The FinanSer

Operational risk - it’s not just for banks

A quick reminder, if any were needed, that it is not just banks that can suffer from an operational risk event. Governments can too. The difference, of course, is that you can change your bank at any time.

More Poor Journalism

I have been out of contact over the last few days due to the fact I am moving house, so when I finally got my podcasts to listen to there were a few. I saw one from the BBC’s Today program on Northern Rock (warning - multi-megabyte MP3 file) and I thought this may be a good one, in light of my previous experience with them. I was gravely disappointed.
In what is now a continuing meta-story, the journalistic coverage of Northern Rock is showing just how little even financial journalists understand banking.

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 This gives rise to liquidity risk, which means that if more than a certain amount of deposits are withdrawn in a short period a bank will not have enough physical cash to pay them.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.

US Basel II Implementation - Final Rules

One event I missed posting on at the time was the final agreement of all of the US regulators on the way that Basel II will be implemented in the US that happened 10 days ago. After some seriously silly obstinate argument from the FDIC, I was please to note at the time that the Fed largely got its way in the end, and now those rules have now been given final agreement.

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?

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?

Google Maps Mash-Up

When I first saw Google Maps I thought at the time this would be a good thing for me and my kids to discuss the news, where everything was and what is going on where. What is happening now is to cut me out of the process - even my kids can now instantly see where things are happening. A mash-up, for those of my readers not perhaps as familiar with terminology, is where information from two or more sources is joined into a seamless whole. A good example, using Google Maps and various news feeds (and advertising) , is the "Global Incident Map" where terrorism incidents (as defined by the news feeds) are combined with the maps to show the location of every incident combined with headlines and, on clicking on it, the full news article. Anyone care to do one for the BIS news feed? Add in the FT, the BBC business news, the ABC business news, The Economist and a ticker above for the latest news and you have near perfection in a banking business news website.

“Thoughts” by Jean-Pierre Landau

I am gradually coming to a general rule on actually reading the speeches published by the BIS - the less interesting the title is, the more likely it is that the speech is actually worth reading.

This one "Some thoughts on securitization and financial turbulences" by Jean-Pierre Landau, Deputy Governor of the Bank of France, is a good example. Fairly boring title - quite good content. His (or, more likely, his underling's)  analysis is robust, with a good idea of what happened over the last few months. He is also right that the worst is currently behind us as the real problem was always the liquidity freezing up, not the size of the actual losses.

Where I feel he is wrong, though, is in the policy prescription:

Strong capital will not guarantee liquidity in all circumstances. There can be panics and sudden increases in the demand for liquidity. That's the job of Central Banks to help in those circumstances. But a strong capital base in the system – and in all its components – is likely to limit future liquidity shocks.

The first two sentences are perfectly correct. Capital is simply not a substitute for liquidity. The next two, though, are wrong - and they do not logically flow from any of the analysis in the rest of his "Thoughts".

Bank regulators commonly get fixated on capital as the be-all and end-all of bank risk management. The attitude commonly seems to be more risk (of any type)? More capital needed. Liquidity, though, is not improved by having more capital; in fact, it may be hurt. The best capitalised bank in the world will not be able to pay its debts as and when they fall due without liquidity - i.e. it will be bankrupt.

Liquidity management is, and always should be, considered separately from capital management. He is right that a well capitalised bank will find it easier to get liquidity in a liquidity poor market - but Northern Rock was, by the standards of the industry, well capitalised and profitable. Having to go to the Central Bank (the Bank of England) was what destroyed them. Adequate liquidity would have meant that they had no problems and no need for the Bank of England's help.

The message? Good capital will help - but in a liquidity crisis what you actually need is liquidity. Also, don't always believe that a Central Banker is right.

Business Journalism

In the taxi on the way home last night after (another) too long day in the office I was listening to a re-broadcast of what sounded like a BBC program on the current market conditions. I was very pleasantly surprised to hear it actually making sense - the talking heads chosen were happy to correct the journalist if she misunderstood and, even better, the journalist was willing to listen and incorporate the comments made by the interviewees.

There was a particularly good section on Citibank and Prince's resignation. In this, the journalist asked if the sub-prime related write-downs were what had prompted him to go and the interviewee said that the write-downs  certainly did not help, but the failure to knit the bits of Citi together over the years since the last lot of mergers was much more important. He also made the point that Rubin was definitely in Prince's camp and, at 69, likely to stand down soon.

All in all a good program. Unfortunately, after a quick search this afternoon I cannot find it on the BBC website. It was re-broadcast in Australia at about midday GMT, probably live, if anyone can point to it.

This reminded me of an old bug-bear of mine about business journalism - with a few honourable exceptions, a lot of it is wrong or completely misses the point. As soon as it gets beyond simply reporting the facts much of the analysis seems misleading.

In risk management one of the great uncertainties is name risk - how can we be reasonably sure that an incorrect or  overblown story does not (undeservedly) damage or destroy our reputation? Is it the fault of the journalists or of the business community if they print wrong or bad stories?

What can we do to avoid it or at least minimise the risks?

Politician’s Economic Populism

All political campaigns generate their own examples of economic idiocy and this one in Australia has been no exception. Listening to the radio this morning, though, reminded me of this. I thought I was listening to some hick economic populist - then I realised it was a serious policy announcement from the Opposition. For the last few years there has been an enormous growth in the capital value of housing, resulting in (measured from average wages) a large difference in affordability.
The announcement was of a tax break for people who have not yet owned a home to create what amounts to a special savings account for the deposit required to buy a home "so that they can get out of the rent trap". Looks attractive - sensible policy right? Wrong - and this is wrong on so many levels it is not funny.

1. Renting is not a "trap" it is a valid financing decision for a home. If you believe that housing prices are going to drop renting is a good idea. Renters in Japan over the last decade, for example, would be laughing at those who borrowed heavily to get into the "joy" of home ownership. The same could happen in Australia particularly given the high current prices.
2. Renting is also very useful if you are only going to be in an area for a few years - if you have the sort of job that moves you around a fair bit then it may be completely inappropriate to buy.
3. Giving tax incentives to buy your first home reduces your mobility - your tendency to move to get that next job. The government will help you get that first home, but not the second. In fact the Australian State governments will tax you for doing so - probably taking all the money the Feds dropped in to help you buy it and more. If you are not prepared to move for a job then you are either going to stay where you are or, worse, become involuntarily unemployed.
4. Most crucially - the housing affordability "crisis" is not going to be solved by throwing money at it. It is not. The problem out there is not that there is not enough money chasing homes, the problem is that there is not enough housing being built. With prices above record levels in most of Australia there is little or no evidence that more money will solve the problem - in fact the reverse is true. All that more money thrown at the housing market will do is to increase prices further, further reducing affordability.
5. Glib, shonky promises like this one give the impression of helping without actually doing so and end up convincing more people that there is something seriously wrong.

There are many more problems, but that is enough to go on with. If the opposition (or the government) were serious about tackling housing affordability there are a few steps they could take:

1. Release more land for building - either green or (better) brownfield land for multi-unit development. This is the one step that will truly tackle land prices.
2. Reduce or eliminate taxation on land and building construction and transfers to reduce the costs of moving.
3. Do the same for the firms seeking to supply building materials to reduce the costs of those materials.
4. Recognise overseas qualifications to improve the labour supply.
5. After the others - remove the impediments on lending to people seeking to build or buy a house, such as the 80% LVR restriction.

I would also like to see the development of alternatives to the current means of financing house purchase - such as encouraging the development of Musharakah financing, but this is not an immediate way to reduce prices.

Personally, as a home owner, I am very happy with the situation.  I am just glad I got in a few years ago. For the Australians that do not currently own a house, and want to do so either now or in the future, the best you may be able to hope for is that Peter Garrett (ex-lead singer of Midnight Oil) was right.

Credit Crunch - Washup (or Washout?)

Now that many of the banks with some losses in the US sub-prime area have reported it may be a good time to look back at what has happened and then look forward to what is likely to happen over the next 6 to 12 months.

Current Situation

Looking back, I am glad to be able to say that, at least on a macro-economic scale. None of the bigger international banks have had any real problems - with most not even having this problem to cause them to drop into losses for the year, even though some have reported losses (after full write-downs) for the quarter.

Northern Rock was the only bank outside the US to suffer real problems and this was a liquidity issue - not a capital one. Inside the US several smaller banking institutions have failed, but these have been quite small banks that were heavily involved in the lending.

In Australia, again, none of the banks, building societies or credit unions have had any real problems and, after a few weeks of liquidity problems, we have largely returned to business as usual.

The ones that have had problems are the non-banks that have relied on wholesale funds to keep their businesses afloat - Rams Home Loans being a perfect example. Rams, as a business, did not fail, but they have been unable to secure funding to keep it going and had to be, effectively, rescued by one of the banks (Westpac).

Really, what this "crisis" has done is what any instability should do - prune out the weaker players and allow the well-managed and run (or just the lucky) to continue. The ones that have failed were the ones with a business model that was too reliant on other players in the market and / or had poor timing on their fund raisings. When there was instability they were the ones sitting there exposed. Again - the strong survive and the weak perish. If a firm cannot go for a few weeks without external funding then, honestly, why should they be able to survive?

As banking crises go, though, this was a puppy - if a bit of a vicious puppy.

The Medium Term

As the remainder of the US sub-prime stuff reprices over the next 6 to 12 months, though, will it get worse? In short, the answer is no. The bulk of it is still to re-price, but most of the banks that have reported have written down their entire sub-prime holdings, not just the stuff that has repriced already. The reason for this is clear - it is both prudent, and required, for them to do so.

A quick look at IAS 39 and FAS 133 (the relevant accounting standards for most of the banks) says that they have to write their assets down as soon as it looks like they have lost value.  In the case of the sub-prime stuff this has already happened. There will be some adjustments to the values over the next few months, but they can be expected to be upward revaluations as the market starts to clear of this stuff. The written down values would be the current worst case - not necessarily their expected outcome.

In situations like this banks (and other listed firms) are increasingly obeying the maxim that you get the bad news out early, and, if anything, make it look worse that it is. The reason for this is that the market hates downside surprises, but likes upside ones. Getting the bad news out early and big is better than a situation where you just gradually dribble out the bad news.

A single, big, poor number is much better than a few smaller ones.

Banks will take a good look at their counterparties and see if they need to re-visit their lending policies, but the worst of this one can now be expected to be over.

On to the next "crisis". A US recession anyone?