May 30, 2009
Foligopoly
"Never was so much owed to so many by so few": Winston Churchill (revised).
In a recent report, the Office of the Comptroller of the Currency (OCC), one of the myriad of US financial regulators, reported that the top five banks in the USA accounted for over 95% of total exposure in derivatives, the vast majority (over 96%) of which were Over The Counter (OTC) contracts. The Top Five were identified, in order, as JP Morgan, Bank of America, Citigroup, Goldman Sachs and the US subsidiary of HSBC. In their Q4/2008 trading statistics, the OCC reported that these five firms accounted for over 80% of the US industry's 'net' current credit derivatives exposure of some $800 billion. An interesting note is that the corresponding 'gross' credit exposure of some $7 trillion is reduced by almost 90%, to $800 billion, by 'legally enforceable bilateral netting agreements'; i.e. they are all trading with one another rather than customers.
If we take a different look at banks in the US by asset size (a fair measure of general lending to the economy) the same five banks dominate, with BofA the largest and two other banks, Wells Fargo and Morgan Stanley, pushing their way into the top seven.
Switching track a little. When the US congress recently debated the need for Credit Card reform, they were informed that the top issuers of US credit cards by outstanding balances were led by, you guessed it, JP Morgan (Chase brand), Bank of America and Citigroup at the top, with three specialist credit card providers, including American Express, pushing Wells Fargo and HSBC into seventh and eighth place. Late to the world of commercial banking, Goldman Sachs has not (yet) ventured into consumer credit cards, but undoubtedly would be 'big in it' if they did. Note too in other areas, the same names pop up at the top of lists, for example in Student Loans, where Citi and BofA dominate after the specialist lender Sallie Mae.
Not surprisingly, when the US Treasury announced the results of its recent 'stress test', these same names (minus the overseas-owned HSBC), dominated the list of banks that would suffer severe losses in an 'adverse economic scenario' although not all of these were judged to need injections of tax-payer funds to cover such losses.
Lest I be accused of being too focused on the USA, the picture is the same in all other major economies, with a small number of huge institutions dominating all aspects of banking in a particular market, such as Deutsche Bank in Germany, UBS in Switzerland, BNP Paribas and Societe Generale in France, the moribund RBS, Barclays and HSBC in the UK and so on. If you were to lump them all together, there would be no more than a dozen large institutions that originate the vast majority of risky banking transactions in the G20 countries. On the other hand, hundreds of institutions pick up the crumbs, Pareto rules!
After all the havoc that they have caused, this small coven of financial wizards have the unmitigated gall to suggest that they need to continue to pay huge bonuses; otherwise their key staff will go elsewhere! Where is there to go? To another one of this tiny band or to one of the hangers-on, such as hedge funds, who grow plump on the scraps that drop from their overflowing tables? Let them go!
Webster's Dictionary [NOT] defines 'Foligopoly' as "rule by a small, elite group of fools".
Is not the global financial market a Foligopoly?
Has the global financial system not been driven, almost to destruction, by a tiny group of financiers who have greedily invented ways of skimming off billions of dollars in compensation for playing roulette with other people's money?
This Foligopoly resembles nothing less than the warring families of medieval Italy without any of the benefits of Renaissance art and architecture. They compete with one another for wealth and power with the ultimate prize being the election of a Pope, or in the case of those latter day Borgias, Goldman Sachs, the office of the Treasury Secretary. They are a law onto themselves.
What can be done to rein in these Foligarchs?
Basel II may provide the hint of a useful solution.
[Now who would ever have believed that one would see Basel II and 'useful' in the same sentence?]
The current capital adequacy rules allow banks, because of their generally good credit ratings, to trade with one another while employing ridiculously low levels of capital to do so. Section 182 of Basel II actually specifies a 'zero risk weight' for collateralized OTC derivative transactions between banks that have netting agreements.
In this perverse environment, a small group of firms were able buy and sell vast sums of assets between one another with little or no 'cost of capital', provided that they have some form of netting agreement in place. If managers get bonused on volume so much the better, and if one of this small cabal of companies were to fail, why worry - the taxpayer will pick up the bill? Despite protestations to the contrary, most of these transactions (beyond those needed to provide liquidity in the banking system) add little to the overall economy, but do help create enormous financial bubbles that are eventually pricked when common sense prevails.
What if the concept was turned on its head and trading between banks, which creates long term risks, incurred much more capital than transactions within the 'real' economy. In other words, credit risk held against other financial institutions in the same market would be rated higher than credit risk with corporations, if held for a longer time than economically necessary.
In order not to freeze the flows of short term cash, a key banking function, risk ratings would be set low for 'spot' or short-term transactions but would increase, maybe exponentially (?), the longer the credit was held. Netting would still be permitted but only for short-term transactions.
This is a relatively simple solution, applicable to all banks covered by Basel II and, in theory, is just (?) a small change to the Basel rules on risk rated 'haircuts' for eligible collateral. For example, regulators could specify haircuts of over 100% for collateral held long term between financial institutions (and hedge funds too). That would stop large risk bubbles building up! Likewise, asset-backed securities, held for non-investment purpose, would also begin to incur prohibitive capital charges if held for a long time; this would stop the dangerous practice of 'warehousing' that was partially responsible for bringing down Lehman's.
Such a market-based approach would encourage banks to lend to businesses rather than just building up huge amounts of credit risk amongst themselves, producing little benefit to the economy as a whole while creating systemic risks to the financial markets.
If such changes were put in place, the Foligarchs would then have to be bonused on their ability to create products and manage risks for economically productive purposes. Such an approach would not stop banks trading amongst themselves, but they would just have to earn much more to fund the capital incurred. It would also encourage good practices, such as 'tearing up' any netted transactions that offset each other, paying differences in good old cash to clear the books.
In a quote that could equally apply to the current crop of Foligarchs, Winston Churchill wrote 'Success consists of going from failure to failure without loss of enthusiasm', to which we could add 'or without shame'?
Off with their Heads (or at least give them a very close haircut)!
Posted by pjmcconnell at 03:04 AM
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