Posts tagged Banking

London Whale - John Cole

JP Morgans ‘London Whale’ beached itself on the front pages again yesterday. This time revealing that the loss incurred by ‘it’ was not the $2.3bn as shown in the cartoon but indeed a mammoth $4.4bn that has caused them to restate first quarter earnings. This will no doubt add a petrol cans worth of fuel to the ongoing regulatory fire that has caused Ed Milliband to give his (rather nasal) two-pence worth. Maybe he should focus more on holding his tea.

But nonetheless the news today has reaffirmed the focus on what regulatory measures should and need to be introduced to the financial system. As a result I think it is worth having a look at ring-fencing and whether it is the answer to crisis prevention. 

Ring-fencing is nothing new. It was part of the Glass-Steagall act introduced in the US in 1933 and the banks managed to operate fairly well under it. This may have been due to the fact that it was somewhat overlooked as regulation and it is argued that when the ring-fencing was repealed by the Gramm-Leach-Bliley Act in 1999 the banks were already operating as though the ring-fence had never been there. But if you look at JP Morgan as an example, their share price the year before this act was repealed was considerably more than it is today. Furthermore, in the time running up to that they prospered, giving out consistent dividends from March 1987 onwards. It is arguable that since the Glass-Steagall act was lifted they have prospered considerably more but I would attribute that more to the globalisation that rapid technological advance allowed rather than being able to mix retail and investment banking interests.

Today ring-fencing is included in the latest regulatory initiatives for both the US and UK. For the latter it forms part of the Vickers commission final report and the Dodd-Frank act for the former. But are these proposed reforms are enough to prevent future disaster? An article by Laurence Kotlikoff, author of ‘The Economic Consequences of the Vickers Commission’, highlights with great poignancy the shortcomings of the proposals. Breaking the ring-fences down into ‘Good’ and ‘Bad’ banks, he goes into the types of assets that good (ring-fenced) banks could hold as well as well as the degree of leverage they can use on these assets. Using his example, ‘good banks would be able to borrow £25 for every pound of equity and invest it all in gilts’. The result being that if gilt prices dropped 4 percent, the commissions good banks would fail. This is a very scary thought.

Kotlikoff actually argues, quite persuasively, that by pushing the bad banks outside the ring-fence and thus segregating them completely from any form of bailout assistance will increase the chances of financial collapse rather than eliminate it. Advocates of ring-fencing will argue that this is the intention and by ‘removing’ this moral hazard, bankers will act more conservatively. This couldn’t be more short sighted. Initially this might happen; banks will have to improve their balance sheets to ensure that investors don’t flee from the added risk. But realistically, as soon as the bull market takes hold again and the going gets good, these investment arms will leverage till the cows come home. And before you say that the shareholders will naturally regulate them just remember how many people were asking questions in the run up to the sub-prime crisis? Few. The majority were going home grinning at their capital gains as I am sure they will do again.

So how do you regulate the banks? Well I don’t envy anyone who is tasked with this and I suspect it will take a few more crises before we even get close to knowing. What I do believe though is that we are looking at regulation wrong. As Kotlikoff points out, ‘good assets go bad’ so how can we build regulation that specifies what is good and bad, risky and not risky. Surely it has to be built on different foundations. For this I think the English legal system has a lot to offer in terms of guidance (ignoring financial law for now). The English legal system is admired the world over for its ability to get justice. Many attribute this to how the various laws allow for enforcers to actually pass ‘judgement’ and use discretion to assess whether the accused acted improperly.

In its current and proposed state, financial law requires institutions to maintain certain levels of capital at a ratio to the amount of risky assets they hold (amongst other measures). This presents a grey area, how do we determine what is actually safe and what is risky? Ultimately this is down to opinion. Kotlikoff reinforces this by pointing out that Spanish, Lehman and AIG bonds used to be considered safe, good assets. So new regulation should focus not on risk, but on providing a set of laws that require the people working within these institutions to act in a prudent manner. The laws should provide scope for severe punishment and accountability against those who do not operate on sound judgement. To give example through the sub prime crisis, proper regulation would have allowed those who did not act with the utmost prudence to be prosecuted (and very few have). Automatically we think of the credit rating agencies who gave AAA ratings to securitised sub prime debt that either they didn’t fully understand or didn’t pay enough attention to. If the regulation allowed it, every person involved in giving these ratings should have faced charges for negligence. This should also extend beyond the rating agencies and apply to every single person who knowingly had contact with these products. Investors who didn’t fully understand what they were buying for their clients portfolios should be prosecuted. It is their duty to do this.

I am not saying that every time an investment doesn’t achieve its intended return, people should go to prison. Investments will always go bad. What I am saying is that new regulation should prosecute those who do not operate with the best intentions and the utmost prudence. Until we are able to predict risk with 100% certainty, risk based regulation will not work.

UPDATE - Loss now up to $5.8bn

I woke up this morning to a fascinating article by Martin Taylor, chief executive of Barclays at the time Bob Diamond was running Barclays Capital.

The article, as Rory Cellan-Jones put it (@ruskin147), shows that Bob Diamond ‘had previous’. Rory also rightly wandered why this story had not had more media focus.

In the article Taylor explains how Diamond had proposed a fivefold increase in exposure to Russian counterparties at a time when Russia appeared to have an appealing domestic bond market. Taylor who chaired the credit committee disagreed and only authorised a ceiling of half that amount. Later in the year Russia defaulted and the ceiling put in place should have limited BarCap’s exposure. This wasn’t the case as Diamond had ignored the limit and significantly increased their exposure. Not only had he increased the exposure but he had tried to cover it up by marking the counterparties as Swiss or American. I think this shows a serious flaw in Diamond’s attitude to rules and highlights that there is likely to be far more revelations in the ongoing Libor scandal. Perhaps more importantly though, it highlights that the board, knowing of Diamonds previous misdemeanours still opted to put him at the top of the company later down the line. Maybe Barclays lack of alignment with public interest and goodwill spread further than just the heads that have rolled recently?

As one former bank executive was quoted as saying, ‘It would be a very good thing if an awful lot of people lost their jobs in a lot of banks’. ‘Not because I wish them ill, but because only by making many examples will you get through to people that this is a very important business’

If this is the tip of the iceberg for Barclays then it will be well worth avoiding in the near future. The Libor probe is being extended to many other banks (bottom of article), which when coupled with the ongoing banking crisis may show investors red flags for the sector as a whole.