Today’s post is from Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. The view expressed here is his own and does not necessarily reflect that of any OECD government.
This week, the German Parliament’s Finance Committee invited Paul Atkinson and me to comment on a draft bank-separation law. The draft is strongly influenced by the 2012 Final Report of the High-level Expert Group on reforming the structure of the EU banking sector chaired by Erkki Liikanen.
Liikanen proposes assigning trading and available for sale securities above a threshold of 15-25% and all activities related to market making to a separate, well-capitalized, subsidiary. This would maintain the advantages of the universal bank model in a holding company structure, but insured deposits could not be used to subsidize the trading activities. The OECD has long proposed a non-operating holding company structure for separation, by ring fencing and separately capitalizing the different activities without restricting a bank from offering a complete range of services to customers. In general terms Liikanen is similar to this. It has the advantage of also of promoting a level playing field for bank competition with stand-alone securities trading firms.
However, the proposal involving a €100 bn “separation trigger” for total assets held for trading and available for sale is not sensible. No bank under €400bn total assets with any amount of derivatives would ever be considered as long as it kept no more than 24.9% of trading assets? If a bank with around €100bn trading assets was subject to a plus or minus 10% volatility cycle in asset values, it could separated and reunited as prices rose and fell.
The Liikanen report urges the Basel Committee and the EU to deal with the shortcomings of model-based risk weighting approach in the capital rules, so that the trading subsidiary (in particular) is well capitalized and not subject to error. The Expert Group also stresses that the directives on resolution and bail-in are an essential complement to its separation proposal. Clarification and pre-notification of instruments that are not guaranteed and will be subject to bail-in should be transparent to promote trust. As far as possible, such instruments should be marketed to non-banks.
Strengthening boards, promoting risk management and disclosure, tackling incentive schemes and sanctions to ensure compliance were also recommended by the Liikanen group.
While the OECD has supported much of this over the years, we disagree with Liikanen on two important points, concerning separation and minimum capital standards.
The first major problem is that, while idea of a threshold for separation is good, the Liikanen group has not chosen the right variable on which to base the threshold. Recent OECD work has sought empirically to explore the factors that make a bank more or less risky: i.e. that take it towards or away from the default point. This research was necessary, because policy after the crisis had to be made ‘on the run’ without enough detailed empirical evidence on which to base reform. Most of the research referred to in the Liikanen report pre-dates the crisis, or is related to recent policy developments, but none of it contains research relating business model features to banks’ distance to default. Yet it is crucial to know which mechanisms are and are not supported by the data.
With respect to the business model features of bank risk, the OECD study shows that liquid trading assets, properly separated from the gross market value of (mainly over the counter illiquid) derivatives, helps to increase the bank’s distance from default and make it less (not more) risky. On the other hand derivatives are overwhelmingly the business model feature that gives rise to interconnectedness risk and default paths arising from illiquidity in crisis conditions (for example the massive margin calls in 2008-2009).
This makes intuitive sense too. Most derivatives are not standardized and trade over-the-counter, i.e. directly between the two parties without being supervised by an exchange. An institution can find itself in a position where it cannot operate because it doesn’t have the liquidity to meet immediate calls for payments on derivatives markets. Dexia is a recent example of such a failure, and if AIG’s derivative commitments had not been met from official sources, bank collapses through interdependence channels would have been difficult to contain. Liquid trading securities, on the other hand, can be sold precisely to meet margin and collateral calls —a very good thing.
This is a fairly major problem for the Liikanen report—they are not looking at the right threshold variable. The idea of a threshold makes sense, but it must be based on the key variable if banks are to be safer. In the OECD view this is derivatives: any bank with a gross market value of derivatives above 10%-15% should be considered for separation.
Putting to one side the empirical evidence for a moment, consider intuitively the case of Wells Fargo (appropriately converted to International Financial Reporting Standards – IFRS – derivatives concepts) and Deutsche Bank. Wells Fargo offers most essential services to its customers, has very low leverage, had no issues in the crisis and is one of the most profitable banks in the world. Wells Fargo received no payments from the US government in settlement of the AIG counterparty positions. Yet Wells Fargo would be considered for separation under Liikanen ‘percent-of-assets’ threshold test. Its trading and available for sale assets were around 21% in mid 2012, but its derivatives were only 6.5% of its adjusted balance sheet—a safe business model for interconnectedness risk according to the OECD research.
Deutsche Bank, on the other hand, with 40% of its balance sheet in derivatives and only 14% of liquid trading and available for sale securities would not be considered for separation on this rule. Deutsche Bank received a payment from the US government in settlement of its AIG positions equal to 37% of equity less goodwill. Enough said.
The second main issue after separation, minimum capital requirements, is dealt with extensively in the Liikanen Report, with calls for “…more robust risk weights…more consistent treatment of risk in internal models [and that] the treatment of real estate lending…should be reconsidered,…”
The Expert Group should have had the courage of its convictions. The core problem is the risk weighting system as proposed in the so-called Basel III international regulatory framework for banks. This introduces an illusory “risk sensitivity” that relates minimum capital requirements to “risk-weighted assets (RWA)”, instead of to actual balance sheets. This has evolved into a system of extreme complexity that invites institutions to look for regulatory ways to reduce RWA relative to total assets (including negotiating with supervisory authorities) rather than ensuring they really have enough capital, defeating the entire purpose of capital adequacy rules.
So long as capital requirements are based on RWA, whose relationship to the actual balance sheet is effectively a management tool, many banks (and the system as a whole) are likely to be under-capitalized. The best solution would be to scrap the risk-weight system at both global and European levels in favor of something vastly simpler and more effective. Failing that, the equivalent can be achieved by strengthening the role of the (non-risk-weighted) leverage ratio to the point where it overrides the risk-weight system.
Today’s post is from Adrian Blundell-Wignall, Special Advisor to the OECD Secretary General on Financial Markets. The view expressed here is his own and does not necessarily reflect that of any OECD government.
The Cyprus crisis is the result of policy mistakes and a failure of collective responsibility, as well as an illustration of what bad policy can do and could do if it’s not corrected. It’s now too late to take the easier steps that could have avoided the problems we’re facing today, but there are alternatives to the myopic, badly conceived plan proposed by the Troika (the committee led by the European Commission with the European Central Bank and the International Monetary Fund that negotiates loans to the states worst affected by the sovereign debt crisis).
While all deposits are supposed to be guaranteed to €100,000, those with above that amount were to be taxed 9.9%, and those with less 6.75%; enough to raise about €7bn, to make up the €17bn estimated to be needed to rescue Cyprus’ banks (since a limit of €10bn for Troika bailout loans was imposed). The deposit plan was (naturally) rejected by Cyprus’ parliament.
The “above-€100,000” depositors are in the main Russian depositors; the bulwark of Cyprus’ role as an offshore centre.
Large withdrawals of electronic funds have been suspended. Electronic transfer of funds from Cyprus has been stopped. Banks are closed, now until next week.
Bank collapses would result in some €68bn deposit insurance liabilities to be paid (at least 1/3 outside the euro area), an amount much larger than Cyprus’s GDP (just under €18bn) —an unthinkable option.
While reports suggested there was a Troika threat to cut off ECB liquidity support (hence collapsing the banks), this was not made by the ECB, which has responsibility for such decisions and continues to support the banks for now.
A key policy mistake in Cyprus was that action was not taken sooner. Hybrid and unsecured bonds should be the first in line (after equity) in burden-sharing during bank failure resolution. Bondholders were involved in burden-sharing in other European countries and implicit bank debt guarantees declined. This caused the amount of outstanding unsecured bonds of Cypriot banks to fall noticeably during 2012 (there is now only €1.2bn of junior bond holders left!) but the Troika failed to take action to deal with the banks. Consequently, the bulk of liabilities now consists of deposits. Early action would have reduced the cost.
There is a collective responsibility here. Starting from the failure to act early, one can add more to the list: the losses of Cyprus’ banks derived mainly from holdings of Greek government bonds, which successive European politicians promised would never be allowed to default; the one size fits all monetary policy; the failure to implement and monitor the Maastricht fiscal pact; and the permission given to enter the euro in the first place.
The Troika’s plan amounts to a confiscation of deposits. The most recent example of this kind of policy was Zimbabwe in 2008—confiscating foreign currency bank accounts (puzzlingly the IMF was critical of this then). And there have been examples in extreme crisis situations in Europe and Latin America before that, which also made things worse and left a deep distrust of banking for generations.
The plan has surprised even the worst critics of the euro project.Not contributing to bank runs is the single most important lesson of hundreds of years of financial policy making in crises, lessons that appear to have been lost on the Troika.
The full implication of this latest policy announcement from Europe is hard to assess. But policy makers need to rethink this policy quickly.
The risk of runs on Cyprus bank deposits is now high, as soon as the banks re-open, in the absence of capital controls and limits on cash withdrawals. Governments went through a lot of trouble to establish new deposit insurance ceilings in Europe. The new harmonised EU (and EFTA)-wide deposit insurance ceilings have to be seen against the background of re-instilling depositor confidence, while also trying to limit moral hazard risks. Major efforts have been undertaken by deposit insurers to raise awareness of these new ceilings. Any policy measure that undermines the credibility of this ceiling runs the risk of triggering a depositor runs in other countries that have banking sectors under stress and weak sovereigns.
The Basel process is trying to discourage reliance on short-term wholesale funding while favouring retail deposits, with a view to improving the outlook for financial stability. Deposits are currently very much sought after. For example, the relative stability of the Italian banking sector in part reflects the ability of Italian banks to increase their domestic retail deposit base. Haircutting small depositors will undermine these efforts.
Restrictions on capital flows, should they prove necessary, perpetuate external imbalances, undermine trust, and may prompt and encourage similar measures by other countries.
There are serious problems on bank balance sheets in certain larger EU economies, which may in the end require bank resolutions. It is only natural that the Cyprus approach be taken as a pointer for what could be done elsewhere (confiscation of deposits). This is very important, because one of the stumbling blocks for the European Banking Union project is the very nature of deposit insurance and who will pay for it. The precedent being set here will make it more difficult to finalise the banking union project.
Trust in the financial system is built around the most basic ideas of caveat emptor for sophisticated participants and protections for unsophisticated investors. European politicians have strongly supported the OECD push for better financial literacy and consumer protection—yet the Cyprus plan says that Europe is prepared to hurt the small unsophisticated depositor in banks that they believed were safe.
Global systemically important banks have not been restructured to separate material derivatives and securities businesses, where caveat emptor should apply, from traditional businesses of deposit taking and lending where protections are important. More volatility can put big banks under pressure via margin and collateral calls, contaminating traditional banking, if the crisis were to escalate from here.
What could be done?
There were so many choices that could have avoided the problems. A list of alternatives from the easiest to the hardest includes:
- Earlier action in the first place—alas now not available.
- Given no meaningful action was taken, ‘tax’ uninsured deposits for all depositors above €100,000 to the amount required. Promises are not broken, and many unsophisticated depositors had more than one bank account to avoid the risk of loss. This ‘big deposits approach’ would undermine Cyprus’ status as an offshore financial centre—but that may not be such a bad thing for the future.
- Capital injections into banks from the European Stability Mechanism (ESM) to the amounts required, TARP-style, in exchange for warrants.
- Fully nationalise the banks, keep them running, and wipe out all equity and bond holders. Restructure the banks, and then sell them back to the private sector—a time honoured and profitable approach, used in Scandanavia, in the US S&L crisis and even on a piecemeal basis in this crisis.
Sticking with the Cyprus plan amounts to telling European depositors and that their money is not safe in any country where banks have problems (bond holders know this already). The ‘coiled spring’ has just been compressed further. For now the private sector believes in ECB magic. This is perhaps the most strongly held market view. But when the strongest-held views are contradicted—even by the slightest hint of a problem elsewhere in the future—the coiled spring could uncoil explosively in a collective unwinding of all those beliefs. This would create new problems and would certainly further delay Europe’s recovery.
Change course now! And, in doing so, clarify Europe’s view on deposit insurance and resolution in the Banking Union plan as soon as possible, making it clear that confiscation of insured deposits will never happen anywhere.
On September 5th 1661, Louis XIV ordered D’Artagnan and his musketeers to arrest Nicolas Fouquet, the “Surintendant des finances”, for the capital offences of embezzlement and crimes against the state (or Louis XIV as it was known in those days). Fouquet was accused of ruining the king through exorbitant interest rates on sovereign debt as well as diverting some of the financial flows from lenders to the royal coffers into his own pocket.
Fouquet defended himself well though, and after a three-year trial was exiled rather than executed. However today he’s mostly remembered for parties that even the Sun King found a tad extravagant (although Louis did build the Palace of Versailles as a bigger, blingier version of Fouquet’s château at Vaux-le-Vicomte).
There’s a lot of truth in the popular image, but it doesn’t tell the whole story. Fouquet tackled problems that would be familiar to any European finance minister today, using means that are still part of the policy response to the current crisis such as cutting public spending, rescheduling debt and raising taxes and improving their collection. (He also used a few that aren’t so common or so blatant anymore such as selling public offices to his cronies.)
Fouquet understood something that is key to the present crisis: the need to restore confidence and get the economy moving. He did this thanks to a number of instruments including reassigning to solvable funds sovereign debt that had in today’s terms become junk bonds and even providing collateral himself for sovereign borrowing.
So, restore trust, fix the financial system, stimulate growth. Three and a half centuries later, you can read a similar argument in a paper by Adrian Blundell-Wignall, Special Advisor to the OECD Secretary-General on Financial Markets. In Solving the Financial and Sovereign Debt Crisis in Europe, Blundell-Wignall looks at why the crisis is worse in Europe than elsewhere and what can be done.
Monetary union means that euro members can’t devalue their currencies to help exports, and pressures on international competitiveness are transmitted directly to the labour market, leading to increased unemployment. Some governments responded by allowing their deficits to grow, and debt with it. Moreover, monetary union has resulted in high levels of debt in the household and corporate sectors in many of the countries that are in the worst competitive positions, leaving little hope that savings can be spent to stimulate growth.
The crisis and recession have increased indebtedness, contributing to underlying financial instability. One of the main reasons the situation is worse in Europe is the nature of its banking system. European banks mix traditional business such as loans to firms and households with activities in capital markets. Countries with large capital markets banks are heavily exposed to the sovereign debt of larger EU countries like Spain and Italy. Traditionally, holding this dull but dependable debt was a safe form of collateral for other activities, but the sharp price fluctuations that are now typical of sovereign debt trading affects the true value of this collateral and the price that shares in this debt could be sold for at any given time.
Deregulation and innovation in financial markets are to blame too. Apart from capital market banking, “re-hypothecation” has grown massively – the practice of reusing the same collateral repeatedly. This increases risk, given that the value of this collateral can drop suddenly, plus the fact that the banks are doing deals for themselves using collateral originally pledged by clients. As the number of deals using the same collateral multiplies, so does counterparty risk, the risk that one of the parties involved can’t meet their obligations.
Blundell-Wignall argues that underpricing of risk is the core cause of the financial crisis and that excessive risk in banking can always be traced to two basic causes: too much leverage, and for a given leverage, increased dealing in high risk products. Far from acting to contain the risk of the proliferation of these products, such as derivatives, regulators cleared the way for them, for example by removing barriers to mixing different types of banking business such as those in the Glass-Steagall Act in the US.
At one time, derivatives were used for practical day-to-day business operations, such as an airline hedging against a big rise in fuel prices, but they rose from 2.5 times world GDP in 1998 (already a staggering figure) to 12 times world GDP before the crisis.
Derivatives trading needs collateral and the price shifts we mentioned above can result in calls for collateral the banks can’t meet. This provokes a liquidity crisis, and the banks don’t have time to recapitalise through earnings, so they stop lending to businesses, especially small and medium-sized enterprises, adding a further twist to the downwards economic spiral.
It’s easy to feel helpless in the face of such arcane and seemingly uncontrollable forces, but solutions exist. Fracturing the eurozone would be one, but while this may lead to a short-term improvement for certain countries, it would weaken the status of the euro as a global currency, increase pressure on countries that stayed in the euro, and create legal uncertainty about financial contracts in euros.
A more coherent approach would include solving the Greek crisis via a 50% or bigger “haircut” on its sovereign debt (reduction in its stated value) and granting the European Financial Stability Facility a bank license. The European Central Bank should continue to support economic growth and investor confidence via funding for banks and putting a lid on sovereign bond rates in key countries. Private banking should be reformed too, with investment banking separated from traditional retail and commercial banking.
That said, sending musketeers to arrest the financiers would appeal to many people.
Smoothing his comb-over to a rakish angle, Vinnie settled his beer gut on the bar and waited for the chicks to come running.
Not the most realistic introduction, I agree, but it’s less naïve than: “Realising that taxpayers would be paying for his greed and stupidity until the Universe started contracting again, the banker apologised sincerely and took steps to make sure it would never happen again”.
In fact, as the FT reports, during questioning by a UK parliamentary committee yesterday, Bob Diamond, Barclays’ chief executive, said the time for “remorse and apology” by banks over their role in the financial crisis should end.
That’s right, Bob, let’s try to achieve closure. The businesses that went bankrupt and people who shut the front door on their homes for the last time managed it, so why not the rest of us?
And if grief counselling doesn’t work, you can always retreat into a magic dream world and “make the issue of bonuses go away”. Bob certainly wishes he could, but when you examine his fantasy closely, it’s not as fluffy as it first sounds. It’s the “issue” (all that mean-spirited whinging) he’d like to go away, not the bonuses they pay each other.
The problem is, it’s impossible to stop paying bonuses without “severe consequences” for business and the banking sector. Let’s face it, the kind of talent capable of losing trillions of dollars and bringing the world financial system to the point of implosion in the space of a few days doesn’t come cheap.
It’s as if the crisis never happened, or if it did, that banks and bonuses had nothing to do with it. That’s not the conclusion reached in 2009 by an OECD study on Corporate governance and the financial crisis: “An area of particular concern in financial firms is whether there is any risk adjustment in measuring performance for the purpose of bonuses”.
In case you’re not clear about what a lack of risk adjustment is, the report gives examples. For instance, despite losing $15 bn in the last quarter of 2008, Merrill Lynch paid out $4-5 bn in bonuses at the start of December before the taxpayer helped with the merger with Bank of America.
Lack of risk adjustment means that the traders and their bosses are more likely to focus on risky short-term schemes that could damage the firm. It also leads to firms overpaying their employees in comparison with their contribution to long-term value creation.
You’d think that proposals to reform the financial sector would deal comprehensively with risk, but as OECD’s Adrian Blundell-Wignall and Paul Atkinson of the Groupe d’Economie Mondiale de Sciences Po show in this paper, the so-called Basel III proposals do not properly address the most fundamental regulatory problem facing the system, namely that the “promises” to repay that make up any financial system are not treated equally.
Here’s what that could mean in practice. Bank A lends $1000 dollars to a company and the rules say it has to hold $80 in capital, so its leverage in this case is a relatively modest 12.5 ($1000 = $80 x 12.5). However, it can pass on the promise to redeem the loan to Bank B.
Bank A now has to cover the capital “weight” of this transaction. Since B is a bank, that weight is fixed at 20%, but not of the original $1000, only of the $80. So Bank A now only has to hold $16.
Bank B doesn’t have to carry the risk either, and can underwrite it with a reinsurance company entirely outside the banking system, and not subject to its rules.
The banks can reduce the capital required from $80 to under $20 and increase their leverage from 12.5 to over 50. Basel III wouldn’t stop this.
Blundell-Wignall and Atkinson conclude that if banks can shift promises outside the bank regulatory system, there’s a strong case for having a single regulator for the whole financial system – and global coordination.
Under medieval insolvency laws, inquiries into bank failure could use torture and hostage taking to get answers. With the loss of traditional values, today’s investigators can only ask questions and seize documents.
Still, they do produce some startling revelations. Speaking to the US Financial Crisis Inquiry Commission yesterday, Dick Fuld, head of Lehman Brothers when it collapsed, said: “Deregulation of the financial industry and lack of government control helped us to make substantial profits in the years leading up to the crisis, so naturally we only have ourselves to blame for the mistakes and mismanagement that led to our bankruptcy”.
Ha ha, only kidding. In fact, he blamed poor decision-making by, wait for it: the Fed. Here’s what he actually said according to the New York Times: “Lehman was forced into bankruptcy not because it neglected to act responsibly or seek solutions to the crisis, but because of a decision, based on flawed information, not to provide Lehman with the support given to each of its competitors and other nonfinancial firms in the ensuing days”.
So, nothing to do with overleveraging, bad bets or Repo 105, an accounting trick that classifies a loan as a sale, thereby reducing Lehman’s liabilities by $50 bn (but only on the balance sheet).
Governments, as we all know, had to step in to clean up the mess, and not just in the US. From October 2008 to May 2010, more than 1400 bonds backed by government guarantees were issued by around 200 banks from 17 countries, for an amount equivalent to more than a trillion dollars.
Aviram Levy of the Banca d’Italia and Sebastian Schich of the OECD’s Financial Affairs Division look at the consequences in an article for the OECD Journal. They show that the guarantees have been effective in resuming overall long-term funding for banks and reducing their default risk, but at least two major issues now have to be addressed.
First, relatively weak banks with strong governments backing them (“sovereign guarantors”) have been able to borrow more cheaply than strong banks with weak sovereign guarantors.
Second, extending the scheme into 2010 allows non-viable banks to take advantage of the continued availability of guarantees and postpone addressing their own weaknesses or, even worse, adopt excessive risks in a “gamble-for-redemption”.
You can’t legislate against the toxic combination of ignorance and arrogance that brought the financial system crashing down. But governments and taxpayers shouldn’t be seen as blood donors permanently on call to stop banks dying from self-inflicted wounds.
OK, wurfing (surfing the web at work) didn’t make it into the new edition of the Oxford Dictionary of English published today, but toxic debt and quantitative easing did.
Speaking of which, haircut was already there. Eh? Haircut, you know: “US informal: a reduction in the stated value of an asset”.
That’s one of the terms you need to understand to follow the argument in a new OECD Working Paper on the stress tests 84 European banks passed so brilliantly in July.
Adrian Blundell-Wignall, Special Adviser to the OECD Secretary-General on financial markets, and his colleague Patrick Slovik point out that the tests only considered “trading book” exposures to sovereign debt, while over 80% of exposure is on the “banking book”.
The trading book consists of the securities a bank buys and sells regularly, even daily, while the banking book contains the products the bank would normally hold on to until they matured, including the bonds used to finance sovereign debt.
For the trading book, the haircut is around €26 bn in the stress tests. No haircut was applied to the banking book, on the grounds a default would be virtually impossible over the two-year period considered. The tests also assumed there would be no bank failures.
Blundell-Wignall and Slovik argue that these two assumptions help to explain why despite the encouraging test results (only 7 banks failed) equity markets are still performing poorly, bond spreads remain high, and banks are still reluctant to lend.
If a bank fails, it cannot hold on to the longer-term assets on its banking book, which would have to be sold for whatever they are worth on the day, even at a loss, and in fact there would be no difference between the trading and banking books. In other words, shifts in the market value of sovereign debt do matter, unless you assume that the stress-tested banks never fail.
That’s a brave, or foolish, assumption in light of what we’ve seen since the crisis broke, but the assumption of no sovereign default over the next two years seems reasonable, given the €720 bn European Financial Stability Facility (EFSF) agreed earlier this year.
The EFSF could more than cover all the funding needs of the most exposed countries, even in the highly unlikely case that no securities could be sold on the open market.
So why are ratings agencies like Moody’s worried about the sovereign debt of even the US, Germany, France and the UK, countries they consider “well-positioned at AAA” in their latest figures?
They’re not worried about the next couple of years, but many analysts foresee problems in reforming labour and pension markets to ensure sustainable growth before the stimulus packages run out. In the medium-term, budget restraints will make these reforms more difficult.
In the longer term, Moody’s is afraid of a situation where states delay pension reform for political reasons, leading to a downward spiral as they try to borrow more to finance deficits, while at the same time, conflict between younger and older generations destroys the social cohesion needed to stabilise debt.
Countries in this situation would lose their triple-A rating.
This OECD paper warns that retirement income may become a “lottery” unless default strategies are carefully designed
“Financial literacy is the new civil rights of today” says John Hope Bryant, Founder, Chairman and CEO of Operation HOPE. Speaker at this week’s OECD Forum, Bryant insists that understanding the fundamentals of finance is a must for everyone. Fighting poverty and unemployment cannot be successful if we don’t give people that knowledge. Check out his contribution to OECD’s educationtoday
Useful links: OECD work on financial literacy