What Do We Do About The Banks – A Risk Management Approach
Mark Garbin, CFA
Much has been written recently about JP Morgan’s $3B CDS loss and Morgan Stanley’s Facebook IPO debacle. We also have many in Congress and other parts of the government again raising a stink about banks “there they go again”. Their answer: Rules, rules & more rules.
Let’s state the obvious: If, even after 5 years, the most sophisticated financial institutions on the planet constantly adapt to new sets of rules and STILL make a mess, how in the world can governments even THINK that any new set of rules can work? Albert Einstein said the definition of insanity is doing the same thing over and over but expecting a different result.
So, in the face of all this, what do we do about the banks?
This is more than a discussion concerning derivatives. It is more straightforward than the 2300 page magnum opus that is Dodd Frank. (By contrast, Glass Steagall was only 37 pages) It goes to the core of what is needed for a 21st century financial system and establishes a framework for regulation:
Disclosure & Oversight and Segregated Capital
Disclosure & Oversight
The lack of transparency with respect to bank balance sheets compounded by lapses by the accounting profession and rating agencies not only make it difficult for analysts and investors to evaluate risks and rewards but it also makes it difficult for regulators to, ex-ante, evaluate institutional and collective systemic risks.
Furthermore we live in a time where governance of financial institutions may be capable in the main, but at multiple points in time and often in the most critical circumstances, each one of these institutions failed to achieve their mandated roles. Why did they all fail and continue to fail precisely at the moments when they are needed the most? The more critical and important question is, how can we expect future financial stability in the face of repeated governance failures?
A major part of the problem lies with the fact that sets of rules vary by country. Another part of the challenge is inherent in the fact that there is no global standardized set of disclosures that each financial institution must report. With an asymmetry of data that are asymmetrically applied it’s no wonder we’re in the mess we’re in.
It is in everyone’s best interest to have an optimally competitive banking industry. However, banks can take a page from the insurance industry: On a quarterly basis, in addition to voluntary segment and loan aggregate exposures, banks should electronically publish in pdf and xls form, a list of securities owned specifying the security identifier number, cost and value. Some banks already provide detailed disclosure in their 10Q filings but it is not standardized and there is often no aggregation of country exposures as well as no delineation of derivative exposures, notional and value at risk. The proposed asset list would be released 60 days after a quarter end (i.e. a 60 day lag) such that competitive advantages are maintained. Just ask leading mutual fund companies if their competitive advantage has materially suffered or pension funds if beneficiaries have been harmed by such a disclosure lag.
Quarterly reports also need to be accompanied by basic risk disclosure: What is the impact to the bank if interest rates change, volatility changes, equity markets change, residential and commercial mortgage defaults change, etc.
What this provides is three things specific to individual banks: Determination of potentially bogus asset valuations, identification of potential problems due to concentration of risk types and asset classes and makes banks officially declare what their levels of risk actually are. While it doesn’t prevent asset losses, a natural and expected consequence of the banking industry, it does allow a larger number of constituencies than currently exists to evaluate the quality of assets and the rigor of their valuation. Think of it as institutionally crowd sourced oversight where the larger the number of self interested evaluators, the fewer the opportunities for obfuscation and outright lies.
Additionally, the disclosure process allows regulators and congressional oversight an early warning signal. It becomes easier to aggregate the totality of asset class risks and break them down by bank and product type e.g. local vs global, mortgages vs corporates, equities vs fixed income, equity derivatives vs swaps or CDS. It also allows non-politically driven groups to draw attention to problems just in case regulators are asleep at the switch.
Standardized disclosure consistent with the highest standards of transparency thus allows for rigorous oversight whereby each financial institution is evaluated and each group can make their own judgments. Here hedge funds and other institutional investors play an important additional oversight role. It is a far more effective and long lasting result if large investors can consider the implications of risk management in order to reign in abuse, however you define it. In the long run, if investors don’t like the way a bank is run, they can exit by, at the very least, selling their shares or if they want to be more activist, short the stock. Yes, shorting a stock allows investors to call supercilious management to task and challenge abusive corporate practices. Alternatively, they can amass stock positions and create a proxy fight as in the case of CP Rail. You may not like activist investors but if you don’t think these are effective practices take a look at the charts of Green Mountain Coffee Roasters, Herbalife or JP Morgan. This is made far more effective by quarterly asset holding and risk and valuation disclosure. Regulators should focus more energies on collective delineation of necessary components of standardized disclosure.
I am also proposing that the industry establish a global oversight valuation group that would examine major components of assets within specific categories to determine whether additional capital needs to be allocated to such asset classes. The insurance industry in the USA has established such an oversight infrastructure called the Securities Valuation Office of the National Association of Insurance Commissioners. While its role is constantly being updated, it is an example of how, proactively, a uniform group of standards can be applied to an industry that is as diverse in size, competitiveness and quality as banks.
Segregated Capital
We now come to the heart of what to do about banks. While disclosure and increased oversight can be effective in their own right and implemented immediately, they are incomplete without a fresh look at capital allocation and segregation. A major issue today is that, from a regulatory point of view, banks use the same capital to cross support a multiplicity of businesses. In this regard, Commercial Banking, Asset Management, Investment Banking, Retail banking and Treasury all benefit from the same capital base making it a very efficient use of capital.
Academically, capital market theory argues that this is beneficial because capital efficiency reduces risk to the system. However, it has been proven over the past 5 years that when there are systemic problems, capital efficiency morphs into capital insufficiency. Basel III only looks at the level of capital inside a financial institution not how that capital is applied by business segment. It does not consider the risk reality of a business segment’s assets, liabilities or cashflow against which capital must be allocated. For example, Basel III STILL does not require capital to be allocated against the holding of ANY sovereign bonds. There is a zero risk weighting and no capital allocation regardless of whether a bank invests in Greek vs US vs Eritrea bonds. Furthermore, it treats all derivatives as capital market instruments. It needs to recognize that a listed call option on a stock that settles and is margined by a Clearinghouse is hugely different than an over the counter Credit Default Swap which may be settled in the future by a Clearinghouse but is not purely a derivative but functions more like a reinsurance contract.
It is too easy to say: “Let’s go back to Glass Steagall”. Such a comment does not recognize the necessary evolution of the modern financial institution and how we all (corporations and individuals) have come to rely upon it. For example, for corporate loans, banks charge interest on a floating rate basis (usually LIBOR plus a spread). This is because it’s how the banks themselves are funded. But this often exposes the corporate borrower to often unwanted interest rate risk. It’s tough enough for a company to take the operating risks of building a plant, creating jobs and making a profit from the products they sell. They operate on budgets. The risk of rising interest rates can materially and negatively impact their ability to execute their business plans. Thus they must necessarily enter into an interest rate swap whereby they lock in a fixed rate. It presupposes that the financial institution with whom they execute the swap has the necessary capital to support it over a 5-10 year period of time. Another example is the home owner who desires a fixed rate 30 year mortgage. Whether they know it or not, they have entered into the same kind of swap that the corporation above has done. This implies that banks must link the credit decision of making a loan to the capital markets derivatives (swaps are derivatives) decisions desired by its clients. Simply put, going back to Glass Steagall means trying to put the genie back into the bottle i.e. not going to happen and more importantly counterproductive and potentially disruptive.
It is right to think that proprietary trading and derivatives can be dangerous. But again it’s too simplistic to say “Let’s stop bank proprietary trading” i.e. implement the “Volker Rule”. Nevermind that some of the smartest financial people on the planet, Mark Carney (Canada), Stanley Fischer (Israel), Augustin Carstens (Mexico) and Kiyohiko Nishimura (Japan) have pointed out how the Volker Rule can result in hamstringing the liquidity of the world financial system at a time when its fragility is being supported by such liquidity. The Volker Rule by definition would also reduce the amount of market making in bonds that banks can do. This is the lifeblood of the institutional fixed income investment world. It is not sexy and doesn’t provide the media talking heads with their headlines of fear and greed. It is, however, the necessary lubricant that supports investments by all the major pension funds for most every citizen in the developed world. Once you restrict such capabilities, costs go up and risks that regulators thought they were controlling actually go up. No wonder these leading global financial minds reject the notion of the Volker rule as it is currently constructed.
Bottom line, there is lots of risk in the capital markets. But so is making loans to people and corporations who can’t afford them. So, how do you define danger? Is it that JP Morgan loses $3B? Is it proprietary trading? Private equity? Not really. Danger is when collective activity requires bailouts by taxpayers. So, what is to be done?
First as Basel III requires, Tier 1 capital needs to increase. That’s a start. However we must go further than that. Banks should segregate their businesses not simply from a financial reporting point of view but formally and from a segregated capital perspective as well. It is not enough to “allocate” capital to a business segment. Most banks and the Fed already do that. It must be both very specific AND walled off. The big change here is that there will be no more cross support i.e. the capital used by the asset management segment for example will not be used to support the investment bank. If it turns out that the investment bank needs more capital, it will have to be provided either by the holding company or by its own means. This will require that each segment be managed like the businesses they are. If the investment bank takes more risk, they need more explicit capital. Notice we are not going back to Glass Steagall but are recognizing that there was some wisdom in separating the functions at least from a capital perspective.
Additionally, since the investment bank has materially different risks than many other segments, I propose that there be created a separate board of directors where some of them are “outsiders” and some come from the bank holding company board and include both insiders and outsiders. There should also be a separate risk committee of the investment bank that presents its findings to the main holding company board on regular specified occasions. It is critical that these risk committees comprise people who are professionally familiar with risks.
Regulators must establish standards such that each of the investment bank, retail bank, asset management, commercial bank and treasury departments need to have their own explicit and segregated capital allocation. This may include triggers for additional capital, limitations on dividends to the holding company, etc. The purpose is to reduce the chances that an impairment of one segment impinges on the others’ abilities to operate. It will allow regulators and investors to distinguish capital requirements in a way that allows for differentiated risks to be covered and fosters business segment diversification. Segregation and business segment reporting should also be specifically identified and discussed in Annual Reports and 10k filings as well as filings that potentially show material changes in business operations. Not every bank does this today. Imagine financial statements that treated each bank segment as a separate company. It would be a whole lot more straightforward to analyze. This fosters the culture of oversight described previously herein and allows anyone to review the required rate of return on capital for each of the business units. It also allows Boards of Directors and shareholders peer to peer transparent reviews that are consistent with standards in the market given the risk adjusted required return on capital. The implication of this means that with respect to JP Morgan, a further loss in Treasury need not impact the business of managing mutual funds or making loans to small businesses. Those in the Treasury segment will suffer for it and the requisite segment disclosure will allow for greater transparency in analyzing a bank and comparing it to its peers.
Capital segmentation should also be part of an expanded brief for the Basel process. This creates better standards that can be implemented world wide to prevent regulatory arbitrage. For example, fee based businesses such as custody, cash management and third party investment management should have a much lower capital threshold than the capital markets group. Additionally, expansion of holding company capital requirements is needed for those institutions that are judged systemically important i.e. “too big to fail” because too big to fail might also become too big to bail out.
These are initiatives that need to be taken, now. The message to the banking industry: Either do this on your own or it will be superimposed on you by regulators who have limited practical experience, no background in risk and may be politically motivated. The message to regulators: Beware the law of unintended consequences. Like it or not, there is much interconnectivity to the financial world. Mark Twain once said: “Every problem has a solution: Neat, Plausible and Wrong”. The role of regulators should be primarily to engage a financial system that supports the growth of an economy. Don’t just make more rules. The more rules you make, the more the banks will slip through your fingers (Apologies to Princess Leia).
Be the moral compass, be the examiners, be the discoverers of trickery and financial baloney. Watch the watchers, the rating agencies, the accounting firms and the third party valuation companies. Superimpose a conduct of transparency. Let the world know exactly what each of the banks owns, what their risk exposures are and work to establish the new global valuation group. More importantly, and more immediately, make the banks segregate their businesses, publicly disclose their assets, establish additional governance requirements and help set rational standards of capital for each of the segments. Grill the banks as to the definition of “segment”. What Wells Fargo considers a “segment” is very different that Citibank’s view. Both are valid so don’t try the “one size fits all” approach. That is a very constructive (AND public) discussion. You might then ask what is a “rational” standard? As the late justice Potter Stewart once said “You’ll know it when you see it”. Take the lead, then make it global.
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