Heidi Moore: Wall Street is winning the long war against regulation

In her Guardian column, Heidi Moore looks at how Wall Street is winning the war against post-financial crisis regulation.

Regular readers know that this is just a minor skirmish in the much larger war Wall Street has been waging against the regulations it was subjected to following the stock market crash of 1929.

In the aftermath of the 1929 crash, but not the 2007/2008 meltdown, Wall Street's behavior was investigated.  What the Pecora Commission uncovered was that everyplace there was opacity in the financial markets, Wall Street engaged in unsavory conduct.

As a result, the FDR Framework became the basis for the global financial system.  The FDR Framework combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

The FDR Framework makes governments responsible for ensuring that market participants have access to all useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Please note that the governments are made responsible for ensuring "valuation" and not price transparency.  This is intentional as valuation transparency is the starting point for the investment cycle and differentiates investing from gambling.

The FDR Framework also provides an incentive for market participants to engage in the investment cycle and independently assess the disclosed information as it makes market participants responsible for all losses on their investment exposures.

The three steps of the investment cycle are as follows:

1. Independently assess the disclosed information to determine the risk and valuation of an investment;
2. Obtain prices from Wall Street at which it would buy or sell the investment;
3. Compare the independent valuation to Wall Street's prices and make portfolio management decision to buy, hold or sell.  

Market participants gamble when disclosure does not provide them with all the useful, relevant information in an appropriate, timely manner.  Without this information, market participants cannot start the investment cycle and independently determine the risk and valuation of an investment.  Rather, they are simply blindly betting on the contents of a brown paper bag when they buy or sell the investment.

When all there is valuation transparency, knowing they are responsible for losses, investors limit their exposures to any investment to what they can afford to lose.  This builds market discipline into the financial system as investors link what they need to be compensated for making an investment to the risk of the investment.  This also builds stability into the financial system and eliminates concerns about financial contagion.

The only exception where market participants are not responsible for losses is for deposits at banks that are less than or equal to the level guaranteed by the government.

As demonstrated in the 1920s and again in the run-up to our current financial crisis, Wall Street prefers opacity.  Wall Street prefers opacity because it makes it impossible for investors and other market participants to properly assess the risk of and value an investment.

Wall Street particularly likes opacity when it has access to all the useful, relevant information in an appropriate, timely manner and investors and other market participants do not.  Examples of this would be opaque, toxic structured finance securities or the banks themselves.

Wall Street also likes opacity because it can hide behind the veil of opacity and manipulate markets.  Examples of this include all the benchmarks like Libor and foreign exchange.

Obviously, Wall Street's preference for opacity runs into the government's responsibility for ensuring valuation transparency.  This is a war without end.

Unfortunately, as shown by our current financial crisis, it is a war where periodically Wall Street wins a  battle.

If you look, you will see that large portions of our financial system are opaque.  Examples include structured finance and banks.  It is these corners of the financial system that froze at the beginning of the financial crisis and have not unfrozen.

Ending our financial crisis requires bringing valuation transparency to all the opaque corners.  One of the results of bringing valuation transparency to banks will be to subject Wall Street to market discipline (not just regulatory oversight where Wall Street can capture the regulator).

Thomas Hoenig calls attention to well known fact: banks operating without much capital

Thomas Hoenig created a ruckus by pointing out that Deutsche Bank is "horribly undercapitalized".  Naturally, Deutsche Bank responded that in the make believe world of Basel capital requirements Mr. Hoenig was wrong.

To settle the matter, Zero Hedge weighed in and noted that EU banks, including Deutsche Bank, needed upwards of 500 billion euros of capital.  Citing the work on EU banks by Benink and Huizinga, Zero Hedge noted

Banks are already saddled with ample unrecognised losses on their assets, estimated by many observers to be at least several hundreds of billions of euros and mirrored by low share price valuations...

This whole debate highlights two important facts about our current financial crisis.

1. Everyone knows that the banks are hiding losses and the extent of their hidden losses exceeds their current book capital levels.
2. Banks are holding policymakers and central bankers hostage by threatening that disclosure of these losses and the related lack of capital will result in financial instability.

Please note that if everyone already knows the banks have low or negative capital, then revealing the exact amount should not result in financial instability.  Revealing the exact amount simply confirms what market participants already know and lets market participants know how close their estimates of the losses were to reality.

Your humble blogger is confident in his statement that revelation of the losses won't result in financial instability for several reasons including: market participants might have overestimated the extent of the losses and we have 6 years of experience that show that banks can continue to operate with what in reality is low or even negative book capital levels because of the combination of deposit insurance and access to central bank funding.

If revelation of the exact amount of losses is not going to result in financial instability, then policymakers and central bankers don't have to remain hostages of the banks.  And if policymakers and central bankers don't have to remain hostages, then there is no reason to continue to pursued the failed Japanese Model and preserve bank book capital levels and banker bonuses at all costs.

Jeremy Warner: this crisis proves that capitalism works

In a very interesting Telegraph column, Jeremy Warner makes a very important point: this crisis proves that capitalism works.

Where Mr. Warner and your humble blogger differ is in how we come to this conclusion.

I look at the stock market which continued to function throughout the most hectic early days of the financial crisis.  Yes, prices did decline, but there were private buyers who were willing to buy at these prices if the sellers were willing to sell.

Compare and contrast the stock market with the interbank lending market or structured finance market.  The latter two markets froze.

Why?

Because of opacity.  Opacity that prevented buyers from having valuation transparency.

The first step in the investment process is to independently assess all the useful, relevant information disclosed in an appropriate, timely manner under valuation transparency to determine the risk and value of an investment.

The second step in the investment process is to solicit the price Wall Street is willing to buy and sell an investment at.

The third and final step in the investment process is to compare the independently determined value with the prices from Wall Street to make a buy, hold or sell decision.

If the first step of the investment process cannot be completed due to opacity, then financial markets effectively freeze except for gamblers who are willing to bet on the contents of a brown paper bag or a black box.

It is the observation that financial markets with transparency function during times of stress and the financial markets with opacity freeze that leads me to the conclusion that capitalism based on the FDR Framework works.

Robert Reich: lack of accountability by Wall Street creating huge problems

On his blog, Robert Reich looks at the problems that are created by not holding Wall Street accountable.

Regular readers know that the only way to hold Wall Street accountable is with transparency.  Sunlight is the best disinfectant because it makes the bankers and their financial regulators responsible for their actions.

The second center of unaccountable power goes by the name of Wall Street and is centered in the largest banks there. 

If we trusted that market forces kept them in check and that they did not exercise inordinate influence over Congress and the executive branch, we would have no basis for concern. 

However, market forces can not keep them in check because market forces do not operate where there is opacity.  Market forces require transparency to exert influence.

We wouldn’t worry that the Street’s financial power would be misused to fix markets, profit from insider information, or make irresponsible bets that imperiled the rest of us. 

Fix markets like the benchmark interest rates (Libor). Profit from insider information like structured finance products (ownership of servicers allows Wall Street to have tomorrow's news today and legally trade on it). Place bets like JP Morgan's London Whale CDS trade.

We could be confident that despite the size and scope of the giant banks, our economy and everyone who depends on it were nonetheless adequately protected.  

But those banks are now so large (much larger than they were when they almost melted down five years ago), have such a monopolistic grip on our financial system, and exercise so much power over Washington, that we have cause for concern. 

The fact that not a single Wall Street executive has been held legally accountable for the excesses that almost brought the economy to its knees five years ago and continues to burden millions of Americans, that even the Attorney General confesses the biggest banks are “too big to jail,” that the big banks continue to make irresponsible bets (such as those resulting in JP Morgan Chase’s $6 billion “London Whale” loss), and that the Street has effectively eviscerated much of the Dodd-Frank legislation intended to rein in its excesses and avoid another meltdown and bailout, all offer evidence that the Street is still dangerously out of control. 

Dodd-Frank was effectively written by and for the Too Big to Fail banks.  The banks were so confident in their writing of the legislation that they even created the Office of Financial Research so that transparency would have a place to go to die.

The only elements not approved of by Wall Street were the Consumer Financial Protection Bureau and the Volcker Rule.

It is rare in these harshly partisan times for the political left and right to agree on much of anything. But the reason, I think, both are worried about the ... depredations of “too big to fail or jail” Wall Street banks on our economy, is ...: It is this toxic combination of inordinate power and lack of accountability that renders ... them dangerous, threatening our basic values and institutions. 

Ultimately policymakers will have to make a choice: bankers or society.

Dani Rodrik on Europe's way out of the financial crisis

In his Project Syndicate column, Harvard Professor Dani Rodrik lays out his plan for how Europe could end its current financial crisis and and restore economic growth.

Regular readers will immediately recognize that Professor Rodrik's plan is essentially your humble blogger's blueprint for economic recovery with one difference.

Professor Rodrik thinks that banks need to be recapitalized immediately by their sovereigns when in fact they are designed so that they can be recapitalized over several years using retained earnings.

Letting the banks recapitalize themselves through retained earnings frees up the sovereigns to use their resources pursuing stimulative economic policies.

The eurozone periphery suffers from both a stock problem and a flow problem. It has too large a debt stock, and too little competitiveness to achieve external balance without significant domestic deflation and unemployment. 

What is required is a two-pronged approach that targets both problems simultaneously. 

The prevailing approach – targeting debt through fiscal austerity and competitiveness through structural reform – has produced unemployment levels that threaten social and political stability.Comments 

So, what can be done differently?Comments 

The most direct way to address the debt problem is a write-down, coupled with recapitalization of those banks that will suffer large losses as a result. This may seem extreme, but it simply recognizes the reality that much of the existing debt will not be paid back without new flows of official financing. 

As the IMF now acknowledges, it might have been better to restructure Greek debts from the outset than to engage in a “holding operation.” 

CommentsDebt reduction by itself clears the way for growth, but does not directly trigger it. 

Policies that directly target expenditure rebalancing within the eurozone and expenditure switching within the peripheral economies are also needed. 

These include: policies to boost eurozone-wide demand and stimulate greater spending in creditor countries, especially Germany; policies that aim to reduce non-tradable prices; income policies to reduce the peripheral economies’ private-sector wages in a coordinated fashion; and a higher ECB inflation target to allow room for movement in the real exchange rate via nominal changes.Comments 

These policies would require Germany to accept higher inflation and explicit bank losses, which assumes that Germans can embrace a different narrative about the nature of the crisis. And that means that German leaders must portray the crisis not as a morality play pitting lazy, profligate southerners against hard-working, frugal northerners, but as a crisis of interdependence in an economic (and nascent political) union. Germans must play as big a role in resolving the crisis as they did in instigating it.Comments 

France will most likely play a critical role as well. France is big enough that if it threw its support fully behind the peripheral countries, Germany would be isolated and would need to respond. But, so far, France remains eager to separate itself from the southern countries, in order to avoid being dragged down with them in financial markets.

Small problem with Fed policies, it is real wages, not wealth effect, that drive US consumer spending

As Pedro da Costa reports in his Reuters blog, a survey shows that it is real wages and not the wealth effect that drive US consumer spending.

This is important because the Fed's monetary policy, including zero interest rates and quantitative easing, is reliant on the wealth effect to drive growth in demand.

Did this reliance ever make sense in anything other than an economic model?

No.

There is no reason to believe that the wealthy dramatically increase or decrease their spending because of the level of interest rates rather than base their spending on what they earn as income each year.

If your humble blogger had to guess why economists believe in the wealth effect it is that they confuse correlation with causation.

Specifically, they saw consumption pick up over the last 30 years as both stock and house prices increased and said "aha, there must be a wealth effect as an increase in wealth is correlated with higher consumption".

In reality, what was really happening is that Wall Street became quite proficient at letting Main Street tap the equity in their houses and Main Street needed to tap this equity because growth in income was insufficient to support the lifestyle they had from previous years.

Federal Reserve officials have touted the ‘wealth effect’ from higher stock prices and rising home values as a key way in which monetary policy boosts consumer spending and economic activity. 

But according to the results of a recent survey from the Royal Bank of Canada, that ethereal feeling of being richer on paper is no substitute for cold, hard cash.

Here’s how Fed Chairman Ben Bernanke explained the benefits of rising asset prices to the real economy during a press conference in September. 

The tools we have involve affecting financial asset prices and those are the tools of monetary policy. There are a number of different channels – mortgage rates, I mentioned corporate bond rates, but also prices of various assets, like for example the prices of homes.  

To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more disposed to spend. If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. So house prices is one vehicle.... 

The issue here is whether or not improving asset prices generally will make people more willing to spend. 

One of the main concerns that firms have is there is not enough demand, there’s not enough people coming and demanding their products. If people feel that their financial situation is better because their 401(k) looks better for whatever reason, or their house is worth more, they are more willing to go out and provide the demand..... 

RBC survey’s findings, explained by the bank’s chief U.S. economist, Tom Porcelli, in a research note: 

That wages and the jobs backdrop matter for consumption is not only borne out in the hard data, but this also came through loud and clear in our June consumer survey. 

When asked about what would embolden them to increase spending, nearly half of respondents noted wage increases while about 1/5 said a better job backdrop. So 65% of consumers think employment dynamics are what matter most. Contrary to popular belief, there was little “wealth effect” from stocks and housing apparent here. 

The bad news: U.S. wages have been stagnant for quite a while.

Paul Krugman: Unproductive finance based on knowing something before other market participants

In his NY Times blog, Professor Paul Krugman finally discovers the role of transparency in the financial markets when he discusses unproductive finance which is based on knowing something before other market participants.

More than half a century ago, in his classic paper on the economics of speculation, Paul Samuelson noted the perverse rewards to knowing stuff just slightly before everyone else. 

He asked readers to imagine someone who, somehow, consistently received crucial information one second before everyone else. 

As he pointed out, the social value of that extra second would be minimal; but the private rewards could be huge.

As regular readers know, with private label structured finance securities including CDOs, Wall Street's informational advantage was not an extra second but rather weeks.  Wall Street had this informational advantage because it owned the firms that were servicing the underlying collateral.

Naturally, when the collateral stopped performing, Wall Street was only too happy to "short" these securities before market participants received this performance information.

Your humble blogger has been saying since the very earliest days of the financial crisis that we need to bring transparency to all the opaque corners of the financial system so as to eliminate Wall Street's informational advantages.

It is these informational advantages that give rise to unproductive finance and our current financial crisis.

Bank of England's Andrew Haldane: Central bank created bond bubble threatens financial system

In his testimony before Parliament, the Bank of England's Andrew Haldane made clear that the greatest threat to financial stability was the central bank zero interest rate/quantitative easing induced bond bubble.

Regular readers know that Mr. Haldane is accurate in his assessment and that the pursuit of ZIRP and QE was totally and completely unnecessary as a response to the bank solvency led financial crisis.

As your humble blogger has been saying since before the financial crisis spiraled out of control in 2008, the way to deal with this crisis is to adopt the Swedish Model and require banks to absorb upfront their losses on the excess public and private debt in the financial system.

Please note, the only way to end Mr. Haldane's concern about unwinding ZIRP and QE and triggering financial instability is to adopt the Swedish Model with a twist.  The twist being that the banks "pay" for their having been bailed out by "donating" their holdings of government securities to the issuing sovereigns.

Will this make the vast majority of banks have low or even negative book capital levels?

Yes, but modern banks are designed because of the presence of deposit insurance and central banks to be able to continue operating and supporting the real economy when they have low or negative book capital levels.  They can do so because with deposit insurance the taxpayers act as the banks' silent equity partners.

A key Bank of England policymaker has warned of the risks to global financial stability when "the biggest bond bubble in history" bursts. 

In a wide-ranging testimony to MPs, Andy Haldane, Bank of England director of financial stability,... told the Treasury select committee that the bursting of the bond bubble – created by central banks forcing down bond yields by pumping electronic money into the economy – was a risk "I feel acutely right now"....

But he described bond markets as the main risk to financial stability. 

"If I were to single out what for me would be biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally." he said. 

There had been "shades of that" in recent weeks as government bond yields have edged higher amid talk that central banks, particularly the US Federal Reserve, will start to reduce its stimulus. 

"Let's be clear. We've intentionally blown the biggest government bond bubble in history," Haldane said. "We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted."

Sheila Bair asks "Does anyone have a clear vision of the desirable financial system of the future"

Since Sheila Bair asked "does anyone have a clear vision of the desirable financial system of the future" and responded by providing a variant of the financial system that collapsed at the beginning of the current financial crisis, I thought I should answer her question.

Ms. Bair's response fails because it substitutes complex rules and regulatory oversight for transparency and market discipline.

The number one lesson of the financial crisis is that a financial system that is reliant on complex rules and regulatory oversight is prone to failure.

It is a myth that more complex regulation and regulatory oversight would have prevented the financial crisis that started on August 9, 2007.

The reason it is a myth is that a financial system that relies on complex regulations and regulatory oversight is dependent on the regulators to a) do their jobs, b) properly assess what is happening in the financial system and c) accurately communicate their findings to market participants.  Because of concern about the safety and soundness of the financial system, regulators will never accurately communicate their findings.

The financial system of the future is the same financial system that was designed in the 1930s and based on the FDR Framework.  This financial system incorporated the philosophy of disclosure with the principle of caveat emptor (buyer beware).

It assigns a very specific role to the financial regulators. They are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.

Fulfilling this responsibility means the financial regulators have to eliminate opacity in all the large areas of the financial system where it currently exists.

For example, regulators need to require that banks adopt that 1930s standard of disclosing all of their current global exposure details.  This includes assets, liabilities and off-balance sheet exposures.

For example, regulators need to require that structured finance securities disclose when an observable event occurs with the underlying collateral, like a payment or delinquency, before the beginning of the next business day.

The FDR Framework also assigns responsibility to the market participants.  They are responsible under caveat emptor for all gains and losses on their exposures.  Responsibility for losses gives market participants an incentive to independently assess the disclosed information.  Market participants use this independent assessment to limit their exposure to what they can afford to lose given the risk of the exposure.

By limiting their exposures to what they can afford to lose, market participants build robustness and resiliency into the financial system and make it so it is not prone to failures.

Unlike Ms. Bair's, my proposed financial system for the future has 6+ decade track record of successful performance.

Ms. Bair's proposed financial system that allows opacity and relies on complex rules and regulatory oversight  has already shown that it is prone to failure within a decade.

ABC's Alan Kohler on casino banking: banks create risk and gamble on it

ABC's Alan Kohler makes the case for requiring banks to provide transparency when he talks about casino banking and how banks create risk that they subsequently gamble on.

Almost all financial derivatives trading adds nothing but risk to the world and should be banned. It won't be, but that doesn't mean the debate is academic. 

Regulators are attempting to bring derivatives into the light through mandatory exchange execution and clearing and "Legal Entity Identification" rules, but progress is slow and fragile. It can be filed under "B" for believe it when we see it.

Please note that derivatives could easily be brought into the light if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Disclosing their exposure details would disclose their derivative positions.

But is there any reason to allow financial derivatives at all? 

New York hedge fund manager James Rickards says they should simply be banned because the benefits are illusory and the effect is that risk is created out of thin air and then multiplied....

Most derivatives trading involves swaps or contracts for difference, where two people bet on movements in an underlying asset or income flow without actually trading in it. It's a bit like betting on flies crawling up a wall, without having to buy the flies.... 

Credit default swaps are bets on whether a country or company will go broke; interest rates swaps are bets on movements in interest rates; contracts for difference are bets on movements in a share price or other asset; and so on....

In fact, derivatives caused the 2008 global financial crisis because banks and investment banks vastly multiplied the leverage on their balance sheets by betting through derivatives and then losing control. 

I wouldn't say that derivatives caused the 2008 global financial crisis.  Derivatives clearly contributed to the magnitude of the crisis.

Since then, the amount of derivatives outstanding has actually grown, and now stands at more than $700 trillion....

Requiring the banks to disclose their derivative positions would have an immediate impact on restraining growth in the amount of derivatives outstanding and would give banks an incentive to shrink their derivative exposures.

Disclosure of their derivative books means that banks are subject to having their cost of funds linked to the risk they are taking.  The more risk in their derivative book, the higher their cost of funds.

This form of market discipline restrains growth in derivative exposures and provides an incentive to reduce the risk of the derivative exposures.

Nevertheless, regulators are grinding their way through consultation and report production with a view to eventually dragging OTC derivatives trading into the open, where the players at least have to say who they are.

The US Dodd-Frank legislation, passed in 2010, requires non-US banks to register as swap dealers with US regulators from next year if they want to trade derivatives there. 

Guess what? Reuters reported last week that Asian banks are cutting their relationships with US banks so they don't have to register, and US banks themselves are restructuring so they can keep going. 

Proving that complex rules and regulatory oversight are not a substitute for transparency and market discipline.

Let's be clear: basically, we're talking about a casino where the gamblers are banks. And banks aren't just any old punters: they also take deposits and lend money, underpinning the financial system on which society rests. 

As with all casinos, someone always loses their shirt occasionally - LTCM in 1998 (US$4.6 billion), UBS in 2011 ($2 billion), AIG 2008 ($18 billion), Barings in 1995 ($1.2 billion), Societe Generale in 2008 ($7.2 billion), and so on. 

The losses of shirts don't always cause a general financial crisis, but there's always a wobble, and in 2008, the combination of AIG, Merrill Lynch and Lehman Brothers and a few others did cause a global recession and is still causing widespread misery....

The only way to restrain bankers' desire to gamble is by requiring they disclose their exposure details.

As Jamie Dimon and JP Morgan showed with the London Whale trade, if banks are forced to disclose their positions, fear of the market trading against them will cause them to exit the position as soon as possible.