October 28, 2009
Regulators - Below Par? No!
'The difference in golf and government is that in golf you can't improve your lie.' George Deukmejian, US Politician
Like many US Presidents, Barack Obama often takes to the golf course for relaxation. As one who has long ago consigned his remaining undamaged clubs to the back of the garden shed, I would not begrudge him the chance to wander aimlessly in the great outdoors for a few hours. The President's handicap (that is golf not Congress) is rumored to be between 16 and 24, though a (probably unauthorized) blogpost of his card at a recent game showed some 30 over Par. Suffice to say that he would be overjoyed to be at Par most of the time?
Of course Par is relative. While the President may be overjoyed at reaching Par from above, Tiger Woods would be distraught if he did not break (annihilate) Par nine times out of ten. Like many things in golf, where you stand is important.
In Finance too, Par is relative. If an investor buys a Treasury bond at Par and interest rates fall causing market prices to rise, he/she is happy since the bond can sold above Par and make a profit. Unfortunately, if rates rise the bond is now priced below Par and whoops, the investor is in the red (or in a bunker at least). If he/she 'shorts' the bond of course the reverse is true. For securities not dependent on interest rates, such as Collateralized Debt Obligations (CDO) or Credit Default Swaps (CDS), the price achievable is the market price, which may, depending on the quality of the underlying credits, be trading above or below PAR.
Apologies for repeating Bond Valuation 101, but it appears that some regulators may have missed that particular lecture (on the golf course maybe?)
On October 27, Bloomberg published a wonderful article on the last days of AIG and the attempts of the company to stay alive by liquidating its portfolio of, almost worthless, CDO backed by, equally worthless, CDS. For those who have come late to the story, AIG had managed, through a UK subsidiary, to acquire billions worth of sub-prime CDOs and CDS and was frantically going back to the banks from which they were purchased and offering them at deeply discounted (but market) prices. The banks demurred to sell at a loss and AIG ended up 'out of bounds', eventually being rescued by the taxpayer.
The story does not end there, however. The major Wall Street banks still held billions of dollars of derivatives written by AIG and hence were, in golfing parlance, deep in the 'rough'. In theory, the now taxpayer owned, AIG should have bought back the derivatives at current market prices, to 'retire' the debt. But there was another problem. If the banks accepted the AIG offer then they would have to sell back the derivatives at a huge loss, since the market price was well below Par. This, in turn, might lead to a 'run' on these bastions of American banking.
The lead banking regulator at the time, the New York Fed, is nothing if not exceedingly generous and agreed (in a series of back door deals) to take back the debt not at the lower market price but at the higher Par value. This meant that the banks lost not a cent but the taxpayer took the full hit, estimated at some $13 billion. The Foligopoly won again!
Golf is an ancient and gentlemanly game (though as Robin Williams points out one where gentlemen can quite respectably dress like pimps). Courtesy and generosity is valued by players. For example, in match play, it is customary to recognize that an opponent is likely to make a winning putt and concede the hole, even though one would dearly love the SOB to have to take the shot and miss. This is called a 'gimme'.
The AIG settlement is one of the greatest 'gimmes' ever. It is as if two duffer golfers teed off on a very long hole, both ending up in the water but mutually agreeing that (though not playing particularly well) both would be able to complete the hole in regular Par - so onto the next hole. In golf, as in life, this is called a 'bad lie'.
The moral here is not only to be scrupulous about marking your golfing scorecard but also never to let regulators look after taxpayers' money. They are too generous and courteous by half.
Bloomberg is to be commended. It is currently seeking, through a Freedom Of Information request, details of the 'secret' agreements between the big banks and the New York Fed. If/when the FOI request is successful, quite senior heads may roll. For the regulator and banks, however, it is as if some cad has questioned the golf club captain on his scorecard for the club four-ball championship - just not within the spirit of the game!
So don't expect information about the dodgy deals to be forthcoming anytime soon - this match may yet go to extra holes.
Writing about golf, Alistair Cooke, the great journalist and commentator on America, could just as easily have been talking about banking regulation- 'an open exhibition of overweening ambition, courage deflated by stupidity, skill scoured by a whiff of arrogance'.
Posted by pjmcconnell at 04:16 AM
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October 13, 2009
Too Big to Succeed - Too?
'The larger and more authoritarian the organization, the better the chance that its top decision makers will be operating in purely imaginary worlds': Oliver E Williamson, Nobel Laureate 2009
On 12 October 2009, the Nobel committee announced its annual Prize for Economics, awarding it to Oliver E. Williamson and Elinor Ostrom (incidentally the first female winner of this prestigious award). The committee awarded these two economists the prize for their independent work on 'economic governance' and 'cooperation in organizations'.
Is the timing interesting or what?
Just as politicians and regulators are starting to think about how to rein in large banks in the light of the disaster of the Global Finance Crisis (GFC), the Nobel committee highlights the work of economists working in a highly relevant area, the problems of managing firm size.
In an earlier blog, I suggested that the world's largest 'universal banks' (or 'financial supermarkets') may have become just 'Too Big to Succeed' and suggested that politicians and regulators may have to force firms to grow smaller and/or increase 'corporate governance'. There is ample evidence from case studies, such as UBS, AIG and RBS, that 'top decision makers' at today's banking behemoths really do appear to be 'operating in purely imaginary worlds'.
I am not an economist and usually tend to agree to disagree with members of the 'dismal science'. But Williamson is not a typical economist, and his training and research includes not only economics but also business administration and management. He works far from the ivory towers that other economists appear to inhabit.
Williamson's work is vast but one of his major contributions is in the area of 'transaction costs'. In its very simplest form, Williamson argues that firms organize themselves to minimize transaction costs but in doing so 'information asymmetries' are created which at a certain size, or complexity, become counterproductive. Increasing hierarchies and so-called 'information impactedness' [crudely you don't know what you don't know] make it difficult and expensive for managers and shareholders to know what exactly is going on. For example, the not inconsiderable costs of creating a risk management infrastructure could be seen as a cost to reduce informational problems, thereby reducing the savings from reducing transaction costs.
One of Williamson's arguments is that the asymmetry of information in a large organization creates 'moral hazard' in that employees will begin to use 'inside' information opportunistically for their own benefit rather than the firm's. Does this sound familiar - rogue trader?
The implication of Williamson's insights is that there is a "law of diminishing returns" to firm size and that after a certain size, or level of complexity, large firms cease to be efficient.
The question of course is 'how big is too big?'
In a prior blog, I suggested that there were two possible actions if a firm was found to be 'too big to succeed': (a) break up the firm or (b) increase corporate governance. But, of course, they are other alternatives and combinations of actions.
In the absence of any feeling for the maximum, or even optimal, size of a financial institution, regulators could consider requiring firms to maintain additional capital based on the number, size and complexity of the transactions that they undertake. One could think of this approach as a sort of internal 'Tobin Tax' that could be used to build up the 'counter cyclical' capital buffers so beloved of global regulators.
If a future Nobel Laureate were looking for a source of data to test a new theory on the 'optimal size' of financial firms, the Australian banking system would provide a great experimental laboratory.
One of the reasons that have been put forward for why Australia has appeared to dodge the GFC bullet is that it has a pretty idiosyncratic banking system based on the so-called 'Four Pillars'. By law, the 4 largest banks cannot be acquired or acquire one another. At first glance, such a concept may appear perverse and certainly is far from efficient (economically) but maybe each of these banks (which incidentally are roughly the same size) has reached a size that can actually be managed successfully? Could it be that Australia has hit upon the secret of the optimal firm size by accident?
When supervising banks, regulators could do well to pay heed to Williamson, 'Parsimony being a virtue, complication must be justified'.
Posted by pjmcconnell at 09:59 AM
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October 11, 2009
Too Big to Succeed?
Oscar Wilde: 'Nothing Succeeds like Excess'
Management theorists, such as Michael Porter and Gary Hamel, have long argued that 'excellent' firms can only succeed by concentrating on their 'core competences' and that firms often come a cropper whenever they attempt to move outside their competitive strengths.
So why do banks believe that they can succeed in selling an increasingly eclectic range of complex financial products to a very diverse customer base in different countries and cultures.
It is often forgotten that the concept of the 'Universal bank', often called the 'Financial Supermarket', or 'BancAssurance' in Europe, is relatively new. In Germany and Switzerland, large banks such as Deutsche and UBS have provided a wide range of financial services to their customers since the mid 20 th century. But in the USA, the 'universal' concept only become banking orthodoxy after the repeal of the Glass Steagall Act a mere ten years ago, in 1999. In Europe, consolidation of financial services across the continent has been driven by the introduction of the 'Single Euro Currency' interestingly in 1999 also. We have had a mere decade of experience in one-size fits all universal banking, and its track record has been far from stellar?
The point is not whether some Universal banks have become too big to fail (the answer is obviously yes, because governments have been loath to let them go under) but the real question is 'Have some banks become too big to succeed?'
The main argument in favour of banks growing big is that larger firms have the potential to become more efficient.
At regards technology, big is undoubtedly better. A large regional retail bank can acquire smaller rivals and by integrating both sets of customers onto a single banking platform they can simultaneously decrease costs and increase customer choice with a wider range of products. This for example is how NCNB, a relatively small bank in North Carolina, grew by aggressive acquisition over 25 years to take over the venerable Bank of America and become the largest US bank by assets.
Likewise, funds (increasingly called wealth) management is a business, in which scale can bring efficiencies, since, up to a certain market share, an investment decision is not dependent on size, the bigger the trade the less transaction cost overhead.
There is also a geographic argument for increasing concentration of banking services, as firms and customers in emerging economies can benefit from experience gained in more mature markets, often achieved by local acquisition. This is why we have truly global banks such as ING and Citigroup.
There are, however, few efficiencies to be gained from combining very different financial services. Other than sharing management there is little benefit, for example, in integrating a retail banking business with a Mergers & Acquisition function. As regards funding, M&A will raise capital not through retail savings but thorough wholesale markets. Even branding will be very different as a large energy firm seeking billions to exploit a new gas field is unlikely to be swayed by advertising aimed at retail customers. Even where the customer segment is the same, such as insurance, there is no reason to believe that an expert is derivatives trading will be able to provide more efficient life insurance than a specialist insurer, even if they have a large retail sales arm.
The efficiency argument in favour of universal banking only holds water if reducing transaction expenses in one area does not increase costs elsewhere.
Where could costs increase in a universal bank?
Risk is one area, as the Global Financial Crisis (GFC) has demonstrated, where costs have increased considerably, arguably because of the growth of diversity in banking.
Financial history is littered with case studies where boards of universal banks have been blind-sided by huge, but unrecognized, risks that have been taken by small units of their business. For example, the recent problems that UBS has experienced with US tax authorities resulting from problems in its 'private clients' business shows that even the most mature universal bank can run into serious trouble. Likewise, Societe General lost billions, in the Jerome Kerviel affair, not in its core banking franchise but in the relatively small equity arbitrage business. Nor is it only banks. AIG, once a byword for excellence in re-insurance, is now a laughing stock because of massive losses due to excess risks taken by a small derivatives unit in London. In all of these cases, valuable capital built up over time through increased transaction fees was lost precipitously due to un-or badly- managed risks.
If universal banks do not increase overall capital efficiency in the economy what purposes do they serve? If these institutions did not have to be bailed out by taxpayers, the question would be largely irrelevant, a matter for shareholders only.
But if they are too big to fail, politicians must ask themselves are the largest banks also too big to succeed?
If they answer is Yes, then there are two courses of action. One option is to break these gigantic firms up letting them re-merge, if necessary, along the lines of product/customer segments where they have expertise and risk management capability.
The other option is to change the principles of corporate governance for financial institutions. Why is it that, when a new business is acquired, regulators and shareholders do not demand that the size of the board is increased correspondingly? Why is it assumed that a board, consisting often of the great and good of the legal and finance fraternity, with expertise of one financial market should be able automatically to come to terms with a completely different set of financial markets and associated risks? It is immature to make such assumptions in theory and unfortunately has proved very costly in practice.
At best, universal banking is a hypothesis that remains to be proven, although contrary evidence is mounting. At worst, universal banking is an experiment funded by unwitting taxpayers that should be terminated immediately before more damage is done. Rather than trying to fix a broken system (until that is it breaks next time) politicians and regulators should look to restructure the banking industry into one that has a decent shot at working, at least from a risk management perspective.
Mark Twain's quipped that 'All you need is ignorance and confidence, and success is sure'. Universal bankers have surely demonstrated success at least in terms of the excesses of their own remuneration but it is the taxpayer that has borne the costs of their stupefying ignorance and unwarranted confidence.
Posted by pjmcconnell at 02:48 AM
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October 10, 2009
100 Fathers
'Success has 100 Fathers, but failure is an orphan': Proverb
In a series of interesting PRMIA blogs, Sai Sireesh has been looking at regulatory regimes in jurisdictions, such as Canada and Spain, that have appeared to have 'had a good war' during the Global Financial Crisis (GFC). Recently, he asked the question: what is the 'Australian secret sauce for managing risk?'
By being the first G20 central bank to raise its base rate, the Reserve Bank of Australia (RBA) has signaled that the Australian economy appears to have weathered the worst of the GFC storm. And there have been lots of fathers coming out of the woodwork to claim at least part of the success and to promote their particular recipe for the 'secret sauce'.
In truth, there is a lot of praise to go around, but the reasons that Australia has (so far) survived the crisis is a combination of good (or at least adequate) risk management, a number of economic factors unique to Australia and some very fortunate timing.
First: Regulation.
Admittedly, prudential regulation is strong in Australia but that is coming off a fairly low base. The disastrous events at HIH, the country's second largest insurer that went belly up, to the regulators' great surprise, in 2001 and the FX options losses at National Australia Bank (NAB) in 2004 both highlighted serious deficiencies in Australian prudential supervision and corporate regulation. Following these well-publicized disasters, APRA, the banking and insurance supervisor, and ASIC, the corporate regulator, have raised their game considerably, hiring many more, smarter and more proactive regulators. Congratulations to the regulators but hardly foresight, more necessity?
Next: Basel II.
Like their European counterparts, Australian banking regulators enthusiastically embraced Basel II but it should be noted that the final blizzard of regulation towards the end of 2007, to meet the 2008 deadline, coincided exactly with the start of the GFC (but in no way could have contributed to it nor for that matter could claim to have averted it). In the run up to the Basel II kick-off it must be admitted that Australian banks had, almost certainly as a result of regulatory pressure, begun to clean up their risk management act. As a result, by the end of 2007, Australian banks were never better placed to manage their risk assets, because they had just spend millions of dollars putting the necessary risk management infrastructure in place. It will be one of the great unanswerable questions of financial history to ask: 'What if the USA had gone through the pain of preparing for Basel II at the same time as everyone else, would the crisis have been averted or at least managed better?'
Banks, Markets and Assets.
Academics, rating agencies and central bankers have been pointing out for years that the Australian banking industry is structured differently to other financial markets, not least in the primacy of the Four Pillars (the 4 largest banks), which is written into law. This unusual and deeply uncompetitive structure means that the major financial institutions cannot acquire each other, nor be acquired by an overseas competitor. In turn, this had led to a sometimes-deep complacency and a natural risk aversion - in economic jargon the system has reached equilibrium so no need to rock the boat. Innovation is rare and new products and services are usually acquired from overseas, but slowly. In the markets that sunk the US banking system, i.e. mortgage lending, the Australian market is again distinctive. Mortgage securitisation does exist but the big banks tend to retain the best mortgages on their books, not least because defaults are low but also because income is predictable and very profitable (as interest rates tend to be higher than other advanced economies). Defaults are low not only because home ownership is embedded deep in the Australian psyche but also, unlike for example the USA, borrowers are legally responsible for their loans and cannot just walk away - no 'jingle' mortgages. Sub-prime mortgages (so-called 'low doc' loans) were given out quite liberally by mortgage brokers in the lead up to the GFC, but constituted only a small portion of the overall market. Generous tax incentives in the form of 'first time' buyers' grants and 'investment loans' also appear to have cushioned the blow of falling asset prices, for now. Australia does, however, have one of the highest high household debt to income ratio in the advanced economies, which may stifle the recovery of the mortgage market for some time.
Lets not forget: Superannuation.
By law, employers in Australia are required to contribute 9% of every employee's salary into an individual pension, or so-called superannuation, account. Over the 17 years of this system, Australians have built up an enormous pool of 'super funds' totaling today almost A$1.2 trillion dollars. This has grown not only by compulsory contributions, but also sound investment management, attractive tax incentives and, on average, a rising stock market. During the GFC, stock markets in Australia have fallen as far and as fast as elsewhere and there have been a number of spectacular corporate collapses, not least the Lehman-like Babcock & Brown, but this huge 'super pool' has acted as a very effective 'shock absorber' soaking up many of the losses that elsewhere would have crippled banks and other financial institutions. For Australian investors, the pain of the GFC will be felt gradually in diminished returns over their lifetime (30/40/50 years) rather than in mortgage distress and high unemployment as in other advanced economies. As an aside, courtesy of a generous government taxpayer-funded guarantee the big 4 banks have maintained, even improved, their risk ratings and hence have no problem raising capital from risk averse superannuation managers, coincidentally cementing their uncompetitive advantage over lesser institutions.
Finally: the Economy.
Sitting on top of a vast continent chock full of valuable, easily mined commodities, Australia has the luxury of having ready markets for every ton of coal, iron ore and uranium that can be dug out. This booming economy has had two major consequences for the management of the GFC, and incidentally many hundreds of fathers claiming credit for the healthy bouncing baby. First in the China-driven commodities boom that preceded the GFC, the Liberal government used the proceeds to pay down government debt placing the country on a much better footing to withstand the crisis than debt-laden countries, such as the USA. Equally, provided with a clean sheet and knowing that many trillions of dollars of commodities still remain under the soil, the new Labour government has been able to return to its Keynesian roots spending its way out of trouble with a huge 'stimulus package', knowing that future repayment will not a problem, and claiming much of the credit for managing the crisis. The game of Australian politics will be enlivened for decades to come by debates about which father was responsible for exactly which feature of the bouncing baby that is the Australian economy. Many politicians deserve a little bit of credit, but are unlikely to be unhappy unless full paternity is recognized.
There is a well-known Australian saying - 'fair shake of the sauce bottle, mate', which refers to the obligatory passing around of tomato sauce to dollop on one of the highlights of local cuisine - the late night meat-pie. It is a colourful variant of the old adage 'give credit where it is due'. Fair shakes would dictate that many people could claim some credit for steering the Australian banking system through the GFC cyclone, and many will. The Australian success in dodging the worst of the GFC (so far, fingers crossed) has not 100 but 100,000 fathers; politicians, investment managers, investors and the tax-payer who together have created what has proved to be a very resilient system. Many will claim personal credit of course. However, before the crisis, many of these supposed fathers were happily indulging in the very practices that caused such pain elsewhere. It is a bit rich now to claim foresight that just wasn't there.
The answer to Sai's question is really that there is no Australian 'secret sauce', but a very appetizing mixture of good luck and common sense, mixed with a pinch of natural caution, a generous slurp of tax incentives, simmered slowly in a large pot of savings. It is not a souffle created by a star TV chef to dazzle but ultimately deflate. The Australian formula is a long-standing family recipe modified to taste by different generations but always, like Mother's Chicken Soup, nourishing and sustaining.
For that last word on sauce recipes, Benjamin Tucker, the 19 th century American anarchist (a very rare breed indeed) may have had considerable foresight on the GFC, noting that 'Laissez Faire [economics] was very good sauce for the goose (labor) but was very poor sauce for the gander (capital)'.
Posted by pjmcconnell at 02:11 AM
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