Unholy trinity sets up bank failures

By Chan Akya

Three discrete events over the past couple of weeks have confirmed the worst suspicions of non-Keynesians that governments remain not just beholden to banks around the world but positively scared of them.

Exhibit A is the cartoonish European bank "stress" tests, Exhibit B is the US government's alleged attempt at financial system overhaul through the Dodd-Frank bill and Exhibit C is the hilarious Basel-III regime unveiled this week.

Exhibit A: The "stress" test
The simplest way of describing last week's European stress test

is, in the words of an anonymous commentator passed on by e-mail to me, "if all the Greek banks passed, the Stress Test failed". No seriously - imagine how good any stress test can be simply by looking at the results.

The major source of disappointment for analysts examining the dynamics of the stress tests was the underlying assumptions. I wrote about the dynamic of stress in European banks (see The 'why' of Europe's banks, Asia Times Online, July 23, 2010); knowing full well that these issues wouldn't be revealed - much less resolved - by whatever the stress tests could possibly accomplish. The wonderful John Kay, writing in the Financial Times, comments as follows:
The concept of stress tests is derived from the procedures used to ensure the robustness of complex engineering structures. There are three stages. You begin by testing each component in conditions considerably more demanding than it is likely to encounter. Then you review system design to ensure that, even if several elements break down simultaneously, this does not jeopardize the integrity of the whole structure. Third, and most importantly, you test the total system for outcomes far outside the range of experience. You do not ask, "Will the bridge survive a strong gust of wind?" You ask, "Will it survive a gale worse than any at this site in the last century?"
And his conclusions of how the Europeans did:
There is much that the finance sector could learn from this, but no indication it has done so. The adverse scenario of the bank stress tests, far from being outside the range of experience or expectation, is not far from the mean... Worse, the stress tests are self-referential. Their purpose is to show, not that the bank is sound, but that it meets the requirements for regulatory capital. But one lesson of 2008 was that capital adequacy was almost irrelevant in a crisis... Shamefully, the purpose of the stress tests is not to ensure that depositors' money is safe or that taxpayers will not be called on again. The purpose is to reassure banks and their shareholders that they will not be required to provide significant additional capital. The lesson - perhaps the only lesson - of the stress tests is that Europe's politicians and regulators have not begun to address, far less resolve, the issues posed by the crisis of 2008.
Readers will remember that little bit of concern that, oh I don't know, the whole world had concerning the potential for European sovereigns to default due to excessive debt loads. The infection from that view to European banks was led by the simple fact that they held the greatest proportion of European sovereign debt. So what do the folks doing the tests - the Committee of European Banking Supervisors - do in this situation? Do the right thing and assume that banks are "stuck" with the sovereign debt and suffer massive defaults? Or do they quietly whitewash the issue?

Here is what they did. They put the whole lot into a "hold to maturity" account for banks, and assumed that any sovereign default that did occur (say Greece) would have a fairly small impact ("severity" in the lingo). In other words, there was no need for banks to worry about the volatility of holding European government bonds, and even if there was an actual default actual losses would be minimal.

If that wasn't bad enough, there is no actual evidence that the banks' liquidity access to the European Central Bank (ECB) was stress-tested. In other words, what would happen to the liquidity position of European banks if the ECB were to change collateral eligibility requirements (say due to pressure from the German government)? What would happen to European banks if a large institution were to collapse? How about the "what if" scenario associated with more than one European sovereign going into refinancing stress later this year?

The obvious conclusion from all this is that the European stress tests were designed for banks to pass, not fail. That alone ensures that the design and implementation of the tests was faulty from the first day.

Exhibit B: US financial reforms
The Dodd-Frank Bill that was passed in the US this month has been hailed by its architects as an important piece of financial regulation that will reduce the chances of financial crises in years to come. As the Washington Post reported on 16th July:
Sen Christopher J Dodd (D-Conn), who shepherded the bill through the Senate, said the legislation will help restore Americans' confidence in the badly battered financial system. "More than anything else, my goal was, from the very beginning, to create a structure and an architecture reflective of the 21st century in which we live, but also one that would rebuild that trust and confidence."

... Meanwhile, most Republicans continued to argue that the bill creates bigger, more intrusive government and fails to prevent future bailouts of financial companies using taxpayers' money. These critics joined with leaders in the banking and business communities in insisting that the new regulations will undermine the competitiveness of the US economy, stifle growth and kill jobs at a time when unemployment is high.

... For weeks, Treasury officials have been holding daily meetings to plan how they would carry out the wide-ranging bill. Similar efforts have been taking place at other agencies, such as the Securities and Exchange Commission, the Federal Deposit Insurance Corp, and the Federal Reserve, each of which will have new responsibilities. The Treasury Department has already assigned dozens of employees to carry out various provisions, such as the creation of the consumer protection bureau.
The Wall Street Journal didn't like the bill (not a surprise per se given their editorial slant) but did make an important point about complexity and unknown side-effects:
Given the radical and experimental nature of this bill, they will, like with the stimulus and health care, have cause to read in coming months about unintended consequences. The White House is not going to be able to prove it fixed the financial system. But it will have to answer questions about the small business that can't get credit, or the Midwest farmer who has been priced out of the derivatives market.

And the timing is hardly fortuitous. The White House got this far by trashing Wall Street and greedy CEOs. It did this so frequently that the discussion is shifting to how its antibusiness policies are hurting recovery.
Take the derivatives market for example. The object of the bill was to restrict US banks from holding excessive derivatives on their book relative to their requirements on trading with customers. However, it is well nigh impossible to determine which trade is which, that is, for banks let alone regulators to figure out the nature of trades that were executed by banks in order to enable trading for their customers, and what represents outright speculation in riskier activities alongside. For example, to hedge a bank's positions on fixed-floating interest rate swaps (the most common form of interest rate derivatives) traders may choose to position significantly on LIBOR (London Interbank Offered Rate) contracts or on bonds issues by US mortgage agencies (Fannie Mae and Freddie Mac). The trouble is, for both the supervisors of traders and their regulators, it is impossible to distinguish between those trades and outright interest rate "bets" by similar traders on another side of the floor.

A simple split of what is known as proprietary trading doesn't cut ice either. Most banks that lost money during the financial crisis did so on account of "customer" trading activities, for example asset-backed securities or collateralized debt obligations created and structured for sale to customers. Nor is the size of an activity relative to a bank's capital position an indicator of risk much less tolerance. While some banks such as Lehman Brothers failed on account of the sheer size of illiquid assets on their books, the same wasn't true for smaller commercial banks for example; in any event the Dodd-Frank Act doesn't do anything new in the area of monitoring and controlling risk exposures.

The more that one tries to examine the real motivations and potential ramifications of the Dodd-Frank Act, the greater the suspicion that this was an overly complex law that was pushed through for the sake of expediency but without much regard to the likely enforceability let alone its eventual impact on reducing systemic stress. The government is seen to be acting but banks continue with business as usual because they have a law that cannot be realistically implemented to any great efficiency.

Exhibit C: Basel-III cop-out
Perhaps the worst case of all though is the new Basel-III regulations. News of the adoption sparked a rally of over 10% for European bank stocks on Wednesday, a true indication if one was needed at just how poorly constructed the regime was likely to be (investors greeted the notion that no new equity or very little equity would need to be raised due to Basel-III).

As the Lex column in the Financial Times explained:
First the European bank stress tests that most banks were bound to pass; now the easing of Basel III capital and liquidity proposals that, by the new implementation date of 2018, banks are bound to fulfill. It is very hard not to view the Bank for International Settlements' relaxation of rules and stretched implementation timetable as yet another win for the banking lobby. The threat of regulators whacking up capital adequacy ratios was one of the last big unknowns for investors. That European banks' stocks jumped 5 per cent on Tuesday suggests that fear is rapidly evaporating.
Initial news reports had suggested that Germany was against the watered-down proposals by Basel-III as it had managed to clean up large tracts of its banking sector beforehand. Instead, the government chimed in to avoid shaking the boat, as the Financial Times reported:
Germany's bank regulator has dismissed concerns that the country is unhappy with international proposals revealed this week to strengthen lenders against a financial crisis. Jochen Sanio, head of Bafin, the financial services supervisor, said Germany expected to reach agreement on schedule this year but had expressed reservations this week because important elements of the proposals remained unclear.

The committee, made up of central bank governors and regulators, said "one country" - Germany - "still has concerns and has reserved its position" until later this year. Mr Sanio told the Financial Times: "You can only reach the final agreement on the whole capital accord. Until now we have only seen some partial portions. We are waiting now for the finalization of the Basel III package. We want the accord to be delivered in time for November's G20 [Group of 20] summit in Korea."

The Basel committee has still to set a key element of its plans: the amount of capital that must be held relative to a bank's risk-weighted assets. "What is still lacking is calibration," said Mr Sanio. "Without it we cannot assess the impact for the German banking system."
The sum total of all of the machinations over the past few weeks is that regulators have expressed a clear desire not to control the future risk-taking of banks, have not expressed concerns over the current composition of balance sheets, and furthermore refused to set a longer-term plan in motion for capital accretion.

Taken together, these missteps guarantee the recurrence of financial crises in future, with each episode likely to be worse than the previous one.

www.atimes.com