Charles Schumer, a ranking member of the Senate Banking Committee, recently penned a letter which created a panic sensation for the bank and the FDIC. IndyMac was focus of a June 26 letter announcing Schumer's concern about financial deterioration at the bank that was formerly a hingepin for Countrywide Mortgage in the mortgage market. Schumer claims that his letter was old news. That depends who you ask.

The FDIC was inflamed by leaked news that stirred panic overtones. The Office of Thrift Management immediately began fuming. They admitted that the bank was in distress, but that Senator Schumer was instrumental in causing the bank run.

"OTS ought to stop pointing false fingers of blame and start doing its job to protect the future of the banking system, so that there won't be other IndyMacs," Schumer railed. "Both IndyMac and Countrywide helped cause the housing crisis we're now in," while claiming that OTS "was asleep at the switch and allowed things to happen without restraint." Schumer then called the OTS a weak regulator.

Even without a trial by jury, the evidence fully supports that all regulators established by the U.S. federal government have been weak and have failed U.S. citizens, albeit the world-at-large. This weakness was supported by George Bush before his second election to office as he glowed about the strengths of banking innovation.

"And now they are doing what the Bush administration always does: Blame the fire on the person who calls 911," piped Schumer. Appearances are that pointing fingers is what Washington does best. Monday was a rough day for the "new bank" as depositors stormed the bank, removing all the cash they could. This morning, the threat of violence loomed at the front door lobby as depositors fought over their place in line. Meanwhile, there is little doubt that the crash of IndyMac was certain. Lack of confidence brought about the result even sooner.

]]> http://ozrisk.wordpress.com/?p=336 Tue, 03 Jun 2008 06:12:06 +0000 Andrew http://ozrisk.wordpress.com/?p=336 Chris has long been one of my favourite bloggers on banking - the problem has always been working out where his blog posts are appearing. This one, though, is a pearler and he is blogging on one of my favourite themes:

... regulators do not make the markets safer. If anything, regulators make financial markets less safe.

Give it a read.

The second paradox is that elements of a massive liquidity freeze occurred in certain financial market segments (for example, the United States) within a context of overall excess dollar liquidity worldwide. In other words, because of bad bank securities and the risk of accepting them or trading value-for-value, bankers on a global scale began to refuse to trade with fellow bankers to protect themselves.

World bankers are looking at these arenas for salvation: risk management in financial institut- ions; the originate-to-distribute business model of the large banks; and the coordination of financial regulation and supervision across financial institutions, markets and national borders.

World bankers say that improvement in financial literacy can be made by realigning the incentives among the originators and other participants in the securitization chain through attention to detail.
Being honest about the risks inherent in structured bank products is imperative, even though bankers refuse to use the word "honesty". Ratings agencies need to improve the usefulness and transparency of credit ratings so that investors can more appropriately apply market discipline. In other words, aggregate information of the past is largely trash in the real world. The proof is in the pudding of the past.

One problem that all bankers around the world seem to miss is that their industry is built on a measure of trust. This is not recognized and in the the industry, I have never heard the word mentioned by mainstream bankers and certainly not the central banking community. Trust has been violated and bankers are clueless.

For the time being, many investors have taken substantial hits and are cold to the prowess of the banking community at-large. Trust will have to be rebuilt. Fortunately, the greed of investors is on their side. Using clever marketing tactics and clever persuasion, eventually investors will be wooed back into the mix.

Bankers, including central bankers, have been insistent on promoting financial innovation for the generation of capital. Even World Bankers have revealed that they are against regulation while looking forward to "market-based solutions".

For those that wonder, nothing has really changed. Politicians are talking and squirming, while generating new law. Everyone is looking at symptoms, but rarely the root cause of any problem. Making money in the long-term is always more important than stability or morality. The World of International Banking doesn't know what morality or ethics is.

Banking has become the "new politic of power". The entire world is politically-powered through the financial power of the International Society of Bankers, a framework of legally independent, yet totally self-dependent and self-generating authority mongers. World Bankers have control of the world in their hands. They have money and want to make more at the expense of all.

The Crikey piece notes that this does not set a binding precendent, but

the fact that a full-time VCAT member provided a judgment noting that the bank-fee charged was unenforceable and amounted to an unfair term in the contract is an indictment on the conduct of a financial institution. While Citigroup did not defend the matter, the VCAT member would have been within his rights to dismiss the application if he was of the opinion that it was without merit.

So, this one is just waiting for a test case. We have an interesting possibility here. If you believe the fees you are paying are excessive then - claim them all back. All of them. Just find a lawyer willing to take on your bank.

Surprisingingly, Citi's newsroom says nothing on the topic of this court loss.

Thanks to The Sheet for pointing me at this.

Remember when Dick Cheney assured the country that the war in Iraq would last no longer than a couple of weeks, tops?

Now we have the grand announcement that the "most sweeping change in banking regulation since the Great Depression" has been initiated by the Bush administration.

Sure it has.

If we know anything about our fearless leader at this point it is this: The more noise and hoopla that accompanies an announcement, the less likely it is that anything is actually happening.

Basically, the 'new' package of 'regulations' consists of giving the Federal Reserve the right to monitor investment banks and hedge funds, but no right to directly intervene unless the financial system appears to be in danger of major and imminent meltdown. You know, kind of like things are already, right now.

Forgive me for stating the obvious, but if the Fed was still capable of preventing a financial meltdown of the entire US financial system, wouldn't it be doing that right now?

So far, the Fed has been reacting to Wall Street volatility like a teenage girl in the midst of a messy breakup with an arrogant boyfriend. You just want to shake her and scream, "Oh for God's sake dump him! He's not worth it!" But you can't, because teenage girls live in a world of their own, and so does the Federal Reserve.

The Federal Reserve was created in 1913 to prevent bank runs on private lending institutions. The Fed itself is a combination private & governmental entity that is not accountable to the American public. Its board of Directors is appointed by the President of the US; its stock is held by a number of private US banks.

A good description of what the Federal Reserve does is found in the book The Federal Reserve in Plain English:

"Just before the founding of the Federal Reserve, the nation was plagued with financial crises. At times, these crises led to "panics," in which people raced to their banks to withdraw their deposits. A particularly severe panic in 1907 resulted in bank runs that wreaked havoc on the fragile banking system and ultimately led Congress in 1913 to write the Federal Reserve Act. Initially created to address these banking panics, the Federal Reserve is now charged with a number of broader responsibilities, including fostering a sound banking system and a healthy economy."

The current instability in the economy is being caused once again by bank runs and the threat of bank runs, but this time the banks in question are investment banks and hedge funds, which are not under the control of the Federal Reserve.

It might seem logical then that putting these investment banks under the watch of the Fed will solve the problem, but that is an empty gesture for a number of reasons.

First of all, at this point we have absolutely no indication one way or the other whether the Fed's current actions are helping to stabilize the economy or making a scary situation even worse. Secondly, and more important, the Fed is not likely to be effective in regulating investment banks over the longterm, even if it can pull us out of the current crisis.

Many economists and market insiders have pointed to the creation of a "shadow banking system" comprised of investment banks, brokerage firms, and various hedge funds, for the purpose of helping large financial institutions skirt banking regulations and make huge profits doing illegal things, or things that ought to be illegal but aren't quite. That is how the current subprime mortgage crisis came about.

Investment banks took packages of subprime mortgages and chopped them up into new packages to back Structured Investment Vehicles, or SIVs. A structured investment vehicle (SIV) is a fund which borrows money by issuing short-term securities at low interest and then lends that money by buying long-term securities at higher interest, making a profit for investors from the difference (http://en.wikipedia.org/wiki/Structured_investment_vehicle).

When commercial banks realized that the assets backing the SIVs were going bad, they wanted their money back pronto. This kicked off the current liquidity crisis and amounted to a run on the investment banks that issued the SIVs. While it is tempting (and easy) to blame the subprime mortgage crisis on poor people who take out bad loans and don't pay them back, when you look at the big picture what you see is a kind of greed orgy taking place in the stratosphere of high finance. The phrase "pigs at the trough" springs to mind.

Corporate America found a way to get around the Federal Reserve Act once, and they will again, and again. Remember that the Federal Reserve Board is appointed by the President of the United States---You know, the same guy who put Halliburton is charge of supplying the Iraq War and rebuilding New Orleans. Who knows how many billions of taxpayer dollars have disappeared already into the gaping, ever-hungry maw of slobbering Halliburton? We may never know.

One thing is certain: Until these guys are out of office, NOTHING will change in regard to the financial sector. Nothing. Nada. Zip. What we need is regulation, real regulation, and real corporate accountability. Any fool can see that financial institutions are completely out of control. (Have you tried calling your bank or mortgage company lately?) And now a bunch of chickens are hovering over America, looking for someplace to roost. (What a weird visual that makes!) It's kind of like a chickensh*t crapstorm.

Don't expect it to look any prettier any time soon. Finally, the President has come to the rescue by putting the fox in charge of the hen house.

Oh goody.

But I better go now, before I drown in corny aphorisms.

Obama’s history shows that he is less interested in specific plans made in advance and based upon assumptions than in real solutions based upon consensus of the parties who know how their own interests will be effected. In short, he understands that commerce, economics, politics and policies are processes rather than events. for those who seek concrete details on the outcome of the processes before they begin, Obama refuses to commit --- because to do so, would be to presume to force others into an apparent consensus rather than a real one.

The Economist has been an advocate for "free trade" based upon [1] ideology and [2] "proof" based upon measurements of commercial activity that they think demonstrates the correctness of their position. Obama starts with a different premise: [1] practicality and [2] broadening the data that is interpreted to include more human factors and more humans.

Obama’s message of inclusion and coalition is not merely a political or electoral message. It is a fundamental, artful shift in approaching commercial behavior from the standpoint of believing that all sides have a legitimate stake in the short run as well as the long term. Criticism of his economic message has focused on lack of specifics. But the truth is that nobody has real specifics because current conditions are either unprecedented or at best difficult to reconcile with historical commercial behavior.

The free market advocates, including those who wish to infuse Basel II which allows Banks more lee-way in making their own risk decisions ignore the fact that the market forces are not free unless [a] there is some referee which inhibits but does not eliminate market dominance of a single company or group preventing access to information or commerce and [b] education and information are available and delivered to level the playing field created by complexity and sophistication in the financial markets that have undermined the notion of risk analysis.

In the recent mortgage meltdown, banks and other lenders made a simple calculation: if they lent the money under circumstances where they were able to sell off the risk element, they stood to enlarge revenue and eliminate losses associated with loan defaults. Stripped of fear of loss, an infrastructure sprung out of the maze of derivative securities that enabled artificial inflation of housing prices, fees and rebates to be paid to virtually everyone in the feeding chain of building, selling real estate, selling securities, lending and investing.

The result was that another massive re-distribution of wealth occurred away from the middle class on the borrowing side, and from government funds, pension funds and other managed wealth on the investing side thus reducing their ability to engage in commercial activity that supports the U.S. economy, which is driven overwhelmingly by consumer spending and availability of capital. The risk analysis performed by poorly educated bankers playing with securities far beyond their level of sophistication has led inevitably to a bubble of unprecedented proportions. Simple stated, a $250,000 house was sold for $400,000 and the extra $150,000 was spread around like confetti.

But the other net result was the equivalent of our eating our young. Most middle class citizens are out of options to come up with money to continue their discretionary buying, and their simply is not enough money around, nor a way to channel money to the middle class that will make up the difference. The result is that the continued divide between ideologies prevents effective solutions that are sitting right on the table but ignored by the decision-makers for fear of abandoning or enraging their political base.

Obama’s message of inclusion and practicality presents a fresh face and a fresh approach. He seeks commonality rather than differences and guides the process toward a consensus rather than either force-feeding poorly vetted solutions or stonewalling perfectly workable solutions. Neither his presence nor his approach crate knee jerk ideological objections in most circles. He presents an opportunity that might not show up again for along time.

As I said earlier - this should be an object lesson to governments not to get involved. I would also add to that and say that there are a lot of takeaways from this for banks -  get the name risk procedures in place early and practice them often. Treat liquidity risk as, if anything, more important than credit risk. On a more personal note - make sure your risk management people are amongst your best. Pay them well.

Buttonwood makes the very valid point that, despite often being derided as the "Wild West" operators, the hedge funds have come through all this (so far at least) without too many major losses. Only a very few have failed (I can think of only one so far, although I am sure there are more) and there have not been many major losses announced.

Banks, on the other hand, have not had a good record. Apart from actually being behind much of the lending that actually caused the issues in the first place the big losses also seem to be concentrated there - just not in the banks that originated the loans. The question Buttonwood asks, but ultimately shies away from is this - is this despite, or because of, the regulations?

Buttonwood puts it this way:

This suggests two main possibilities. Either the standard of bank regulation is very poor or there is something about being regulated that leads to trouble.

The answer from Buttonwood is that it is both - but clearly puts more weight on the first. I would, respectfully, disagree on where the weight should lie.

There are many faults with bank regulation around the world - Basel I, for example, I regard as having improved matters to the extent it was global, but made matters worse by its reliance on simple rules - for example that a loan secured on residential real estate shall attract a 50% weight - regardless as to whether it was super-prime, prime or sub-prime. It also created strong incentives to "game" the system by the "originate and distribute" model that really gave rise to securitisations. This gave a logical reason why a bank may choose to eliminate assets from its balance sheet (other than the possibility they were bad assets) and the market for these assets grew - and ultimately the market got fed some rubbish oops, I mean high-yield assets.

Basel II, particularly the Advanced methodologies, is much better in that economic capital is much closer to regulatory capital - a point I have made many times. It is, however, nearly impossible for smaller banks to implement and most regulators have also said that, to an extent at least, Basel I will effectively continue to apply for a while through the capital flaws floors.

The incentive to game the system, then, will continue, particularly for the banks going Standardised. There are also many other examples of regulations that, while possibly carefully thought out, end up causing many more problems than the one they were originally designed to stop (submissions invited in comments).

Buttonwood's proposed solution is, essentially, to re-introduce the US Glass-Steagal Act of 1933, essentially separating commercial banks (that interact with the general public) and investment banks (that do not). The commercial banks would attract a government guarantee and the investment banks would be free to fail. Entities like Citigroup would have to break themselves into two.

In the (probably too many) years I have been dealing with bank regulation I have seen it fall into several categories - ranging from the ones that simply mandate what would otherwise be common sense to the merely annoying to the outright catastrophic. The last ones tend to be introduced and then pulled pretty quickly.

Some of it is needed for legal or criminal purposes - AML/CTF falls into this category. For the rest I would like, as I have said earlier, to see the regulation substantially removed (or at least pared back) and solutions other than a single monolithic regulator for each country to be tried. If a single regulator gets it wrong now the whole system is at risk until the government rides in on its White Charger - see Northern Rock. A truly competitive system would not allow a single regulator to have that much downside on its failure.

This blog's focus is on financial matters I would be interested in feedback on the questions of what real impediments are there in Western (and in particular Australian) law to allowing Sharia to govern financial arrangements? Given there is wide freedom of contract (within the regulatory limits) I am not aware of many contractual problems - provided the parties to a contract agree to the terms then generally the courts here will enforce it - regardless of whether it is founded on Sharia or not.

Regulatory and taxation issues seem to be the big ones - the banking regulatory system as it stands essentially does not cope with many Sharia compliant frameworks.

A good example of this is a Sharia compliant mortgage institution, which would not be allowed to treat its mortgages in the same way as interest bearing ones and would be effectively penalised with a much heavier capital load. This can be fixed, though - the IFSB regulatory framework could be allowed in the same way that the Basel II one has been.

Insurance would be another regulatory issue. A Takaful structure is also not coped with under current APRA standards - but there is no reason why they cannot be. In theory at least, because a Takaful insurance structure is truly mutual it should be less likely to fall over that a traditional Western insurer.

Funds management and superannuation I have dealt with previously, but as these can be dealt with under the "ethical" banner these should be the least trouble of all.

Taxation is an issue. Like the UK, the  tax law is not set up here for many of the Sharia structures - with the bond-like instruments a particular example. Again, like the regulatory issues, and like the UK, these could be dealt with through fairly simple legislative changes.

By the way, there is a slightly misleading title to this piece, as the standards released today are plainly not final. In the response to submissions paper APRA moot two further changes, both to undo changes that have been made to this version. These are covered below.

One other little gripe - I had some trouble finding the response to submissions paper on the Basel II home page at APRA, as, silly me, I was looking for a paper released in 2008. Perhaps in a cunning plan to make it look like they were early, the release date on the page is 6 February 2007, not 2008. I trust this will be fixed shortly. If you are with APRA, you may want to talk to your web people and get his fixed, pronto. On the other hand, maybe not.

OK, onto the actual content. I will use the APRA paragraph numbers from the response paper to talk through them. If you are really interested, print the thing out. Double sided, it is only 7 pieces of paper. Don't ever print all the requirements.

Advanced ADIs

2.1 - Credit margin data

This was always really just an attempt at further statistics data by APRA, so it is no surprise it got adverse comment and therefore has been deleted. I think the discussion about "gaining a better understanding" and "implementing reporting" over the next 12 months is butt-covering. They may try to bring this in, but I think that there will need to be a bit of systems development before they can do so.

2.2 - Submission timeframes

this wa the big change - APRA essentially got told "no way, José" on the 20 day (4 week) limit for reporting. The extension out to 6 weeks is a good move, particularly early on while these things are bedding down. One of the two reversions mentioned above is that they are talking about moving back to 20 days eventually - with 2009 being mentioned as a possible target. This would mean that there would only be between 4 and 7 quarterly reports done before it moves to 30 days. I am not sure this is enough reports to get the timings down by a third, so I think this will probably be pushed out further. Look to this in 2010-2011.

2.3 - Scaling factor

This was essentially the correction of an error by APRA in application of the scaling factor, so I will leave it there.

2.4 - Repricing analysis

Big raised digit here from APRA to the banks who asked about this one - no change on this front. Although IRRBB will not be a factor until mid-2008, reporting on it starts now.

Win three, lose one - not a bad result.

All ADIs

3.1 - Securitisation

This is an interesting one - some banks' systems do not allow them to split out all the data required for the securitisation reporting and so they said they cannot do it. It was also a bit of an information grab by APRA. They have therefore just given a bit more time as they believe all ADIs should be able to identify this - one quarter. I think there will be a few large spreadsheets as an emergency measure to calculate this one at some ADIs.

3.2 - Derivative and liquidity

Unusual result this - the ADIs actually asked to have some reporting put back in. None of the banks I know asked for this back in, so I guess it was a few of the smaller ones who need to report this to other banks and want the cover of an APRA report to do it. Odd. If anyone knows more, feel free to comment.

3.3 - Operational Risk

This was just a sensible change, where APRA had originally tried to write an exhaustive list of "other businesses" to be excluded from the ops risk capital calculation. The ADIs pointed out many things that were similar to the exclusions noted and were not excluded, so APRA have reverted to a principles based-approach. Much better.

Basel I Continuing Reporting

The other thing - a bit under the radar and not in the response to submissions - is that all Advanced institutions must continue to report under Basel I as well - per ARS 150. This is so that the minimum capital does not fall under the Basel I standards for a while, at least until APRA is comfortable. Though annoying, from APRA's point of view this had to be done as they have said that this will not be allowed. All Advanced banks will therefore have to report under two standards and their minimum capital will be the greater of the two. Well, OK - 90% of Basel I, but you get the idea. I somehow doubt that APRA will actually expect this floor to be hit any time soon.
Remind me, what was the idea of Basel II again? Oh, that's right, lower capital in reward for better risk management.
Those that are continuing to apply Basel I as they are nearly Basel II advanced, but are not there yet (NAB and BankWest) are also covered here.

By 31 December 2007, over 30 on-site inspections will have been conducted in 20 institutions, involving at times up to 100 inspectors at a time. These on-site inspections examined IRB systems for credit risk and advanced operational risk measurement approaches.

As SocGen is one of the largest banks in Europe I am presuming that they were one of the banks visited - I think this a safe assumption. This means that SocGen was assessed for operational risk issues while all of the rogue trading activities was going on - the trading that was risking much more than the capital of the bank.
He goes on to say:

...and 5 institutions (accounting for almost 60% of the total assets in the French banking system) are expected to adopt an advanced operational risk measurement approach. As institutions have the possibility under Basel II of using their IRB approaches to calculate regulatory capital requirements, supervisors must ensure that these approaches are reliable.

I really wonder how reliable the regulators found SocGen's risk management to be in their supervisory visit? How closely did they look? You would have thought that the trading arm, where most, if not all of these events have historically happened, would have been a primary focus of that review. What did they see?
At the very least, SocGen will probably have to carry a much heavier operational risk capital burden now than they would have originally calculated less than a month ago. I think the BoF will have to have a bit more to say on this in the not too distant future. Who is next in line to resign over this? They may not be at SocGen.

[Update]In the light of the latest revelations - see here it looks like a lot more than a single trader should lose his job. It looks like senior management were turning a blind eye to the trading while it was making a profit and only got concerned once it was making a loss. If so, it would make the criminal charge hard to sustain.

There is a lot more to come from this one…[/Update]

This should be an object lesson to governments - do not get involved beyond what the law says you must do.

Introductory paragraphs:

It has long been recognised that that there is a strong complementarity between monetary and prudential policies. A sound financial system is a prerequisite for an effective monetary policy; just as a sound monetary environment is a prerequisite for an effective prudential policy. A weak financial system undermines the efficacy of monetary policy measures and can overburden the monetary authorities; a disorderly monetary environment can easily trigger financial instability and render void the efforts of prudential authorities. Economic history attests to this, as illustrated by the anatomy and consequences of the financial crises that have affected the industrialised and developing world, going back to previous centuries.
So much is agreed. What is more contentious is the view that some fundamental changes in the economic environment over the last quarter of a century may actually have tightened the interdependence between monetary and prudential policies, potentially calling for significant refinements in policy frameworks. In some research at the BIS in recent years we have been exploring this possibility in some detail.

I, personally would disagree with what is "agreed" above - to me, the contrast between "weak" and "sound" is a false one - a "sound" prudential policy can also be a "weak" one, such as using a free banking paradigm and allowing competitive non-state regulators. The "agreement" here is more likely to be amongst regulators and others in the regulatory industry.

That said, within the confines of the current system this is a very useful paper, even if it needs a little bit more proof-reading^*. The authors' access to data and people looks very good and the conclusions they have drawn out of the data and their references look useful.

The real "meat" here, though, is in the tables starting on page 20 - the analysis of the response of regulatory authorities to various financial events over the last 10 to 15 years. The last column in the table could be fuel for weeks of blog posts and discussion. The annex is also useful, being a "first pass" at assessing the impact of the measures taken. Again, for those interested in the area, this stuff is highly contentious, but this analytical framework is a useful one - comparing those countries with took both prudential and monetary approaches to tackling what was viewed as an imbalance to those which only took a prudential measures and looking at the results.

I am not strong enough in statistics to fully evaluate the results, but the methodology looks sound. If you are interested give it a look - and if your stats knowledge is better than mine feel free to give some feedback.

*Last time I checked it was the United States that had an S&L crisis, not the "Untied States".

• Catallaxy: "Rothbard and the Social Credit Theorists" has restarted after a bit of an hiatus.
• Unqualified Reservations: "A straightforward explanation of the current credit crisis, part 1" explains the process well - but just to re-iterate, I disagree. The debate is considerably more civilised, though.
• Marginal Revolution: "New money does not have to enter the loanable funds market" seems to confuse Rothbard with the whole of Austrian economics, but is worth a good read.

Those are the three that I am aware of that are currently active. If you know of more, let me know. I know this is not strictly bank regulation, but I enjoy the topic.

Normal service on banking regulation will resume one I have completed a current job at one of my clients.

I think this would be a good Wikipedia page, or at least a good addition to the current one on Basel II. If you would like to put down notes on your own national regulator's approach(es) to Basel II implementation please put them down here. Once there are a few I will transfer them to the Wikipedia page - or, like anything on Wikipedia, you can just put them in there.

Suggested format (I will work it into a decent table):

Country: Australia
Regulator: APRA
Approaches Allowed:

Credit Risk: All
Operational Risk: Standardised, Advanced
Market Risk: All

Implementation date(s): 1 January 2008 - All approaches
Notes: Some banks (NAB, BankWest) are delaying full implementation until they are accredited for the advanced approaches an are staying on the Basel I based regulations until this is complete, expected 1 July 2008.
Links: Prudential Standards (the implementing regulations)

Feel free to suggest changes or further information to add in.

I say sort of in Australia as a few banks are staying on Basel I for some things, not others. The usual sort of "phased implementation" (AKA foul-up) you often get with major changes like this. Anyway, welcome Basel II.

The sideline on liquidity risk is to note that the one area that has caused the recent problems has been liquidity, not a lack of capital or other problems. Liquidity is the one area that is not really covered by international standards, with all differing regulators following different mechanisms (as noted below). The next project of the BCBS really should be to establish some standards in this area, and it looks like (thanks GRR) this is underway. While not a great fan of regulation, common standards I always believe to be useful, so perhaps some principles-based standards would be a very useful thing here.

Anyway, happy new year. My wishes for this year are:

1. May we get better risk management from our banks;
2. Less regulation from the regulators; and
3. More principles-based standards to follow.

I also believe porcine aviation will make great leaps this year. If you have any similar wishes, feel free to add them in.

Rothbard's (and the Social Credit mob) saw fractional reserve as an evil thing as it allows banks to create money, as it is commonly defined - in that accepting a call deposit and then making a loan from the funds deposited effectively creates money. Both the deposited funds and the loan funds are money - so the bank has created money. I explored this a bit further on the earlier thread and so will not go into it here.

The point I would like to raise here is whether, in the absence of much other regulation, it can just be banned. My point is this. Say a government (for some odd reason) decides to agree with Rothbard and then bans the maturity transformation of call funds. I believe there will be a couple of major problems with this:

1. Firstly, the legislation would have to define "call" precisely. Once you think about this is becomes, to me at least, a tricky thing. How long a call period, and under what conditions, means that a deposit remains "money"? Is it only instant call, 1 second call, 1 hour call, 24 hour call, 11am call or what? Additionally, would a term deposit (of, say, 12 months) that has a call option with penalties remain a  term deposit or does the call option render it a call deposit? If so, what penalties would be needed to make it a "term" deposit?

2. Would the banks not just walk around this anyway? Say the call period decided upon was one week. Could the customer not just deposit funds on one week term and the bank then just grant a revolving line of credit up to the value of the deposited funds, effectively allowing the customer full access to the total value of their deposit (and creating the same effect as an instant call deposit) without breaking the legal definition of "call"?

To me, the only things keeping banks within any mandated ratios that they could walk around are:

1. The ratio is set at a point where the bank would keep it anyway, such as a typical 7% reserve asset ratio (or 9% HQLA in Australia); or

2. The regulators have lots of other tools that the banks fear so they do not bother to try.

Rothbard imagined a world where the "fractional reserve" could be banned and then other regulations become unnecessary.  I cannot see how he could be right.

Now - how long before they formally tell the banks concerned? So far, as far as I have heard, they have not yet been told. You would have thought it would be polite to tell them.

All I can do is encourage those interested in the area to read it.

Abstract:

Although there are differences between Islamic banking and "conventional" banking, there are some fundamental principles that apply equally to both. In particular, rigorous risk management and sound corporate governance help to ensure the safety and soundness of the international banking system. In the light of the growing importance of Islamic banks and Sharia-compliant financial innovation, the increasing integration of Islamic financial services into global financial markets serves to strengthen this point.

The Basel II framework improves the risk sensitivity and accuracy of the criteria for assessing banks' capital adequacy. This framework is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure, the importance of which has been underscored by the recent problems that have arisen in the banking industry worldwide. The guidance provided by the Islamic Financial Services Board (IFSB) is a useful contribution to the realisation of these global goals. It will support the establishment of resilient financial market infrastructures and sound and robust core Islamic financial institutions operating according to safe and sound risk management practices.

With about 20 days to go, the banks were simply told this morning whether they were going Advanced or not and what they were allowed to do. It included a couple of real surprises - not about which banks, but a whole approach.

APRA have been consistent from their first letter on Basel II (23/6/2003) that "...AMA will not be available to non-IRB banks." Yet their announcement this morning gives AMA to two banks not going IRB - NAB and BankWest. Better yet, these ones are not even going Basel II Standardised yet - they are staying Basel I for credit risk.

Of course, that leaves a very big question for these two - what will our capital requirement be next year? Basel I implicitly included the capital for operational risk within the credit risk component. Basel II explicitly splits these - meaning the banks going Basel I plus AMA are having their operational risk capital double counted. APRA will need to clear this one up - and fast. For Australia's biggest bank (never mind BankWest) this is only a slightly important question.

Macquarie's announcement to the exchange this morning was very interesting, claiming to get the "advanced approaches". Note the (presumably very careful) omission of the capital "A" on advanced. This is because they have gone "Foundation" not "Advanced" for credit risk. To me, this comes close to "misleading and deceptive conduct" - but probably not quite there.

Likely attitudes to the announcement:

• ANZ - happy and able to crow about excellence in the usual things that banks like to crow about;
• BankWest - wondering what APRA was thinking about to come up with this approach;
• CBA - happy and able to crow about excellence in the usual things that banks like to crow about;
• Macquarie - reasonably content (and quite smug on the wording of their press release);
• NAB - wondering about how to calculate their capital requirement for next year and how the market will digest this over the next few days (and how to phrase their press release - not out yet);
• St. George - feeling a bit sore but confident they can fix it; and
• Westpac - happy and able to crow about excellence in the usual things that banks like to crow about.

All in all, an eventful day.

• ANZ
• CBA
• Westpac

Foundation and AMA -

• Macquarie

AMA only -

• NAB
• BankWest

There is a lot of gossip in here. Just as a first cut, I went to the banks' websites to have a read - at this point only CBA had their media release out. The rest still had their usual "we are wonderful" media releases.

Macquarie going Foundation is interesting. The difference between Foundation and Advanced is really only in the Retail area and, as Mac Bank does not have a huge exposure to retail lending (except through securitisations) this seems a sensible approach.

NAB not getting Advanced credit risk is really a smack in the eye. They have (according to rumour) spent the most on their project of everyone and have failed to do it. For Australia's biggest bank this is not good. They, and BankWest, can beexpected to catch up soon, though. APRA originally said that no-one would be able to go AMA without an Advanced credit risk approach, o this means they, and the Millionaires' Factory can be expected to go Advanced credit risk soon.
The notable absence is St. George - who seem to have disappeared off the radar. Anyone with decent gossip on this?

[BTW - if you do leave gossip I maintain I will not hand out contact details or other information unless compelled to do so by a court of law. Keep it factual and there should be no problems.]

Go here for the announcement and here for the standards. I will be writing up a review of them if there is anything truly different about them. I hope there is not, as we all have to apply them only a month from now - well, almost all of us. See below.

I will also be retiring my page on the standards, as it is now redundant.

Just out of interest, I did a search for Basel II on each of the Bank's websites earlier this week. Hit stats went something like:

Majors:

ANZ - 36
Commbank - 4 (2 identical documents in two places)
National - 1 (an employee profile only)
Westpac - 1.

Very poor outcome - but try the same using Google site search and the results change a bit:

ANZ - 26 (a drop?)
Commbank - 21
National - 1 (the same)
Westpac - 52.

Others:

BankWest (HBOSA)- 0 (I cannot find a search facility. Odd)
Macquarie - 29 (but many repeats)
St. George - 8 (again, a few repeats)

Google:
BankWest (HBOSA)- 0 (looks like the search facility would not have helped)
Macquarie - 13 (no repeats this time)
St. George - 3 (again, no repeats)

Additionally, not many of the documents are recent. This is, I suspect, for a good reason - several of them will not be ready on time or have been otherwise failed by APRA.

Under the prudential standards, this leaves them in an interesting place - the existing prudential standards will be withdrawn on 1 January and the Basel II ones will come in - but the banks that APRA have "delayed" accreditation for will not have done Standarised projects, and so will not be able to go to either system.

In practice, as Bernie Egan (APRA Basel II program director) made plain, these guys will stay on Basel I until they are cleared.

The big question is - who has already been cleared? Maybe those making the most noise about it?

The errors in this particular piece revolve around a mis-understanding of one of the absolute basics of banking - liquidity risk. The premise of the argument in it was simple - Northern Rock was unable to meet calls on deposits meaning Northern Rock is insolvent and therefore worth nothing.

A basic understanding of banking would show this up as not a logical argument. As discussed in the post on liquidity risk linked to above, banks borrow short and lend long. This gives rise to liquidity risk, which means that if more than a certain amount of deposits are withdrawn in a short period a bank will not have enough physical cash to pay them. This can be, and must be, separated from the overall worth of a bank.

To put it in simple terms (and turn it around a bit) - let's say I borrow money from a bank to buy a house. I manage to service the loan for a few years, during which time the value of the house goes up by 50% per annum - making me very wealthy (in part due to the leverage effect). Unfortunately, I lose my job and, during the period where I cannot find another one I cannot meet the repayments on the loan.

Am I financially worthless? Clearly not - there is a lot of value in my home. Can I meet the bank's demands to pay my mortgage? No.

The Today piece confuses these when the journalist and the talking heads pulled in for the piece argue (at some length) that the failure to pay the demands of depositors means that Northern Rock is worthless.

To those of us watching from the outside this has been a painful process. I can only imagine how difficult it must have been for the US banks. The end result was close to the right one - the one I suggested a full year ago. In this, at least, the delay was worthwhile. Going with the FDIC's original position would have been close to suicide for the whole US banking system - and a long, slow suicide it would have been.

Randall Kroszner's speech on the matter is worth a read. The way he delicately steps around the blithering idiocy errors of the FDIC and the local bank lobbyists is almost artful.

One bit irks me, though - at the bottom of page 5 of the speech he is seeming to say that the US regulators will be coming up with a "standardised"  method of implementing Basel II. Amazing - I wonder what paras 50 to 210 of the New Accord are?

Anyway, if you are interested in my opinion on the whole process read the category. Reading in reverse order is probably best. I think some of my best posts have been in there.

In most of the rest of the world the process has been fairly sedate - well, as sedate as a nearly complete change to the bank regulatory framework can ever be. What am I going to talk about in this way again while we wait for Basel III?