4have qualifications as professionally trained bankers (despite TK saying new directors get taken through an exhaustive induction process and that there were many sessions to learn about risk) the fact is that equally important is what did they know or understand about economics? What we have are 4 bankers who like many others were helicoptered into 'boardroom banking' without thorough experience of the work by rank and file bankers in the engine room. Similar accusations may be levelled at engineers and mathematicians helicoptered into structured finance and derivatives and allowed to play with $billions involving traditional banking assets without understanding the reality of these; they are nor mere numbers games! Hester (on the 11 Feb)for RBS admitted to over $500 billions of derivatives exposure NET, which raised McFall's eyebrows as high as they can ever go! This number will be more forensically examined!
Except in this one case, Hester, even alongside Varley and Daniels, came across extremely well as one of the most astute bankers to have as yet appeared before the Trsry Cmte, and he a government appointee, ex of Credit Suisse and British Land!
Wednesday's hearing with Abbey (Santander), RBS, Barclays, HSBC UK, and Standard Chartered.
Questioning began with how much public funding support the banks had received. All said they were not allowed to say how much they obtained via the Bank of England's SLS. (Though we know the total to be £185bn from £285bn of asset backed collateral). On bonus-culture all said this was under severe review. John Varley (CEO Barclays) interestingly referred to Basel II counter-cyclical awareness by banks suggesting that economic cyclical understanding was weak among the banks! (At Treasury Questions on Feb 13, the ministers stated that stress-testing is central to diuscussions with the banks and central to the G20 London Conference in April when improvements to global financial regulation will be progressed. These issues go to the heart of matters that John Morrison and I have advised and publicly argued for years concerning Basel II Pillar II. It should be noted that the Trsy Cmte's questioning of the big 4 auditing firms elicited that they have no legal or fiduciary responsibility and may lack expertise or resource to audit the risk models and stress-testing and Pillar III statements of the banks. Beyond how these aspects are now part of IFRS7, the auditors when qualifying or appending notes to accounts are not expected to encompass these matters when deeming the solvency of the banks for the next 12 months after the accounts are signed off. The Trsy Cmte is determined to address this important topic! By doing so the implications will be international and the Trsy Cmte is conscious of EU liaison on these issues.)
Eric Daniels (CEO Lloyds Banking Group) said taking over HBOS was for systemic stability reasons, without which the bank would not have needed government funding support, but that the takeover would prove good commercial value for Lloyds. Daniels said 5,000 man-days of due diligence was done on HBOS purchase, including advisory firms and law firms! (At a reputed cost of £130m, reliably reported elsewhere, perhaps he had meant to say 'man-months' including weekends?)
On the question of governance, Hester said non-execs should deliver strong constructive challenge to the executive. On whether splitting traditional banking and investment banking should be separated given their different cultures, Varley said it is important to have investment banking experience on boards and in banks, especially the most esoteric parts of it as part of the challenge. The implications here, which I believe is totally valid, is that it will not be possible for the banks to return to traditional banking only where loans and deposits are equal. This does not mean, however, that reviing Glass-Steagal is not a practical option. In the present circumstances, however, when Morgan Stanley and Goldman Sachs have both turned themselves into 'banks' to be eligible for central bank support, and given that banks have immense problems that would impact economic growth if they had to reduce their funding gaps quickly and subsequently only grow at roughly the pace of growth of cash deposits i.e. a purist 'transmission mechanism'? Therefore, some hybrid combination of safeguards are required. And, furthermore, some aspects of these will have to extend to 'investment banks' and the 'shadow banking' sector.
The Treasury Select Committee questioning has focused more on retail banking than on investment banking, more on what the public understand such as credit risk matters, less on market risk in both cash markets and derivatives markets. The banks were not asked about bringing 'over-the-counter' money and credit markets 'on-exchange' or about their 'own-book' portfolio trading in the markets, or about swapping assets between 'banking book' and 'trading book'. The auditors were not asked about this either. But these are issues that the Trsry Cmte is concerned about including 'fair value' etc. The bankers were asked about 'bad bank' and insurance options for dealing with toxic assets and did not give definitive opinions. At Treasury Questions (13 Feb) The Chancellor indicated he was waiting on the details of the US measures recently announced. His team also reported that all EU countries are now delivering proportionally the same re-capitalisation funding and fiscal responses as had been led by the UK (and the USA). (But, we still lack a clear statement as to the precise scale of this along the lines that we have calculated at reported here and elsewhere i.e. one times banks capital reserves plus 8% ratio to GDP fiscal impulse, with the banks tasked to recover another one times capital reserves while maintaining lending levels of 2007, but with changed composition.)
NOTE 1: UK Banks Funding
Pages 8 & 9 show total UK banks' funding gap over not much over $700bn. Page 29 graphic shows c.£240bn of banks' bonds maturing in 2008/09/10 but a ctually approx.£800bn of refinancing is required in next 2 years! In fact, RBS needs £266bn, HBOS £156bn within a year, Barclays £176bn, Lloyds £96bn = nearly £700bn! UK banks got £185bn from Bank of England SLS, £50bn from UK Gov funding, £51bn rights issues, £250bn Gov. Guarantees = £536bn leaving residual raising required of about £194bn this year and £70bn next year (possibly most from Bank of England's new liquidity window, "son of SLS") less whatever has been borrowed via ECB liquidity funds.
Tuesday afternoon also saw the House of Commons (less than 20 MPs) debating Lords amendments to The Banking Bill which authorises working capital funding for the banks in which Government has a systemic interest. The main issue appears to be that HM Treasury does not want to report to Parliament quarterly but on a 6 months basis (first report next October) about working capital money given to the banks (including what the banks claim from Gov. guarantees) and not to name he actual institutions supported, and with the deemable right not to make any report at all!
Hence. we might not know directly from Government what of the £264bn still required by banks and £250bn guarantees is used, not until some indeterminate time after next October, with broad totals only by that time, though not necessarily so.
At Treasury Questions, the Chancellor was asked when the Acting Chairman of the UKFI would be permanently replaced? This is in process. The failures of the FSA were also raised. Essentially the answer was that notifications of problems in the banks were not notified to the Treasury until the crisis was obvious to all! What this confirms is that the FSA has treated its supervision as too confidential and the lack of liaison with the Bank of England (which has systemic risk responsibility) means that individual bank details pertaining to systemic problems could not be discussed even by the Bank of England with the Treasury! What has also not yet been asked is the regulatory status of the bank holdings of UKFI. These are by law now outside of regulatory law - unless the FSA can continue to supervise at Government behest and or focus on banking licenses and bancassurance subsidiaries belonging to holding companies that are nationalised? The legal precdent in EU law is established by the nationalisation of Anglo-Irish Bank.
NOTE 2 Moore's letter to Treasury Committee
Moore writes that in Nov. 2003: the FSA had assessed key parts of the Group as posing high or medium-high risks to the achievement of its statutory objectives of maintaining market confidence and protecting consumers; the risk posed by the HBOS Group to the FSA's four regulatory objectives is higher than it was perceived" and, about Halifax (retail): "There has been evidence that development of the control function in Retail Division has not kept pace with the increasingly sales driven operation. There is a risk that the balance of experience amongst senior management could lead to a culture which is overly sales focused and gives inadequate priority to risk issues." Moore does not say what risk issues are referred to? These appear to me to be FSA Arrow comments and all board directors read those. The Boards also have to sign off formal reports to the FSA setting out the banks risk accounting and risk management framework etc. Moore warned in 2005 that the bank was growing its retail business too fast. He complained to his boss, the CFO, of mistreatment by others in group finance. He wanted to question the retail "operating and strategic plans" to the board? And it seems this was objected to by others in Finance on the usual grounds of being probabilistic (stochastic) and just guesswork (forecasting) as reflected in, "the sentiment that constantly questions the competence and intentions of GRR carrying out its formal accountabilities for oversight plus the ever present need to be able to prove beyond reasonable doubt as if we were operating in a formal judicial environment" when the strategy had most likely been financially okayed, but a formal doubt to the board meant an underling going over the head of the CFO, Mike Ellis, who may have considered this a bid for GRR promotion to the board (something Moore's successor acheived).
Moore writes, "I was obliged to raise numerous issues of actual or potential breach of FSA regulations and had to challenge unacceptable practices and the conduct of others in fulfilling their obligations under the Principles for Approved Persons including very senior executives." I understand this well. I'm sure he did the above. Everyone in his position had to be doing that, being irritating (otherwise called 'a challenge'), some lacked guts or confidence to do so. Can we presume that of his successor?
Dennis Stevenson said there had been an external enquiry (by PwC) validating the bank's risk governance. DS also shifted the problem in line with Moore's letter to the James Crosby period and DS with Andy Hornby said they had cut back from 2006 on and even reduced the bank's mortgage maket share latterly. (In 2008, that is true, in a 50% smaller market, HBOS share of new business went from 20% to 8% and Lloyds TSB from 8% to 20%!). Both Stevenson and Hornby said they had begun in 2006 to cut back in assets growth but in hindsight should have cut back more. This helped them to shift the blame (from Moore on risk governance issues) onto James Crosby, who according to Moore's letter personally sacked him and it was this bypassing of HR processes that got him an out-of-court settlement i.e. his sacking was improper, but a settlement does not prove his allegations?
This helps Hornby to get out from under the accusation that he wanted to keep pushing sales growth in mortgages when Crosby wanted to cut back and - as an earlier story in the media had it - that was why Crosby had to go when the board backed Hornby's strategy. Stevenson and Hornby may have agreed this would be their tactic since both backed the line that they had been cutting back on growth, had held the composition of assets steady and slowed or stopped new lending e.g. sticking with long term customers only in property and construction. Hornby also said his bank's funding gap was inherited from Crosby! The resignation of Crosby on Wednesday helps to sustain this proposition. So we have here a testable claim by Stevenson and Hornby that they were not responsible for over-ambitious (foolish or irresponsible) retail sales growth or for the funding gap? I think this is disengenuous at best.
The Treasury Committee questions did not focus enough on funding, liquidity risk, and nothing on systemic risks to UK banking. The questions gnawed at bonuses, banking qualifications, risk reporting access to non-exec directors, and governance, to get to the issues raised by Paul Moore's letter. My impression is that this much of this line of questioning had not been deeply considered and displaced other questions arising out of the longer term work of the Treasury Committee. The blaming of Crosby was picked up as an issue by Conservative ministers and clearly he had to resign not least to retain confidence in the Treasury Committee as well as the Government and the FSA.
When Moore writes, "My team and I experienced threatening behaviours by executives when carrying out its legitimate role, in overseeing their compliance with FSA regulations". This is frankly sadly normal and what good risk managers know to expect to deal with. Moore does not refer to funding risk. He also blames his own dept. by writing: "Actually, the responsibilities for getting into the current position are held all around the organisation and not just in Retail... and I include Group Risk functions in this. What would be absolutely fatal would be if there was ever a perception - explicit or implicit - that different parts of GF&R took different views." He is indicating here the gulf within Group Finance & Risk and by threatening something 'absolutely fatal' sounds like proposing to make differing views known - perhaps to the FSA - and/or insisting Finance has no choice but must agree with Risk?
This is a severe problem that is common to all banks. Finance and Risk are different cultures and cannot be happily integrated and must perforce be challenging each other and become rivals for board attention. But, no questions were asked by the Trsry Cmte about risk accounting and finance accounting differences and where in understanding the issues between these two should might triangulate the problem. The 4 directors gave a clear message that the problem was wholesale funding (the 'funding gap") but this aspect was not pursued directly!
Moore's letter focuses on the sales culture in retail, "...exactly what level of sales growth is achievable... without putting customers and colleagues at risk" which is curious phrasing, but could go straight to AH as being to blame as he was in charge of retail, or a risk appetite question or one risk diversification, of capital reserves, or of liquidity? Was Moore aware of the bank's ABS, covered bonds and MTN programs? Behind the retail sales strategy was a very aggressive off-balance-sheet funding plan, which knew precisely the enormous funding gap and intended to make it bigger! (I have copies of these strategies & sales piches to board and counterparties.)
That information was witheld from the board is also typical. Similarly, future funding plans and much else were probably withheld from the GRR. Moore writes, "I was strongly reprimanded by the CFO for tabling at a Group Audit Committee meeting the full version of a critical report by my department making it clear that the systems and controls, risk management and compliance were inadequate in the Halifax to control its over-eager sales culture. Mysteriously, this had been left out of the papers." This might have concerned basic regulations concerning the sales pitch, cooling-off period, insurance cover, third party agents fees and suchlike matters, not the most obvious causes of the credit crunch? I don't know - the answer is not obvious from Moore's letter.
Moore's points imply severe criticism of the CFO Mike Ellis and also of Hornby in charge of Retail. but Moore redirects his criticism at Crosby! If the CFO was wrong, was he protecting his own accounts or Hornby, for applying ASDA discount pricing in place of prudential risk-pricing? Whatever the case, Moore's letter greatly helps Hornby and Stevenson by ending strongly, saying it was all Crosby's fault; the aggressive sales strategy was his alone!
Stevenson and Hornby appear to go along with this. DS offered the Committee the PwC Report. Will a between-the-lines interpretation of this support putting the blame onto Crosby! Hornby must be most thankful for Moore's letter! I expect the Treasury Cmte will support Moore's recommendation for "Regular formal independent audit of risk management, compliance and internal audit functions to keep them honest" Yet, that is what the FSA is already supposed to be doing and as Moore indicates has been doing? But, the FSA is due for more criticism and Moore provides a useful constructive form for this by saying the FSA needs more expert, much better paid people - I agree. Moore's letter is an effective distraction. It makes some good points, but ultimately it diverts attention from more truly serious matters.