The Financial Services Club's Blog

How to deal with an insolvent bank

Sitting in a conference talking about living wills isn’t how you want to spend your typical day, but it did spark a whole bunch of thoughts in my mind.

The FSA issued their consultative paper 11/16 last summer.

The idea is that every bank with assets over £15 billion must produce a Recovery and Resolution Plan (RRP) by the end of this June.

The RRP = a ‘living will’.

I’m not going to delve into the depths of such matters – you can read all about it on the FSAs website - except to say that the RRP comprises a Recovery Plan and a Resolution Plan.

The Recovery Plan must include a sufficient range of material and credible options to address a range of crisis scenarios, and show how the institution would address these issues to continue operating in a stable way, avoiding capital shortfalls and pressures on liquidity.

The Resolution Plan would show how a firm would wind-down if it failed for any reason, including how it would avoid any impact to taxpayers and the public funds.

All well and good.

Or is it.

Whilst I like the idea of a living will for a zombie bank, it strikes me that we still haven’t gotten to the heart of the matter.

The question is really: what do we do with an insolvent bank that could bring down the economy of our nation?

The answer is not to let a bank become so big that it could bring down the economy of the nation.

So the real answer should actually be more to do with limitations on bank size, structure and asset base leverage, rather than getting it to open up a living will.

To me, this is what the Vickers report separating investment and retail banking, and the Volcker Rule shutting down prop trading is all about.

So the two work in tandem – a bank must shrink its size to be big enough to fail and, if it does, have a clear plan for how to deal with failure.

Yet even then, it doesn’t solve the issues.

For example, the average life of a company in the S&P500 is just 15 years today; most banks have been around for over 100 years.

The reason why banks have been around so long is down to governments regulating and maintaining them, rather than any c0mpetitive forces.

If banks weren’t protected by regulations, they would fail far more often, just as commercial firms do.

And if a large commercial firm fails – Rover, BP or Tesco – they just get acquired or shutdown. 

They don’t bring down the entire economy.

When a bank fails, it brings down the whole economy because the economy runs on finance.

Finance is the oil in commerce – no oil, no commerce.

That’s why banks aren’t allowed to fail.

It’s also why we realise the mistake when they do.

A small bank – a Northern Rock – can fail, but it won’t shake the fabric of the economy of system.,

A large bank – a Citibank or Royal Bank of Scotland – is different.

At the height of the banking crisis, UK bank liabilities were 400% of GDP: £5 trillion against GDP of £1.2 trillion – and the Royal Bank of Scotland alone had more liabilities (£1.8 trillion) than the UK’s GDP.

So now we get into the heart of the matter.

How do you deal with an insolvent bank that could break the economy?

A living will is one piece.

The separation of investment and commercial banking (Vickers) is another.

But the real test would be to go back to the trigger of this crisis: would these regulations have dealt with Lehman Brothers collapse any better?

There are two or three things that come to light in this area.

First, when Lehmans collapsed they had $400 billion of debt on their books.  That debt was linked to global credit default swap derivatives (CDS) and amplified by a factor of 20, according to Barclays Capital.

So for every $1 of debt that Lehmans were exposed to, the markets were exposed to $20 due to their AAA-rating backing derivatives traded through the OTC markets.

Hence, the real exposure of risk the markets felt on September 14^th 2008 was a $8 trillion market collapse, not a small bank folding.

Do living wills, Vickers and Volcker deal with this spaghetti of complexity that each banks’ balance sheet is linked with?

Not yet.

Second, when Lehmans collapsed the company most wrapped up in their web of debt was AIG.  AIG Financial Products in London had been trading CDS to such an extent that most of the market exposure landed on their doorstep and dragged the firm down.

However, AIG Financial Products was also a complex web of structure.

AIG was the largest insurance firm in America, trading in risks through their London office which was registered for European operations in Paris.

So three regulators were meant to track the global risks being traded by one global firm through a web of global offices.

Fail.

Do living wills, Vickers and Volcker deal with this web of globality that each banks’ balance sheet is linked with?

Not yet.

The two points made here are making it clear that the regulators need a global level playing field if their attempts to regulate the markets successfully are going to truly succeed.

But a global level playing field is also impossible, as no country can agree with another on taxation, fiscal and monetary policies.

Just look at the EU right now, and the transaction tax, if you want to see why a global level playing field is not going to work.

Sorry to be a downer Messrs Osbourne, Barnier and Bernanke but, as one speaker said yesterday, “the worst mistake regulators can make is to believe in their own rules”.

Point taken.

 

Postnote: yes, I know that OTC Derivatives regulations with a single data repository is addressing some of the last points made here, but do bear in mind that they haven't yet agreed how to define 'speculative' versus 'commercial' derivatives locally, let alone globally, and you get a sense of why this isn't working yet.

 

The future of capitalism

It’s Davos time, as usual.

In the last week of January, the great and the good of the world’s leadership from governments, business, academia and media all gather in Switzerland to debate the future of the world’s economies and the World Economic Forum, #WEF.

In the build-up to this year’s WEF, it seems that all the magazines, media and men are talking about capitalism, what capitalism means post-crisis and what the future of capitalism will be.

David Cameron made a speech about this last week, as did Nick Clegg and Ed Miliband, and much of the debate resonates with the speech of Amartya Sen that I attended last week.

The core of the debate is embodied in the quote by Winston Churchill that “capitalism is the worst form of economics, except for all the others that have been tried.” 

Link: TrogloPundit

True.

The debate is then what form of capitalism you want: state capitalism or liberal capitalism.

A wholly state run economy fails, as demonstrated by communism; whilst a wholly liberalised, free market economy also fails, as demonstrated in 2008.

So there needs to be a middle ground, but how middling is that middle ground?

Somewhere between the extremes of Western and Eastern approaches to commerce.

Some believe that the West is crumbling due to over-excessive free market liberalism.

In a 2011 report, the Organisation for Economic Co-operation and Development figured that the level of income inequality in the 22 member nations it studied increased by 10% since the mid-1980s, with conditions deteriorating in 17 of them.

A recent report  by the Institute for Policy Studies, a Washington-based think tank, found that CEOs at large U.S. firms earned, on average, $10.8 million in 2010, a 28% increase from the year before, while the average worker took home $33,121, a mere 3% more. At that level, CEOs’ paychecks are 325 times bigger than their employees’. In the 1970s, CEO pay rarely topped 30 times more.

Meanwhile, the average income for an American has reduced every year for the past three years.

On the other extreme, Asian markets are rising fast and taking over, using a more state-led capitalistic approach.

“The world’s ten biggest oil-and-gas firms, measured by reserves, are all state-owned …  state-backed companies account for 80% of the value of China’s stockmarket and 62% of Russia’s.”  [The Economist]

“The ten largest economies in Asia now spend roughly $400 billion a year on research and development (R&D)—as much as America, and well ahead of Europe’s $300 billion. China’s investment leapt 28% in a year, propelling it past Japan to become the world’s second-biggest spender … America’s share of global R&D spending is falling. In the decade to 2009, it tumbled from 38% to 31%, whereas Asia’s rose from 24% to 35%. But science is not a zero-sum game.”  [The Economist]

So there is a new model rising which, according to Time Magazine, “is not so much between capitalism and another ideology but between competing forms of capitalism. The financial crisis, growing inequality and faltering economic performance in the U.S. have tarnished American ‘leave it to the markets’ capitalism, which is being challenged by ‘capitalism with Chinese characteristics’, euro­capitalism, ‘democratic development capitalism’ (India and Brazil) and even small-state entrepreneurial capitalism (Singapore, UAE and Israel). All these models favour a more significant role for the state in regulation, ownership and control of assets.”

The Economist furthers this debate, asserting that the winner is ‘state capitalism’.

Link: Ifyouhavetoaskyoudontknow

“The crisis of liberal capitalism has been rendered more serious by the rise of a potent alternative: state capitalism, which tries to meld the powers of the state with the powers of capitalism. It depends on government to pick winners and promote economic growth. But it also uses capitalist tools such as listing state-owned companies on the stockmarket and embracing globalisation.”

Examples of state capitalism include:

“The 13 biggest oil firms, which between them have a grip on more than three-quarters of the world’s oil reserves, are all state-backed including the world’s biggest natural-gas company, Russia’s Gazprom, China Mobile and Saudi Basic Industries Corporation is one of the world’s most profitable chemical companies. Russia’s Sberbank is Europe’s third-largest bank by market capitalisation. Dubai Ports is the world’s third-largest ports operator. The airline Emirates is growing at 20% a year ...  State companies make up 80% of the value of the stockmarket in China, 62% in Russia and 38% in Brazil. They accounted for one-third of the emerging world’s foreign direct investment between 2003 and 2010 and an even higher proportion of its most spectacular acquisitions, as well as a growing proportion of the very largest firms: three Chinese state-owned companies rank among the world’s ten biggest companies by revenue, against only two European ones.” [The Economist]

“State-Owned Enterprises (SOEs) make up most of the market capitalisation of China’s and Russia’s stockmarkets and account for 28 of the emerging world’s 100 biggest companies.” [The Economist]

“France owns 85% of EDF, an energy company; Japan 50% of Japan Tobacco; and Germany 32% of Deutsche Telekom. These numbers add up: across the OECD state-owned enterprises have a combined value of almost $2 trillion and employ 6m people.” [The Economist]

The Economist believes the trend for the next decade will be towards state capitalism based upon the Chinese model, albeit with caveats and issues along the way, and  concludes that “the Chinese no longer see state-directed firms as a way-station on the road to liberal capitalism; rather, they see it as a sustainable model. They think they have redesigned capitalism to make it work better, and a growing number of emerging-world leaders agree with them. The Brazilian government, which embraced privatisation in the 1990s, is now interfering with the likes of Vale and Petrobras, and compelling smaller companies to merge to form national champions. South Africa is also flirting with the model:

• Over the past 30 years China’s GDP has grown at an average rate of 9.5% a year and its international trade by 18% in volume terms. Over the past ten years its GDP has more than trebled to $11 trillion.
• China has taken over from Japan as the world’s second-biggest economy, and from America as the world’s biggest market for many consumer goods.
• The Chinese state is the biggest shareholder in the country’s 150 biggest companies.
• China’s 121 biggest SOEs saw their total assets increase from $360 billion in 2002 to $2.9 trillion in 2010 … in 2009 some 85% of China’s $1.4 trillion in bank loans went to state companies.”

But note that, unlike America where CEOs’ paychecks are 325 times bigger than their employees, state capitalism is fairer in terms of income disparities: “in 2009 the average SOE boss earned $88,000 and the highest-paid, the chairman of China Mobile, $182,000.” [The Economist]  China Mobile has 600 million customers and is one of the largest telecoms in the world.

FYI, I debated these points a couple of years ago, and concluded that the future is one where capitalism is heavily influenced by the influence of the Chinese and Islamic principles.  

Seems to be coming true?

Link: The World Is Not Enough

Postnote:

The main reading behind this blog post is inspired by two cover page stories:

• How to Save Capitalism, Time Magazine
• State Capitalism, Economist supplement

 

How will the world look post-crisis?

I’ve been debating some future presentations with various folks today, and a little ray of light went off in my head.

The light was triggered by a comment: “can you talk about what impact regulatory change may have on bank to corporate relationships using examples historically?”

The question was really asking about the unintended impact of regulatory change in the past and what it might mean for their future, but it made me think about something else.

Each time we have seen a major bubble burst, the cause has been a coagulation of several forces of change.

Forces for change come from four major directions: Political, Economic, Social and Technological (PEST).

These forces for change are used in many ways, and can be seen in my banking history discussions (and soon to be published book) which talks about many historical periods including the Italian Renaissance, the Great Depression and the Credit Crisis.

In each of these, we can see Political, Economic, Social and Technological forces working together at the same time to drive change.

In the fall of the Renaissance Italians, it was a mixture of change between the break from the Catholic Church with the Protestant and other movements (Political), mixed with the ruin of the Italian banks due to over-extension of credit to overseas Royal Houses (Economic), along with expansion of merchant shipping and colonisation (Technological).

In the Great Depression, we saw the end of the Industrial Revolution (Technological) combined with post-war wrangling over the gold standard (Political and Economic).

Right now, we see a major world of change too.

We have the rebalancing of power between America and Asia/China (Economic) combined with an internet revolution that is connecting everyone on the planet (Technological), leading to changes in society, where a Molly Katchpole can reverse a bank’s policy and an #Occupy movement can change global thinking (Social).

The Political outcome of all of this is what is driving bank regulations right now.

And the outcome of all of this will be a massive change.

A New World Order?

Probably not.

We already have a New World Order as China is expected to be the world’s largest economy by 2018 (ten years ago, it was estimated to be 2047).

But we will see a restructured playing field and one that is not level.

We can see this already as one major economy (America) bans prop trading whilst another (UK) just separates prop trading from retail bank operations.

Even more pronounced are the differences between the US and EU on OTC Derivatives regulations and how to define and regulate Systemically Important Financial Institutions (SiFi).

From CME Group in October 2011:

“In an ideal world, global financial regulators would function something like a team of horses, with policymakers in the United States, Europe, Asia and elsewhere all pulling at once in the same direction, and moving toward a common goal.

“Reality is turning out be far more chaotic, however. Regulators and lawmakers are having a tough time forming a consensus even within their own national borders, let alone across international boundaries. The result is turning out be a patchwork of overlapping and often inconsistent approaches to regulation in the aftermath of the financial crisis that gripped global markets in 2008 and 2009. Many financial experts fear that the inconsistent global regulatory framework will alter the flow of capital around the world, as trades are directed to the cheapest jurisdiction, a process known as regulatory arbitrage.”

So we end up with a world where the politicians are trying to react to the implosion of markets at the end of another revolution – Globalisation – and find that they are seriously lacking consistency, vision, leadership or agreement.

The Eurozone is one of the best illustrations of this, although America and China aren’t guaranteed to come out of this stainless as the American elections will change ground again, as will China’s challenges of a property market bubble and inflationary pressures.

All in all, the PEST approach to the world today says that we are going through a momentous change from all angles – Political, Economic, Social and Technological.

Where will it end up?

Probably in a place no-one expects and one which, on this blog, I’m going to avoid predicting decisively.

From Reuters:

“By 2020, the workforce in western Europe will shrink by 2.4 percent, including a 4.2 percent contraction in Germany, according to a Boston Consulting Group study.

Looking further ahead, HSBC projects that Germany's working population will shrivel by 29 percent by 2050, Russia's by 31 percent and Japan's by 37 percent.

Over the same period, the population of many African countries will double. Nigeria will log a rise of 3 percent a year in its workforce - in contrast to a 1 percent decline in Russia and Japan - and will have as many people as the United States by 2050.

On current projections, Pakistan will be the sixth most-populous nation by the middle of the century. And the Philippines could be the world's 16th-biggest economy, HSBC reckons.”

 

Save the City

There’s an interesting economist out this week with a front page saying: “Save the City”, which seems to be getting everyone a little bit worked up.

Why?

Because it’s in defence of the City.

The story talks about the history of the City, and how its future may be jeopardised by the regulatory and taxation changes taking place today.

The actual main story this relates to – three pages about “Death by a thousand cuts” – is actually a very good factual piece about the City’s role in the UK economy.

Here’s a short summary of the key information in this article by Gary Neill:

First, Britain let banks get out of hand, creating a bubble of exposure that could have ruined the country if the government had not acted the way it did.

“At the height of the financial crisis Britain feared not only the collapse of banks that were too big to fail, but the terrifying risk of having to bail out banks that might have been too big to save.”

This is why the costs of the new regulations proposed in the Vickers report “is likely to be significant: perhaps £3.5 billion to £8 billion ($5.4 billion to $12.5 billion) a year, or even higher”.

But it won’t cripple the City whose “growth over the past six decades has come from international banks choosing to do business in London rather than from the growth of British-owned banks. TheCityUK, a lobby group, reckons that 251 foreign banks have branches or subsidiaries in London and that over half of all British banking assets are owned by foreign banks.”

It is why we talk about London to banking as being like the Wimbledon to tennis – we provide the courts but not the players – and is reflected in the UK’s popularity for trading in OTC Derivatives and FX.

But then other rules are worrying, such as the EU’s proposed financial transaction tax which will raise money for Europe – some believe as much as €55 billion a year, with up to 70% collected in Britain – but would seriously impact London as a viable trading centre. 

“The European Commission’s own impact assessment reckons that it could force 90% of some sorts of trading activity simply to move from the EU, with the loss of hundreds of thousands of jobs.”

Combined with other proposed changes to regulations, all designed to “threaten a market that Britain dominates, to the benefit of centres such as Paris or Frankfurt.”

Add onto all of this that, “on a rough calculation for The Economist by KPMG, getting out of London would be advantageous for high earners.”

Similarly, “the share of Britain’s GDP accounted for by insurance and finance, including retail services like arranging mortgages, has already dropped to just under 8% from above 9% in 2007. The number of people employed by the industry in Britain fell by 7% in the three years to the third quarter of 2011. More jobs losses are likely …

“London has hung on to its top ranking in the closely watched Global Financial Centres Index published twice a year by Z/Yen, a consultancy. But the gap between London and New York, in first and second place, and Hong Kong and Singapore in third and fourth has narrowed in recent surveys …”

At this point, the article makes a strong case for why London succeeds as a financial centre when others fail:

• “Incumbency is a powerful barrier in industries, such as finance, where there are strong network effects.
• Trading attracts liquidity and thus more trading.
• A steady supply of skilled financiers adds to the virtuous circle.
• The use of English around the world gives London an edge over other European centres.
• London goes to work in the middle of the global trading day: the City day starts just as Asia’s financial markets are closing and its financiers are still at their desks when the New York market opens. That makes it an ideal spot for global asset managers.  One-third of the £4.8 trillion of funds managed in Britain is on behalf of foreigners, according to TheCityUK.
• London is also an ideal place to strike deals between parties from different countries, because of its highly respected body of commercial law and experienced judges.
• London’s lead in foreign exchange, as well as in interest-rate derivatives, grew out of its reinvention in the 1960s and 1970s as an offshore centre for dollar deposit-taking and lending, after sterling’s decline as a reserve currency.”

But it also talks about threats to this strength, such as many of the City’s bigwigs are from the 1980s, and a new breed of financier is coming out of Asia.

I liked this piece, and think it builds on my history of the City of London series which is soon to be released as a new book.

The article is balanced, informative, factual and has some great content.

Then there are the two supporting articles that go with it, which are not.

They are contentious, ill-informed, biased and potentially xenophobic.

These pieces really are not good, with some saying it’s an appalling piece of journalism, such as Ian Fraser.

Ian is an outspoken journalist about the crisis caused by the British banks, and is often damning in his views about the banking system.

With this piece, he’s surpassed himself.

“This intellectually lazy piece of journalism is a disgrace. More than any Economist article I’ve recently read (some of which have been excellent by the way), it has made me give serious thought to cancelling my subscription to The Economist.”

Why so harsh a criticism?

Well, here’s the article Ian picked on: “Save the City”.

He claims “it doesn’t even start to acknowledge the multifarious failures of the financial sector, or the damage it has wrought on the UK economy in recent years. The article fails to mention the massive risks posed by “crony capitalism” and “regulatory capture”, including wilful blindness to fraud, and even includes the words –

Finance—the funnelling of savings to their best use—is a vital industry. Britain is very good at it, leading the world in various financial markets, including foreign exchange and over-the-counter derivatives.

Who wrote this garbage I wonder?”

I don’t think it was quite so bad myself.

Instead, I took offence at the other article supporting the City.

This one is from Schumpeter – named after a famous Austrian-American economist from the last century – and is entitled: “the dangers of demonology ”.

Here's a brief excerpt of what I found misleading:

“Throughout history, moneylenders have been persecuted. Ethnic minorities—most obviously the Jews in Europe and America but also the Chinese in Asia—have clustered in the financial sector first because they were barred from more respectable pursuits and later because success begets success. At times, anti-banking prejudice has acquired a strong tinge of ethnic hatred.

“In medieval Europe Jews were persecuted not only because they were not Christians but also because killing them was a quick way to expunge debts. Karl Marx, who came from a Jewish family, regarded Jews as the embodiments of capitalism who could only be rescued from their ancestral curse through revolution.

“The forgers of the ‘Protocols of the Learned Elders of Zion’ wanted people to believe that Jewish financiers were engaged in a fiendish global conspiracy. Louis McFadden, the chairman of the United States House Committee on Banking and Currency in the 1930s, claimed that ‘the Gentiles have the slips of paper while the Jews have the lawful money’”, and “a survey in the Boston Review in 2009 found that 25% of non-Jewish Americans blamed Jews for the financial crisis, with a higher percentage among Democrats than Republicans.”

In other words, the Economist is running an article that implies the banking crisis could lead to anti-semitism on a grand scale once more: “demonising bankers will not solve these problems—and may well, if unchecked, bring a lot of ancient ugliness back to life.”

I personally think that is incredibly inflammatory and biased.

When combined with the Save the City, these two articles undermine the Economist’s credibility and heritage.

It’s a shame, as the death by a thousand cuts piece has some real substance.

Ah well.

So much for the heady days of journalism with integrity, I’m off to watch Hacks again.

 

 

 

 

Banker commits murder and gets away with it

A year ago, the FSA issued a short 298-word statement saying that after an extensive 17 month investigation into the collapse of the Royal Bank of Scotland (RBS), no action would be taken against Sir Fred Goodwin or others. There was a general outcry, so much so that after initially dismissing any indepth report, they decided they would write one.

It was released today – all 450 pages of it – although it doesn’t add to much more than what we knew a year ago:

(a)    the market conditions allowed it to happen; but

(b)    it was the CEO Sir Fred Goodwin and his management team that were at fault; and

(c)    the FSA messed up by not challenging them.

The report does however make clear that there is more to what happened than can be generally perceived, and provides some interesting insights about the history, issues and prevailing culture within the bank at the time.

For example and in hindsight, it’s obvious that the megalomaniacal Fred Goodwin was doing too much unchallenged.

How megalomaniacal was he?

Well, he was almost Machiavellian according to many reports.

I still remember the fact that he wanted to rename Scotland’s capital city Fredburgh, and that the corporate HQ at Gogarburn was his testament to history with its own golf course.

The fact that he would override decisions made by his management team, including those of the Chief Risk Officer, if he felt it was the right thing to do.

And the reports that have come to light that he even would go mental if the wrong sort of biscuits were served at meetings, goes to show the lengths he had reached in his boardroom seat.

Then the world collapsed for him as the disastrous ABN AMRO acquisition, plus a catalogue of other errors, meant that the bank’s capital and liquidity position had become over-exposed.

This is all in the FSA report, although not in the terms many would use.

For example, a section of the report is headed: “The ABN AMRO acquisition: an extremely risky deal”.

It was originally titled: “an extremely risky gamble”, but Fred’s lawyers forced the FSA to take out the word gamble as it could be used in a case against him, should one ever come to court.

It won’t be, as there is nothing in the legislation today that says that a bank CEO who screwed his bank can be brought to court.

This is one of the changes recommended by the FSA’s report, which elects to offer either a strict liability or clawback basis for curtailing a bank executive’s bonuses, pensions and more, if he or she causes the bank to fail.

But that’s for the future, not for the past, and hence Fred and his team get off scot-free so to speak.

What really gets me in this report is that the FSA knew he was a rogue CEO as far back as 2003.

I would rewrite it, but today’s Guardian summarises this piece well:

The FSA said that between 2003 and 2006, its supervision team highlighted "chief executive dominance" during meetings with the then RBS chairman Sir George Mathewson and that, with hindsight, more senior regulators should have been involved in a review of the bank at this stage.

The FSA sets out how it attempted to assess the risks posed by Goodwin's dominance. In October 2004 because of a "poor regulatory relationship" and lack of access to non-executive directors, its supervisory team recommended that a "section 166" review be commissioned. These reviews – named after the clause in the FSA's rules – require banks to hire independent firms to conduct a review of certain activities and report back to the FSA.

In the event, the FSA did not commission the review because its supervisors met a group of non-executives in December 2004 who were able to provide examples of where they had challenged Goodwin. One example was when Goodwin had wanted to launch an electronic bank which was rejected by the non-executive directors.

The FSA's report into what went on at RBS concludes that if a section 166 review had been commissioned, as first intended, it "would have sent a strong message to RBS, including its board, and might have provided the FSA with more information on the effectiveness of governance, particularly around the potential dominance of the chief executive".

In the event, the FSA kept reviewing the board structure of the bank until October 2006 when it concluded that the "risks associated with CEO dominance and challenge to him had been mitigated sufficiently that the issue could be closed". It was convinced that the appointment of a new chairman, Sir Tom McKillop, and new finance director would provide a new challenge to Goodwin.

But, with hindsight, it says that a "key missing element" in deciding to close the review about corporate governance was "engagement at the most senior FSA executive level".

"This reflects a more general tendency in the FSA's pre-crisis supervisory approach for key supervisory decisions and responsibilities to be delegated several layers below the FSA's CEO," the report said.

Another area of anger is that we all knew the ABN AMRO acquisition could be disastrous back when it happened.

Back then, it was obvious that a battle with Barclays over ego had taken place, and Fred just wanted to win at whatever the cost, in order to stick two fingers up to John Varley, the Barclay CEO.

He therefore not only outbid Barclays in over-valuing ABN AMRO, but ABN also sold key assets in the USA before the acquisition went through, devaluing the bank.

So the result was an overpayment for a smaller bank than the one Barclays originally bid for, just to satisfy the ego of Fred Goodwin.

This is corroborated in the report, which states that “due diligence was inadequate in scope and depth and hence was inappropriate in light of the nature and scale of the acquisition and the major risks involved”.

It asks:

• “Whether the Board’s mode of operation, including challenge to the executive, was as effective as its composition and formal processes would suggest.
• Whether the CEO’s management style discouraged robust and effective challenge
• Whether RBS was overly focused on revenue, profit and earnings per share rather than on capital, liquidity and asset quality, and whether the Board designed a CEO remuneration package which made it rational to focus on the former.
• Whether RBS’s Board received adequate information to consider the risks associated with strategy proposals, and whether it was sufficiently disciplined in questioning and challenging what was presented to it.
• Whether risk management information enabled the Board adequately to monitor and mitigate the aggregation of risks across the group, and whether it was sufficiently forward-looking to give early warning of emerging risks.”

It’s just a shame that it cannot say that this was the case, but had to wrap it up in whethers and possibles due to the legalese issues, in the same way that it couldn’t call the ABN AMRO deal a gamble, as this is exactly what it was.

The report concludes that there were six factors predominantly at play here, on top of the poor management controls internally, namely:

• “significant weaknesses in RBS’s capital position, as a result of management decisions and permitted by an inadequate global regulatory capital framework;
• over-reliance on risky short-term wholesale funding, which was permitted by an inadequate approach to the regulation of liquidity;
• concerns and uncertainties about RBS’s underlying asset quality, which in turn was subject to little fundamental analysis by the FSA;
• substantial losses in credit trading activities, which eroded market confidence. Both RBS’s strategy and the FSA’s supervisory approach underestimated how bad losses associated with structured credit might be;
• the ABN AMRO acquisition, on which RBS proceeded without appropriate heed to the risks involved and with inadequate due diligence; and
• an overall systemic crisis in which the banks in worse relative positions were extremely vulnerable to failure. RBS was one such bank.”

Well worth the two and a half years of researching and writing such analysis, not!

Meanwhile, fyi, Fred’s back on the prowl  looking for a job in the City … and knowing his ability to avoid shit hitting his fan, he may well find a new fan to fuel for the future.

Just like several other characters I could name.

So Machiavelli is maybe a good comparison after all: “the question whether it is better to be loved rather than feared, or feared rather than loved. It might perhaps be answered that we should wish to be both: but since love and fear can hardly exist together, if we must choose between them, it is far safer to be feared than loved.”

 

 

The London Protest #OccupyLSX is useless

I’ve been down to the #OccupyLSX, or #OLSX for short, site several times. 

That’s the Occupy London Stock Exchange site for those not following them on twitter.

They were inspired by the #OccupyWallStreet, or #OWS folks, who began protesting back in September.

Our group is a similar rag, tag and bobtail amalgamation of disparate folks, from happy-clappy hippies …

… to anticapitalist activists …

… with a healthy dose of travellers, vagabonds and vagrants …

… thrown in.

They do have a point, but their point is lost with so many disparate views and groups. 

Some want environmental change; some want legalised drugs; some want a more eqaual society; and some just want to play their didgeridoo and hope for peace in the world.

It’s amusing rather than concerning.

• some are more activist, e.g. some took over buildings this week as protests and were being police kettled away;
• some  are more sharp, e.g. they caught an undercover policeman in their midst during the protests; and
• some are just dumb, e.g. the policeman who got so drunk that he fell asleep in the protestors’ tents.

In between, there is a serious point here.

From the Occupy London website:

“The words ‘corporate greed’ ring through the speeches and banners of protests across the globe. After huge bail-outs and in the face of unemployment, privatisation and austerity we still see profits for the rich on the increase. But we are the 99%, and on October 15th our voice unites across gender and race, across borders and continents as we call for equality and justice for all.

“In London we have occupied the forecourt of St Paul’s Cathedral, next to the London Stock Exchange. Reclaiming space in the face of the financial system and using it to voice ideas for how we can work towards a better future. A future free from austerity, growing inequality, unemployment, tax injustice and a political elite who ignores its citizens, and work towards concrete demands to be met.”

Now many sympathise with the point that the divide between rich and poor is too great, and that fat cat company bosses are getting away with daylight robbery.

For example, in this ‘age of austerity’ where most folks are losing their jobs, the latest survey of boardroom pay finds that the average compensation for a FTSE100 company director went up by 49% last year to £2.7 million per CxO; the richest 400 people in America have more wealth than the 155 million poorest combined; and it’s getting worse.

According to CBS News, “the top-earning 20% of Americans received 49.4% of all income generated in America compared with the 3.4% earned by those below the poverty line.  That’s a ratio of 14.5-to-1 gap between the richest and poorest; an increase from 13.6 in 2008 and nearly double the low of 7.69 in 1968.

“The poorest poor are at record highs. The share of Americans below half the poverty line - $10,977 for a family of four - rose from 5.7 percent in 2008 to 6.3 percent. It was the highest level since the government began tracking that group in 1975.

“The poverty gap between young and old has doubled since 2000, due partly to the strength of Social Security in helping buoy Americans 65 and over. Child poverty is now 21 percent compared with 9 percent for older Americans. In 2000, when child poverty was at 16 percent, elderly poverty stood at 10 percent.”

Also see Mission Silver for more.

Now most people agree with these core views.

Even bankers agree.

In a study by St Paul’s, that was released just after the protest started, they found that most financial professionals believe that bankers, stock brokers, FTSE 100 chief executives, lawyers and city bond traders are paid too much.

They say that of the 515 financial professionals surveyed, 75% agree that there is too great a gap between rich and poor.

So where is the disparity of opinion here?

There isn’t one.

But the issue lies more in expression.

If the 99%, as they call themselves as well – that’s the 99% of people not feeding at the trough of capitalism – want the 1% of those who are feeding to change, they need to make their point clearer.

And they need to make it more pertinent.

In fact, in London, they’ve really messed up by occupying a Church rather than the London Stock Exchange.

Who are they protesting against?

God???

Attacking a Church for Christ’s sake – sorry, for Cameron’s sake – is not going to change anything.

Meantime, no-one in the City cares about them.

In fact, no-one in the City is affected by them as their occupation doesn’t affect the banks, who are all now based in Canary Wharf and around Liverpool Street.

What a waste of time.

And if they want to make their point more pertinent they really need to hit people where it hurts, not just banks, but corporate greed and the divide between the rich and poor.

So how do you hit where it hurts?

In the wallet.

That’s what they really need to focus upon.

And to achieve that it needs political change, which is happening anyway.

Take note, the Bank of England are considering a crackdown on bankers’ bonuses through regulatory reform.  From the Sunday Telegraph this weekend:

Robert Jenkins, an external member, said earlier this month: "Return on equity is the wrong target. Over the last 10 to 15 years it has helped to make many bankers rich and loyal shareholders poor."

Return on equity, or RoE, rewards bankers for taking risk that in the recent crisis was ultimately borne by taxpayers.

Instead, both Andy Haldane, the Bank's executive director of financial stability and a member of the FPC, and Mr Jenkins believe that bonuses should be measured against return on assets, or RoA, which adjusts for risk.

"While the risks have typically been borne by wider society, the returns have been harvested by bank shareholders and managers," Mr Haldane has said.

According to his analysis, the effect on bonuses from switching targets would potentially be huge. Between 1989 and 2007, in which time there was "increasing focus on RoE as a performance target", the average pay of the top seven US investment bank bosses rose from $2.8m to $26m. If their performance had been linked to RoA, it would have increased to just $3.4m.

"Rather than rising [from 100 times] to 500 times median US household income, it would have fallen to around 68 times," Mr Haldane said.

The difference can be illustrated using a mortgage. If a house price rises in value from £100,000 to £110,000, the RoA is just £10,000, or 10pc. But if it was bought with a £10,000 deposit and £90,000 debt, the RoE on the £10,000 of equity is 100pc.

However, where homeowners bear the risk of a fall in house prices, bankers do not. According to Mr Haldane: "In effect, RoE is skill multiplied by luck."

The changes are therefore happening, but not as a result of the Occupy protest, but down to good old common sense.

And if the protestors want to push the regulatory changes through faster,  I would recommend our hippies, anarchists, travellers and homeless to go Occupy the Bank of England and Parliament until they get their regulations right and make the disparity between rich and poor, particularly where it’s based upon pure luck and no skill, a little bit better.

Meanwhile, their protest is pretty useless anyway.

By comparison with the States, where they have real passion, our lot are a damp squib.

In fact, there are many rumours that the protestors don’t even occupy the site in the evenings as it’s too cold.

So we went down there on Friday.

I stood by the tents and said: “I’m in favour of bankers’ bonuses, would anyone like to argue about that?”

No-one responded.

St Paul's Protest, 2nd December 2011, Part One from Chris Skinner on Vimeo.

I walked round the camp for about five minutes saying that I’d like to argue about why bankers’ bonuses are a good thing.

No-one came out of a tent.

St Paul's Protest, 2nd December 2011, Part Two from Chris Skinner on Vimeo.

It was 6:30 on Friday night, 2^nd December.

So much for an effective protest.

 

 

Risk is not a discipline, it’s an attitude

One of the panels at the trading technologies show that I chaired was all about pre- and post- trade risk, and the impact of real-time risk management.

We were meant to talk about real-time risk, what it would mean, the ability to be able to see credit, market and liquidity risk across counterparties, asset classes and instruments throughout the day as it happened, rather than intraday or, worse, yesterday.

Yea.

Hmmm.

As the panel progressed, I realised something was wrong.

I realised that real-time risk is irrelevant.

It means nothing.

Forget it.

Real-time risk is too late.

It means it’s happened.

What you need is forecast risk, not real-time.

You need a great way of looking at future risks and being able to map them, then you need real-time to address emergency situations as risks hit the business that were either unknown known’s or unknown unknowns (that old chestnut again).

The thing is that we’re all talking about risk these days, and that banks must take on risk to be in business.

The nature of banking is to borrow your money, in the form of deposits that they pay you interest against to look after, and then lend that money at a profit to others in the expectation that others will pay it back at some point.

That last part is where the risk exists, and it’s a simple matter of assessing the risk of default.

It was simple, but not anymore.

It was simple because it was purely credit risk: if I lend you money, will you pay it back?

It got complicated as the banks began to speculate with money through investment instruments: if I invest in this equity or currency, will I make a profit?

That’s when market risk became a discipline.

Now it’s hellishly complicated, as banks have to build in a new form of risk dimension: if I invest in this equity, currency or derivative, and suddenly the credit lines for those assets are taken away due to the market volatility and irrationality, can I cover my liquidity position?

No wonder banks have to run massively complicated scenario models through Monte Carlo simulations to try to ensure they catered for every potential eventuality and ensured it can be managed.

That’s the forecasteable aspect of risk which we’re really trying to get at today: being able to cater for any market movement, loss of credit or liquidity in real-time thanks to having fantastic scenario models and plans to manage every forecasteable situation.

Obviously impossible, but a good objective.

What is possible is to minimise risk exposure.

You can’t eradicate risk, otherwise there would be no risk, but you can minimise exposures.

A little like fraud: you can’t get rid of it, but you can reduce it to an acceptable level of tolerance.

And this is where it gets real interesting, as it means that risk is a management discipline and science.

You can run risk modelling and crunch it through FPGA systems and then manage the whole lot in real-time.

But even that’s not good enough.

And this was the other realisation I had as the panel debated and dialogued.

It’s not good enough as, even with all of the best systems, simulations, models, disciplines and risk scientists in the world, risk is nothing to do with technologists or analytics.

It’s to do with culture.

That’s where the operational risk exposure kicks in.

The culture of a bank determines it’s appetite for risk.

In the case of RBS, their risk appetite was determined by Sir Fred Goodwin, the Chief Executive.

That’s what screwed them.

If you want to know what I mean, here’s an insight.

In the good old days of Sir Fred, all decisions on important matters of risk were made by a panel of risk managers from across the business.  But if Sir Fred disagreed with the Chief Risk Officer’s view, he could override that decision.

In other words, RBS’s former Chief had the final risk vote, not the discipline and management who understood risk.

The same could be said to be true of HBOS, which was run by a retailer who understood selling but not risk.  No wonder they sold billions of pounds of commercial loans that then went belly up.

And the same is true where we see rogue traders like Jérôme Kerviel of Société Générale‎ and Kweku Adoboli of UBS appear.

In these instances, the culture of the trading room was all about alpha at the expense of prudence.

The management encouraged such irrational practices and the risk management discipline was lost for the expense of bonuses and profit.

And there’s where all banks are now trying to sort out the issues, as are regulators.

But the issues will not be resolved if the bank’s culture is one that encourages risk without discipline, accepts opportunity without prudence, and seeks alpha without beta.

Like the Greeks, the bank will be insolvent, and the markets will feed on its rotting bones.

So risk is nothing to do with systems and models, but all to do with people, management and culture.

Well worth remembering the next time you see the extraordinary madness of banks.

 

Postscript:

Picture of a known gnome from my garden lol

 

 

10% of lending via P2P?

I joined an interesting webinar yesterday about P2P Lending alongside:

• James Gardner, author of "Innovation and the Future Proof Bank"
• Gijsbert Koren, author of "Crowdfunding - The New Investing"
• Rhydian Lewis, CEO of RateSetter

What was new to me was Rhydian’s take on P2P Lending.

Rhydian is a career investment banker and set up Ratesetter with colleague Peter Behrens of RBS in 2009.

I had assumed it was another Zopa, but Rhydian distinguishes between the two by saying that in Zopa’s model the investor (or saver) chooses the borrowers they want to accept based upon risk profiles.  Ratesetter is just a pure S&L (Savings & Loans) platform, and they pool funds and allocate to borrowers on a purely commercial, rather than social offering.

Here’s the low-down on Ratesetter from their blog of October 7^th:

“RateSetter today celebrates our first full year in business. One year ago today, we launched RateSetter on an unsuspecting world, with the vision of creating great value Savings and Loans products between creditworthy Borrowers and smart Savers.

“In that time, we have reached some terrific landmarks. We have matched just shy of £9m (now £9,800,645 with an average loan size of £3,695), across 2,400 loans, and 65,000 members. We regularly match more than £1m a month, and have helped create over £165,000 in interest for our Savers.”

And from May 26^th:

“The Provision Fund (PF) is what makes RateSetter different from any other P2P lender. It is a pot of money that shields Savers from defaults from Borrowers. If a Borrower is late on a payment or defaults altogether, the PF steps in to compensate whoever lent the money. If/when that money is recovered, it returns to the PF.

“The easiest way to understand the PF is as a company. Credit Rates are like revenues, and any late payments or defaults are like costs. RateSetter acts as the management for the PF, managing both revenues and costs. It’s important to note we have no direct financial interest in the performance of the Fund (though naturally we have a substantial indirect interest).

“The reason that the PF exists is because we believe that this is a better way of mitigating the risk for Savers – it drastically reduces the element of “luck” that loans will go bad, that Saver returns will be less than expected. We have a very stringent credit policy, which at the moment declines over 85% of the applications made to it. So it’s important to recognise that the PF makes us no less cautious than if we were lending our own money (which incidentally some of us are).”

So this is a very different offer from social P2P lending, as it removes the social context and makes it pure crowdfunded lending via a third party risk manager.

For example, here’s how Zopa talk about their style of operation:

“Peer-to-peer lending is a smarter, fairer and more human way of doing money. It's like borrowing and lending with your friends and family - except there are thousands of people you can lend and borrow with.

“Both lenders and borrowers get better rates, because peer-to-peer lending is more efficient than the traditional banking model. Banks have massive overheads, with thousands of employees to pay and hundreds of branches to maintain. So they have to take large margins on the money that passes through them.

“There's no smoke and mirrors here. Banks use your money to make even more money for themselves. They lend some of it out, gamble some of it on the price of tin or the Yen depreciating, and invest the rest in any other money-making schemes they can think of.

“Whereas at Zopa, people who have spare money lend it directly to people who want to borrow. There are no banks in the middle, no huge overheads and no unethical investments.”

A key point Zopa make on their website is that “Lenders make lending offers - 'I'd like to lend this much to A-rated borrowers for this long and at this rate'”; and “borrowers size up the rates offered to them, and snap up the ones they like the look of. If they don't like the rates today, they can come back tomorrow to see if things have changed.”

Ratesetter fixes rates and risk, Zopa allows the lenders and borrowers to match as a community structure.  There are also other P2P operations in the UK, such as Funding Circle, Yes Secure and Quakle.  Each is slightly different, e.g. Funding Circle focuses upon SMEs, and there are equally other examples of new models such as CrowdAboutNow in the Netherlands, Smava in Germany, Communitae in Spain and Kickstarter and Prosper in the USA.

Either way, Rhydian made the point that the consumer credit P2P market was purely competing with banks on rates.  He did qualify that service came into it too, and brand and trust, but that the social aspect was meaningless and purely played to some investors who liked the philanthropic returns of such activity.  

He claims P2P lending is nothing new, not innovative and purely an alternative source of funds in the S&L markets.

This is demonstrated by comparison sites like moneysupermarket.com, where the P2P offers appear.

So I went to moneysupermarket to have a look and wasn’t that impressed, as a search for a £7,500 three-year loan resulted in Zopa and Ratesetter coming in at rates 1.4% and 1.8% respectively higher than the equivalent from a mainstream building society and other competing retailers like Sainsbury and Tesco.

It made me question Rhydian's claims as, if it was purely rates, why would Zopa have grown so dramatically in cumulative lending levels:

In 2010, Zopa processed £70 million ($100 million) in enabled lending – about £6 million per month ($10 million) – and hope to increase this to £140 million this year.  Ratesetter is so far under £10 million and growing, but Zopa can claim more brand and trust as they’ve been around longer.  Maybe that’s why their list of active lenders is up from 9,000 in 2008 to 16,000 in 2009 to over 22,000 last year, and an expectation of around 35,000 this year.

I think the figures reflect the community orientation of Zopa – where savers and borrowers connect with each other to set rates and match – versus Ratesetter’s model which is purely to crowdfund and compete with banks on narrower margins.

Rhydian claims that the community aspect of Zopa’s business model is the part that’s unsustainable.  We shall see.

After all, it may be that credit is so tight with the banks that finding a loan is now only available through alternative markets.

Either way Rhydian then went on to say, wearing his other hat of part of the P2P Finance Association, that the average age of funders in P2P networks is 55 years old and borrowers are 39 years old.

The P2P lending market in the UK has sourced over £200 million in funds, with £100 million funded this year.  This is a similar experience to the USA, where Prosper and Lending Club are seeing significant growth in funds managed:

Lending Club issued a total of $24.9 million in loans in September, up 8.3% on a month-over-month basis from its August total of $23.0 million in loans. Lending Club has issued $373,473,595 across 35,918 loans since it launched its service in 2007.

Comparatively, Prosper has now issued a total of $262,342,733 across 43,950 notes as of September 30th, 2011 since launching its service in November 2005. The company issued a total of $7.4 million in loans, up 7.1% on a month-over-month basis from its August total of $6.9 million in loans.

What this tells me is that, in the scheme of things, P2P Lending is now grabbing a good slice of the USA and UK market for consumer and small business lending.  This is demonstrated by the Bank of England’s stats for lending which shows unsecured consumer credit pretty much disappearing off the radar since 2008:

It’s a good time for these guys to be in the market and the prediction of 10% of all unsecured retail lending being in the hands of P2P lenders by 2010, made by Gartner in 2008, may have been precipitate but is not far off the truth of today.

As always, we anticipate the speed of change to be too fast and the impact to be far less than realised.

For more on P2P Lending, follower the twitter stream of P2P Lending News.

 

Postnote: Simon Deane-Johns, a mate of ours, has written a good piece on regulating these markets too, A New Regulatory Model For Retail Finance

 

 

 

 

40% of City workers to lose their jobs

I’ve recently been thinking about headcount cuts.

It’s always hard …

And it's getting harder.

For example, I wrote in August that thousands of bank jobs were being cut, adding up to an expectation of 15,000 City jobs this year.

Each job loss represents a significant loss to the economy, especially those in the City:

“Based upon an average salary of £150,000 and income tax of 50 percent, employer national insurance of 2 percent and employee national insurance of 2 percent, this works out at an average lost tax income per lost City job of £81,000 per year, or a total loss of about £1.3 billion in tax revenue.  To put this into context, financial services workers paid a total of £18 billion income tax for the tax year 2009/10, or 15 percent of the UK total, so this year's redundancies alone could lower the sector's income tax contribution by about 7 percent.”

That doesn’t include all the job losses at Lloyds Banking Group (43,000 or more job losses)  and Royal Bank of Scotland (28,000 generally plus a further 5,000 just announced in the investment bank).

Nor does it even look at the USA figures, where Bank of America recently announced 30,000 job cuts, a similar number to those recently announced by HSBC.

In fact, every bank is cutting … how far could it go?

According to one leading light in the City, Mary Caroline Tillman – shortlisted for Woman of the Year, Head of the Global Financial Practice with headhunter firm Egon Zehnder, and formerly Managing Director and Chief Operating Officer of JP Morgan's European Advisory Business – the losses will rise to around 40% of all City jobs.

In an interview over the weekend with the Independent, Mary said the following:

“The Masters of the Universe are facing a really tough time.  The shake-out is only just beginning after the crash. There is a big consolidation still to come, which means there will be far fewer banks; a 40 per cent cut in jobs will be the 'new normal'. This is because of the tougher regulatory environment.”

A 40% job loss in the City would spell disaster.

For example, the article reckons that there are about 360,000 people working in the City and some 670,000 in New York's securities industry (this does not take into account all the ancillary and related services from accountants and lawyers to bar staff and restaurants).

If 40% disappeared in London, based upon my earlier calculations, which would be 150,000+ job losses.  A loss of around £13-£15 billion a year in tax revenue … or more.

I wonder whether the government really wants this scenario therefore, and the Occupy Wall Street brethren.

Meanwhile, as the industry does go through its transformation from reckless risk to wrestled risk, it was interesting to see the change Mary sees happening in the core investment community of London.

“The restructuring means a different kind of leader is emerging. They are coming from the more functional areas. You can see that, with risk officers such as Robert Le Blanc at Barclays and Marc Moses at HSBC, who are now at the top … Boards want the finance guys, accountants, risk specialists, those with knowledge of IT and compliance.  These are the future Masters of the Universe … and these new bankers are determined to show that banking can be a decent and good business.”

Good.

 

 

 

Just a brick in the Wall ... Street

Obviously, many of you will be aware of the #OccupyWallStreet protest by now.

If you’re not, it may be that you were at #SIBOS when it all started, so here’s the low down.

My friend who lives on Wall Street told me that a bunch of around 200 protestors set up camp in the park by Wall Street just over two weeks ago, and they started taking it in shifts to block access into and out of Wall Street holding up placards and shouting with drums.

It’s very annoying he says.  In fact, it’s very, very annoying.

And that may be how it started, but it’s gradually getting more and more serious.

For example, the police didn’t know how to handle a ‘peaceful protest’, so they started to deal with it by manhandling people with force …

Unfortunately, in this age of never ending streaming smartphones and tweets, you can’t get away with anything.  The result is that the mood is now also anti-police, with chanters shouting: “racist, sexist, anti-gay! NYPD go away!”

This is due to the mass arrests that have been taking place since the protests became so belligerent and irritating to everyone in downtown New York, with 700 arrested on Saturday alone.

Mind you, it's not irritating everyone as celebrities from Susan Sarandon (particularly vocal) to Mark Ruffalo (who?) are  getting involved.

To keep up with what's happening, I suggest you follow #OccupyWallStreet on twitter, as it is a great source of news and views about what’s going on.

It's also interesting to see that the US protesters are using Vibe to avoid the UK tactics where, , after the UK rioting, the police forced Blackberry's hand to share instant messaging details about the riotous organisers.

Vibe allows users to send any-to-many messages, similar to twitter, but the message are always anonymous and can be set to self-destruct after a set period of time.

Another difference is to note that, due to the viral nature of such social networking, the protest is now spreading.

It’s no longer Occupy Wall Street, but also Occupy Any Business District from LA to Seattle to Chicago to Boston.

What do they want?

No-one knows, except to protest.

Protest about what?

The economy, banking, unemployment, welfare, prices, life … the government.

The message is mixed because there is a core group who offer a manifesto with a list of demands and a declaration that is being refined ...  but they have been joined by so many other protest groups that there appears to be no big message, except that people are angry about the world and want change (something I thought Barack Obama had promised).

This has been critiqued by many but, as one tweeter puts it, it “is more than just a protest. It's the start of a new government. A government free from greed and corruption.”

And how do the banking fraternity feel about this annoying development?

Watch this (one minute in) …

I'm sure the musical version will be here soon, with a slightly different theme tune:

We don't need no occupation 
We don't need no thought control
No dark sarcasm from the government
Police leave them kids alone
Hey! Police! Leave them kids alone!
All in all it's just a brick in the Wall ... Street.
All in all you're just a brick in the Wall ... Street.

 

The similarities between banks and landmines

Last night I was presenting to the MAG-net group.

MAG-net is the networking group in the City for the Mines Advisory Group, MAG, a charity supported by the Financial Services Club and others that clears areas of mines so that schools, villages and life can continue as it should in post-war territories.

They invited me to speak about anything I wanted, and so I created a new presentation about the similarities between banks and landmines (see UBS today).

The presentation developed around the idea of banks being mines that explode in economic terms, in a similar way in which landmines explode and blow away people and animals in the real world.

My premise was that just as landmines blow the legs away from humans, banks blow the legs off economies.

It’s obviously the case that this is true today, what with the Lehmans collapse with Credit Default Swaps creating the first financial crisis; and now sovereign debt in the Eurozone is developing the second.

How can such economic landmines exist in a world where we should have cleared them by now?

They exist because we allow innovation in financial instruments in an unregulated form.

That innovation is all around derivatives of derivatives.

Untried and untested weapons of financial destruction are being created every day and planted as hidden potentially unexploded bombs across the financial system.

This has been well documented in many books, with F.I.A.S.C.O. cited by many as a great illustration of the issues in a storybook form or, if you prefer the academic version, Infectious Greed, gives you the lowdown.

These two books by Frank Partnoy document the issues of derivatives, which are both good and bad.

They are good in creating leveraged risk which allows commerce to become more capable.   They are good in hedging risk, allowing trades to take place that otherwise could not.  They are good in bringing together mixed asset classes, so that previously unrelated goods and services can now be traded together.  They are good in offsetting future uncertainty, which is why they are used.

They are bad because they are so complex, most traders don’t understand them.  They are bad because they are called ‘exotics’, and are so exotic that they can explode.   They are bad because they allow firms, such as Goldman Sachs, to create a massively web of interlinkage between risk that ensures those in their world can have huge exposures whilst Goldmans themselves avoid such loss.  They are bad because they allow debt to be leveraged so greatly that it becomes unmanageable.

All of the latter are the landmines of economies, and are no better demonstrated than by Lehmans collapse and Europe’s sovereign debt crisis.

I illustrated these two points with two charts.

The first is from June 2008, and shows the notional exposure of Goldman Sachs’ main counterparties just before the collapse of Lehman Brothers (doubleclick image for larger version):  

Oh what a tangled web we weave, when first we practise to deceive! Sir Walter Scott 

Now don’t think I’m Goldman bashing because, as I said last night, they are the most effective bulge bracket player in the world’s markets in creating risk and therefore alpha returns.  That’s why their clients use them.  However, they are also the most effective institutions in the world’s markets in creating risks that can explode in the face of their clients.  That’s why they sell ‘crap’ to their customers (by their own admittance) and are happy to do it.  

The second chart I used to illustrate the landmines that firms such as Goldman Sachs lay in the world’s economies is the European sovereign debt crisis and a data visualisation of which countries are most exposed to whom:

Again, derivatives were used to package sovereign debt in the same way as mortgage debt, and has created this second loss of confidence in the European economies. 

The whole presentation can be seen here (needs the words to make sense probably) ...

The similarities between landmines and banks

View more presentations from Chris Skinner

... and the only positive note is that we can save human limbs by clearing landmines using mice to sniff the mines out.

Let’s get some more mice in the financial markets.

 

Postnote:

 In researching the presentation, I found large numbers of images of people with limbs missing.  Some were graphic, some were funny, some were moving and many were tragic.  Give MAG five minutes of your time http://www.maginternational.org/ to consider supporting them.  And any MAG-net member gets a 20% discount if they join the Financial Services Club so it’s worth supporting them for that reason alone surely?

 

 

Bickers over Vickers: the right stuff?

So the Vickers Report has finally crept out into the wilderness.

All 358 pages of it.

Half of it talks about how to increase the competitiveness of banking and the other half about what to do if a bank fails in another crisis.

The latter has garnered all the news headlines, whist the former has been generally overlooked.

More copy has been written about this report than anything else in banking over the past week or so, with a selection of headlines that makes the mind reel.   Here’s just a few:

• Search for new approach to banking has begun - Financial Times
• The complexity of bank reform cannot be underestimated - The Telegraph
• Ring-fencing will dent growth, says forecaster - The Independent
• ICB to admit its reforms will cost banks billions - The Telegraph
• David Cameron in push to dilute ICB ring-fence reforms - The Telegraph
• Oxford Academic Becomes Key for U.K. Banks - Business Week
• 'Shadow banks' move in amid regulatory push  - Financial Times
• Grab some bargain banking shares while you can - The Telegraph
• The wrong reforms will break the banks - The Telegraph
• Banks 'at risk from devaluations' - BBC

If you want the truth, you can read the full Vickers report, which I’ve been reading this morning and so far have found nothing too surprising, as most has already been leaked.

Here’s a summary of the key points on ring-fencing:

• Ring-fencing is confirmed, where banks separate domestic retail banking services from global wholesale/investment banking.  The commission is vague about whether banking to large companies should be in or outside the ring-fence but it suggests that between one-sixth and a third of the £6 trillion of bank assets should be inside the ring-fence.

• The ICB describes the ring-fence as "high" and said that the ring-fenced part of the bank should have its own board and be legally and operationally separate from the parent bank.

• Ring-fenced banks should have a capital cushion of up to 20% comprising equity of 10%, with an extra amount of other capital such as bonds. The largest ring-fenced banks should have at least 17% of equity and bonds, and a further loss-absorbing buffer of up to 3% if "the supervisor has concerns about their ability to be resolved without cost to the taxpayer".

• Capital could be moved from the ring-fenced bank to the investment bank, as long as the capital ratio of the ring-fenced bank did not fall below the 10% minimum.

And on creating new competition:

• The ICB has backtracked on an idea in its interim report that Lloyds Banking Group be required to sell off more than the 632 branches it currently has on the market to meet EU rules on state aid. It dilutes this, to say that it "recommends that the government seek agreement with Lloyds Banking Group to ensure that the divesture leads to the emergence of a strong challenger bank."

• It should be easier to switch bank accounts and the ICB recommends "the early introduction" of a system that makes it easier to move accounts and that is "free of risk and cost to customers". It rules out number portability — as is used with mobile phones — in favour of this switching service. The amount of interest that customers miss out on by having a current account — known as interest foregone — should also be published on annual statements.

• The industry should be referred for a competition investigation in 2015.

For the most part, I’m disappointed with this report.  It’s not that I’m against bank reform, but what is the right sort of bank reform?

What this report appears to do is tread a fine line between bank anger, government need and public input, and comes out on the side of muddle.

It’s already had plenty of flak for this, but let’s pick on a couple of things.

First, account portability. Why hasn’t the ICB included this, as it makes eminent sense as discussed back in December at the ICB meeting I attended.

What the report actually says about this is as follows:

“The Commission recommends the early introduction of a redirection service for personal and SME current accounts (to make account switching easier) which, among other things, transfers accounts within seven working days, provides seamless redirection for more than a year, and is free of risk and cost to customers. This should boost confidence in the ease of switching and enhance the competitive pressure exerted on banks through customer choice. The Commission has considered recommending account number portability. For now, it appears that its costs and incremental benefits are uncertain relative to redirection, but that may change in the future.”

In other words, the cost of using different account numbers between banks allowing portability is too great.  For example, if might from RBS to Lloyds with account number 75280025, there may already be someone at Lloyds with that account number.  Therefore, to introduce account portability of account numbers, you would probably need to renumber all the bank accounts in Britain with unique ID’s.  That’s why it’s been dropped.

But then the report adds more details to this idea (page 218) and shows it is feasible:

“Under account number portability, a customer’s sort code and account number would not change when the customer changed banks, thereby avoiding the need to change any payment or credit instructions. Evidence to the Commission suggested that the effect of account number portability could be achieved through the creation of an ‘alias database’. This proposal is for a new database to be created with a new code for each account that would be assigned to each sort code and account number: a customer would give the direct debit originators (and creditors) they deal with the new code, which would never change; when the customer moved banks, the sort code and account number assigned to the customer’s code would change and nothing else.”

Later on (page 222), it expands on the risks and opportunities of account portability:

“One significant benefit of account number portability (whether done through making existing  account numbers effectively portable, or through the creation of an alias database) is that it would remove the cost of switching to direct debit originators, as well as those who make automatic payments into customers’ accounts. However, given the importance of the payments system, it would be critical to ensure that the migration to account number portability did not disrupt the flow of payments or introduce greater operational risks into the payments system.”

In light of a need for bank reform, this would have been a worthwhile aspect to develop now, and it is something left in the report for further evaluation so you never know.

Nevertheless, the big question is whether this would improve competition anyway?

Competition is more about the barriers to entry – governance, licensing, capital, technology etc – and hence, these are more mighty areas … that the report also fails to address.

The report mentions competition 414 times, and yet the main recommendations of the interim report:

• “that the divestiture of Lloyds’ assets and liabilities required for EU state aid approval will have a limited effect on competition unless it is substantially enhanced;

• “that it may be possible to introduce greatly improved means of switching at reasonable cost, and to improve transparency; and

• “that the new Financial Conduct Authority (FCA) should have a clear primary duty to promote effective competition”;

... have all been watered down.

Then we move onto ring-fencing, which purely addresses the aspects of what to do if a bank fails.

"Structural separation should make it easier and less costly to resolve banks that get into trouble.  By ‘resolution’ is meant an orderly process to determine which activities of a failing bank are to be continued and how. Depending on the circumstances, different solutions may be appropriate for different activities. For example, some activities might be wound down, some sold to other market participants, and others formed into a ‘bridge bank’ under new management, their shareholders and creditors having been wiped out in whole and/or part.  Orderliness involves averting contagion, avoiding taxpayer liability, and ensuring the continuous provision of necessary retail banking services – as distinct from entire banks – for which customers have no ready alternatives. Separation would allow better-targeted policies towards banks in difficulty, and would minimise the need for support from the taxpayer. One of the key benefits of separation is that it would make it easier for the authorities to require creditors of failing retail banks, failing wholesale/investment banks, or both, if necessary, to bear losses, instead of the taxpayer."

Living wills and all that aside, the proposal to leave banks as integrated universal operators – good for Barclays – by purely creating a delineation between their domestic commercial and retail banking operations versus their global links is a duck out.

Why?

Because it does not address the issue of why banks fail, but just what to do when they fail.  This is a positive thing according to some and yes, sure, it's a good thing to know what to do when a bank fails ... but why not try to deal with the core of failure as, even if we know what to do, a bank failure in its investment arm will still destroy value in its overall operations.  

Northern Rock illustrates this well where, as a pure retail bank, it failed due to securitising its loans and mortgages in the wholesale markets.  Surely these aspects of potential liquidity failure should have been in the report, and how a bank builds an illiquid position that leads to failure, rather than just what to do post the event.

And no, I'm not forgetting that through a ring-fence recommendation increased capitalisation of both the retail and investment operations will help, but an illiquid position is still on the cards and that is surely a point that should have been the core of the reforms, not the post-failure fall out?

Equally as Sir John Vickers has been saying in today's press calls: “the too big to fail problem must not be recast as a too delicate to reform problem”, but is he reforming or just adding insult to injury?

As the action of ring fencing is a unilateral action not being followed by any other major nation right now, it may be the latter.

Renowned former Federal Reserve Chairman Paul Volcker gets to the heart of the matter when he says that he “completely doesn’t understand the British approach, where they can leave all these questions unanswered.  They said they wanted a retail bank in the same holding company as everything else. I don’t know what ‘everything else’ means.  Is that not a bank too?  It’s just a wholesale bank.  Who makes the payment system work – the retail bank or the wholesale bank … the philosophy is you are a group of banks that serve the consumers, the retail customer, and that hold their deposits with the central bank and so forth, does not solve the problem with all the other parts of the financial system.  I also don’t believe in a firewall or Chinese wall between them, as you need a very high ring fence to stop the deer jumping over.”

Sir John may claim the fence is high, but it cannot be high enough.  

When a Barclays investment bank fails, it will still bring down Barclays Bank  as Barclays investment banking operations represents 42% of the bank's total revenues (Royal Bank of Scotland generates a third of all revenues from investment operations; HSBC 27%; and Lloyds Banking Group is unceratin as it has no official investment banking arm).

Meanwhile, the costs are at least £4 billion to implement these reforms and the overall programme has really hammered the value of the UK banking sector in the world's financial markets:

With much of the loss of value this year due to Sir John's committee's actions combined with the Eurozone crisis.

So my key question is that we are living in a world where Basel III, G20 reform, European Union Directives along with American restructuring is creating so much imbalance in the global financial system that adding to such imbalance though unilateral action is questionable.

This is corroborated by the views polled by City AM and Politics Home.

“Among just those working in the banking sector, however, support for the idea has collapsed - and while a small majority of bankers still back a ring-fence, net support have fallen from +46% to +15%. This is surely a reflection of recent rumbling in the press on the dangers of such a scheme to the sector.

Those working in the banking sector, however, thought the idea would make no difference in preventing a repeat of 2008, while thinking it would be actively damaging to promoting UK economic recovery, getting banks lending, as well as keeping HQs in the UK.

All in all, the whole area is a cauldron of trouble and messiness that this report has done little to resolve and, if anything, has fuelled more debate about the UK’s sole stance in the face of global regulatory drives.

So what should we do?

We should ensure that we work in harmony with Wall Street on the capital market reforms whilst implementing domestic policies to lower the barriers to entry for new entrants in banking.

The former may be seen as being difficult, but the #1 objective of the UK should be to maintain UK’s attractiveness as a centre for financial services.

That’s the piece that has been most badly damaged by these proposed reforms.

Luckily, it won’t be implemented until 2019 in order to ensure consistency with the developments of Basel III, so delay was inevitable after all.

A few further comments:

Andrew Gray, UK banking leader, PwC, said: “The report from the ICB today sets out a clear statement of the direction it believes should be followed in order to reduce the risks of banking in the UK, increase competition and ensure globally competitive banking based in the UK.   The measures recommended will have a far-reaching impact on the way in which banks operate in the UK in future. A key question for government to consider will be the trade-off between improved financial stability and facilitating economic growth.  The core proposals revolve around the use of ring fencing of retail banking activities to ensure both the financial stability of the banking sector, but also to ensure the government is not called on to rescue the banking sector in the future. Ring-fencing on its own does not change the risks inherent in banking (except when it comes to resolving failed firms) and the ICB recommends higher capital levels than those proposed by the Basel Committee.  The importance of a strong banking sector as an integral part of the UK economy is clearly recognised, as is the need to ensure the UK remains a globally significant centre for financial services. Overall, these proposals, while not unexpected, will represent a significant change to the UK banking landscape.  These are detailed proposals which will take time to digest and, in doing so, more questions will emerge.  It is too early to assess the real impact on the UK banks and the wider economy.  The real consequences will only become clear once the Government decides what is to be passed into law.”

Michael McKee, Head of Financial Services Regulation at DLA Piper, commenting on the Independent Commission on Banking - Final Report, said:   "The ICB Final Report has stuck to the line set out in the Interim Report. Most interesting is the detail of how the ring fence will operate.  It will focus on deposits of individuals and small businesses - but this is likely to catch a lot of private banking business too. The ring fence looks like it will be quite a "hard" ring fence - a retail bank will have to deal at arms length with other parts of the group and apply large exposure rules. Moreover the ICB sticks to its guns about a minimum level of 10% capital for retail banks and also wants a lower leverage limit than international proposals.  Overall, therefore, the ICB has withstood political pressure from the Liberals but has taken a tough line on the content of its ring fence."

Edward Sankey, Chairman of the Institute of Operational Risk (IOR), said: “We are concerned that the Vickers Commission are proposing economic solutions to what they believe are economic problems. However the IOR believes that the root causes of the financial crisis were failures in people, processes and systems, which are the targets of operational risk management.  The proposals will not on their own do anything much to reduce the possibility that failures by people, processes and systems will not again threaten banks and their clients. Time and again we have seen that more sophisticated regulation and restriction leads to more sophisticated efforts to find ways through them, or even plain evasion.  We have a great opportunity to make lasting reforms that will not only help to ensure a sustainable and profitable UK banking sector, but also strengthen UK economic growth. Unfortunately the Vickers Commission is focusing on the wrong solutions – solutions that will do little to correct the failures in people, processes and systems that preceded the crisis.”

Andrew Wingfield from SJ Berwin’s Financial Institutions Group commented: “The ICB’s proposals totally focus on retail protection and would impose a cost ahead of any bank failure.  The costs of restructuring and higher equity capital levels will place returns under further pressure and the ICB’s proposal will likely be a Herculean task given that people and IT systems are intertwined within banks.  The key recommendation (in our view) is around a clear message to UK banks to ring-fence their operations with the tone of the political debate already showing signs of an irreversible process and the Government committing to immediate steps towards implementation.  Over the next few weeks, it will be interesting to see whether support for the recommendations wanes as the party conference season approaches.  However, the message is softened by a long final implementation deadline of 2019, which is intended to synchronise the timeline with the implementation of new international standards under Basel III.  In our view, all Banking reform measures adopted by the UK authorities need to be carefully analysed in order to ensure that the full consequences on the economy and the recovery of banks’ ability to support customers is understood.”

 

 

 

The Brown Bottom

From my friend Derek Bond …

With the gold price hitting new nominal highs, now may be a good moment to remind ourselves about the consequences of Gordon Brown’s sale of much of the UK’s gold reserves.

Between 1999 and 2002 he sold 395 metric tons of gold at an average price of $275 an ounce.

Today the price stands at $1,749 an ounce.

No wonder Brown’s sale on the gold price charts is known as The Brown Bottom.

He also gave notice to the market that the sales would take place, thereby giving market participants every opportunity to drive the price down further.

Here are some calculations of the value which would have been accrued if we still held the gold today:

                                         Sold then             Value now
                                       1999 - 2002                2011
Quantity sold tons                  395                        395
Average price $/oz               $275                     $1,700
Sum realised US$m            $3,477m               $21,492m
Exchange rate                       $1.52                    $1.63
Sum realised £m                   £2,287                 £13,185

The 2012 Olympics are estimated to cost some £9 billion, so we could have paid for the Olympics with the amount of value he surrendered and had over £2 billion in change left.

p.s. at the 10 year anniversary of the sale in May 2009, the loss was only £3.9 billion [Ed: did someone just say 'only']

 

 

The real rip-off culture ... is not Wonga? Part Two

One of the more outspoken reactions to my post on payday firms came from Wonga.

Not surprising as my original headline was that “Wonga will wrestle with regulators”, and they will as the markets are pretty unregulated today.   A point I made last Friday. 

I also mentioned last Friday that the original reason I wrote this was because of two statements in a Wired Magazine cover on Wonga from May.

The first said that “within a year, Wonga had issued 100,000 loans, worth £20 million, earning about £15 million by charging interest at an eyewatering headline rate.”

The second was a letter from Steve Perry in Wired in June that said:   “When I could no longer repay a Wonga loan, it took 50 days of ringing and emailing to get through – an £800 loan became a £1,700 repayment.” 

Both lines made me angry, and hence led to this debate.

So, just to set the record clear, let’s look at Wonga in depth.

First, what is the Wonga business model?

Their business runs on super flexible, short-term loans, delivered via the internet in minutes.

The offer is made using a simple calculation system on their homepage that lets you put in how much you want to borrow – up to £400 (or £1,000 for repeat customers) – for how long – up to 30 days maximum.

The interest is made clear to you as you enter this information.  For example, £300 over 7 days racks up £26.59p in interest and fees whilst, over 30 days, this would be £95.89p.  Bear in mind that £5.50 of these amounts are the transmission fees to move the money to your bank account in real-time, and the rest is the actual interest rate.

In other words, the real interest rate is around 360% APR or 1% per day average.

Although the APR on the homepage states that it is 4214%, this is purely a number required by law to show how much the loan costs over a year.  As a result, the interest rate is compounded to represent how the Wonga loan period would look if spread across a year, even though the company does not offer annualised loans.  So the fee and interest is compounded and added as a mathematical view of APR, rather than real view.

360% interest rates per annum may seem high, but it’s not competing with those long-term loans.  Wonga doesn’t offer long-term loans although, if they did, it would be at 360% interest rates, which they admit themselves: “Even if we were to launch a year-long loan at the same interest rate we charge now, the APR would be much lower than the current figure, more like 360%, because there would be no artificial compounding involved.”

But Wonga doesn’t offer annual loans. Their maximum lending period is 30 days and, in that context, Wonga’s rates are a fraction of those charged by high street banks for unsecured overdrafts and credit cards, which are the markets they are most interested in taking business from.

So Wonga specialise in short-term loans to give you coverage for a few days when you most need it.

Their team shared some interesting stories with me in this context and it’s generally for people who don’t want a bank loan – as such loans tie you up for a long period of time with amounts that are reasonably fixed – or can’t get one due to poor credit history or a recent change of job or address, or need cash fast and it would take too long in the bank.

A few examples included a customer whose dog needed emergency treatment and they needed cash in minutes, and a guy who had lost his job and needed to buy a car to become a minicab driver but couldn’t buy the car through the bank as he was jobless.  The latter is a Catch 22 – how can I start work if you don’t give me the loan?

The loans are incredibly short – typically  a few days – and are high interest due to the costs of acquisition and processing.

Although the company does not publish public records – they are a private firm with £90 million of venture capital backing [Wonga Company Number is 06374235] – they point to similar firms in the USA such as Cash America and Advance America, who have to provide transparent reporting of returns under SEC filings.

What this shows is that Cash America makes less than 10% net income on revenues of over $1 billion …

… whilst Advance America made a net income of $35.8 million on revenues of more than $600 million

This is because the business costs are high with cost of customer acquisition being the highest, followed by default rates which are also significant.  Wonga say they have theirs under control by using sophisticated technologies to avoid high risk customers, but one US study found that as much as a quarter of a payday firm’s revenues can be attributed to defaults.

This does not even include marketing and processing costs, with the cost of data being a major overhead in the process too. 

For example, Wonga use Experian and other credit agencies to real-time check customers during their online acquisition processing.  That’s all at a cost and many other payday firms don’t use such sources for this reason. A typical payday firm would just ask to see your last salary and bank statements and would then approve.  This is why their default rates are high and Wonga’s are lower.

But it makes the point that this is high risk, high volume, low margin business that is hard to make money unless you’re good.

It is also why Wonga claim they do not target vulnerable customers.

Why would you?

Vulnerable customers are more likely to default and less likely to pay back, so that’s not the market they want.  Wonga make the specific point that, being a private firm backed by venture capital, it’s their money they are putting at stake, so they only want to target the right customers?

Who are the right customers?

Wonga want customers who sit between core bank lending markets and the unbankable markets.

These are often customers who have never used a payday loan firm – 75% of the customers have never used an online payday loan before – and they are often bank customers – every customer has a bank account and access to full banking services.  This means that they also have access to traditional credit products, such as loans and credit cards, but often don’t trust themselves with such products.  They would rather pay high interest on a short-term loan they can manage than lower interest on a long-term loan.  This is because the short-term loan is easy and manageable, rather than escalating and invisible credit on a card or fixed for years on a bank loan.

Here’s a few more facts:

• 59% of Wonga’s customer are male, whilst 41% are female
• They are average wage earners (£22,000 per year) and aged typically between 21 and 40 years
• Most are tech savvy and are regular broadband and mobile users
• 14% of Wonga’s customers use an iPhone
• The average first-time loan is for £160 and the average loan across the customer base is £230
• As long as you demonstrate you are a responsible borrower, you can increase your maximum loan to up to £1,000 over time
• Wonga serviced their first customer in October 2007, and is now estimated to be making more than 100,000 loans per annum
• 3 years after launch Wonga.com had made in excess of 1.5 million loans to customers

These customer demographics prove that the customers aren’t necessarily the vulnerable and needy, but the sophisticated and informed.

They use the internet and mobile connectivity and like the flexibility of a short loan that avoids bank overdraft fees.

From a risk perspective, Wonga ensure the select the right customers, not the vulnerable ones, through their technology analytics and algorithms again, and means that most Wonga customers are actually not the normal payday loans customers.

In fact, as mentioned, the technology is something that impresses.

Not only does it credit check and money transfer in real-time, but it goes further by completing the whole process in under fifteen minutes typically.

That’s why Wonga actually describe themselves as a technology firms that offers financial services, which gives you a clue to their positioning right from the start.

They are also very transparent.  Everything is clear up-front.  For example, they calculate the total amount repayable upfront, showing the figures clearly and including all interest and fees.  You might say that’s better than a bank?

There’s also a good guide to ‘responsible lending’ that’s accessible from their home page .

They also make it clear that “the only way costs can increase is if you fail to honour the agreement.”

So what happens if you fail to honour the agreement, like Steve Perry did?  What’s your maximum liability?

Well, it appears Wonga are also semi-flexible on this point too.  If they get a customer who is in trouble, they don’t just keep hammering them with fees and charges, but will apply penalties to a maximum of 360% interest.

At that point, it stops until some form of agreement or compromise can be made.  For example, in Steve Perry’s case, Wonga waived the outstanding balance with Wonga’s head of communications, John Moorwood, saying to me:

“We lend our own money and we’re completely incentivised to make selective decisions and help people who can afford the service and are likely to repay a loan quickly. A typical loan is around a fortnight and a quarter of our customers repay early every month, which they can do without any catches.

“We decline the majority of first-time applicants and we also decline some returning customers, or limit their access to credit, based on the same checks and prior use of the service. Again, we have nothing to gain from helping someone who can’t afford the loan or is in serious financial difficulties. We don’t claim to be perfect, but we believe we are doing everything we can to make the best decisions possible, which has seen us win a number of respected risk-based awards judged by industry experts.

“The fact we’re achieving this aim of making the best possible decisions is supported by the very low rate of arrears and positive feedback from most customers, whom we survey and speak to regularly.”

Now, I can find loads of other complaints against Wonga that are similar to Steve Perry's from Debt Line, the Review Centre, UK payday reviews and more.

Most of the complaints are down to people who failed to payback on  time, didn’t read the rules or ignored them, have been declined as a repeat customer due to their credit getting worse and related issues.  The worst one is that Wonga charges rollover fees if funds are not in the customer's account on the morning of the due date, even though funds may be in the account later in the day.

Even so, none of these complaints appear to be about Wonga not doing what it says on the tin: we will lend you a short term loan at high interest rates and not charge you excessive fees unless you don’t pay back on time.

If you want more on this part of the operation, read the Payday Loan Master write up on the Wonga Scam from June 2011.

My conclusion on Wonga is that they are hard on customers who don’t play by the rules, but they make the rules clear upfront and it’s down to you to absorb or ignore them.

It's all about transparency.

In fact, Wonga regularly survey their customers on what they think and, in the last survey performed by Populus in January 2011 of 15,200 people, Wonga’s customers thought:

• Wonga is better than a bank overdraft, bank loan, credit card or other payday loan
• 77% thought Wonga’s service easy to use, compared to 7% with the banks
• When asked: “how well or poorly is information communicated when you use Wonga’s service?”, 66% think ‘very well’ and 30% ‘well’ – only 1% rated communications poor
• The Financial Ombudsman Service received 30 complaints in 2010 about Wonga, equivalent to 0.003% of their customer base of a million customers; by comparison, Barclays bank had 276,000 complaints which, with around 14 million customers, equated to 2% of their customer base

If you want to read more about Wonga, here are their documents:

• About Wonga 2011 (400KB)
  
• Wonga.com code of practice (2.7MB)

Finally, I asked Wonga their views on interest rate caps, loan caps, and more qualification of the borrower and their other financial exposures, particularly for repeat customers.

They actually agreed with these recommendations, saying that more payday loan firms should be responsible lenders to ensure they don’t get a bad reputation.  For example, they use Experian and credit scoring to ensure they avoid vulnerable and poor credit based customers.  If every payday loan firm did, then they would all qualify borrowers better.  The fact that most don’t, due to the costs of data access, makes this a vulnerability.

Wonga don’t agree with interest rate caps, as they think competitive market forces rule.  As a result, they promote transparency of overall costs as being the way to go, as per their homepage, rather than regulatory limits on lending.

This is in line with a recent analysis by PriceWaterhouseCoopers of consumer credit – “UK consumer credit in the eye of the storm” – which states on page 19 that: “in the case of payday lending, an APR is fundamentally misleading.  Annualising the interest cost of a product that is only offered as a short-term facility confuses the purpose of the loan and misrepresents the true cost.  It’s similar to suggesting that the typically annual cost of a rental car might be close to £15,000, rather than a daily rate of £40.  The total charge for credit may be a more beneficial measure for the consumer in this instance.”

The report goes on (page 16) to say that “while rate caps could reduce the cost of borrowing for some, there are a number of potential arguments against rate caps that should be considered:

• Reduce access to credit;
• Migration of interest rates towards the rate cap;
• Reduced competition and diversity of products;
• Introduction of, or increase in, ancillary fees and charges; and
• Growth in the unregulated market.”

 

The Office of Fair Trading came to a similar conclusion a year before:

“The OFT has also considered the case for price controls for pawnbroking, payday loans, home credit and rent-to-buy credit and concluded that they will not address the problems identified in the high-cost credit sector, which stem from both limited supply options and consumers' lack of ability to drive competition. The OFT is concerned that such controls may further reduce supply and considers there to be practical problems with their implementation and effectiveness. These problems include the potential for suppliers to recover income lost through price controls by introducing or increasing charges for late payment and default.”

Finally, going back to Wonga, they recognise that payday firms can rip-off customers and cite examples in the USA where some firms would actively try to rollover customers at least four times to ensure they recoup their customer acquisition costs.  Wonga claim they do not do this but, as demonstrated by the Payday Loan Master, the most serious disputes between short-term lenders and their customers are when firms add fees claiming that funds were not in the customer’s account on the due date when the customer claims there were funds.

In this instance, Wonga has a zero tolerance approach to late payments and this is why they do have issues with customers who fail to meet the criteria of making sure they payback on payday.

In summary, I’m sure I’ll come back to this discussion again at some point, but Wonga fill a gap in the market for those who need short-term cash, want to avoid banks for various reasons and understand how the system works.  They have very high customer satisfaction and recommendation levels, depend upon repeat customers, and have no interest in poor credit vulnerable customers as they will not pay back.

The net:net is that Wonga does not see themselves as bad company.  However, they live with bad company in a too lightly regulated part of the financial markets.  Regulation is required therefore, and we both agree that regulation needs to be clear, fair and to ensure that customers are effectively protected.

All in all, a good dialogue and much greater clarity about this market, its challenges and issues.

 

The real rip-off culture? Part One

Further to my write-up about Wonga the other day, I have been contacted by author and campaigner Steve Perry, who has been on the wrong side of the payday loans industry.

Now don’t get me wrong. 

I am NOT against payday loans firms or their operations (I actually admire Wonga's technology ops). 

I AM against the uncapped interest these firms charge on their vulnerable customers.

However, this also needs to be qualified in terms of who are 'vulnerable customers' and who actually charges 'rip-off' rates and how.

For example, Wonga have also contacted me to put their side of the story and made clear that they do not target 'vulnerable' people with 'rip-off' rates.  

Read Monday's blog to see what their take on the world is, particularly as my original piece was kicked off by the Wired magazine coverage of Wonga.

In that coverage were two issues.

First, the line in the article that stated: “within a year, Wonga had issued 100,000 loans, worth £20 million, earning about £15 million by charging interest at an eyewatering headline rate.”

I had a fundamental issue with a firm making those sort of rates of profits on loans, but Wonga tell me their margins are nowhere near these levels and, having met with them, I will take that as fact.

Second, the star letter that followed in Wired the following month saying:   “When I could no longer repay a Wonga loan, it took 50 days of ringing and emailing to get through – an £800 loan became a £1,700 repayment.”  Steve Perry

As mentioned, Steve contacted me following the blog entry and I discovered that he is a person who got into serious trouble using payday loans.  Wonga tell me they are not a payday firm, which again I will explain on Monday.

But let's look at Steve's story.

Steve borrowed £15,000 in a year from payday loan firms.  This led him to be in serious schtuk, and having to pay back £22,000.  In other words, even though he tried hard to manage it, he was being charged extortionate interest rates and, having nowhere else to turn, spiralled into debt by borrowing off one payday firm to pay back another,.

In one instance, he borrowed £1,390.00 from PayDay UK between June 2009 and February 2010; he paid back £2,852.50 over 15 months. 

Due to losing his job and trying to manage his commitments to payback PayDay UK, Steve unfortunately then borrowed from another payday firm to pay back the first payday firm.

In July 2009, he borrowed £160 from Payday Express. By the end of his borrowing with them – October 2010 – he had taken a total of £1,225.00 in payday loans and had to pay back £1,975.00.  This is over 15 months. 

Again, the uncapped interest on payday firm operations is illustrated well as, so far, Steve has borrowed £2,615.00 over 15 months which, with a bank, would incur interest payments of around £650 max but, through payday firms, incurred interest of £2,212.50.

It’s the difference between average APRs of around 19% versus 90%.

One of the points Steve raises is that the payday firms do not take into account your other financial commitments, whereas banks do.  If you have borrowed to the hilt, a bank will take this into account and refuse you a loan.  Payday loan firms do not ask about your commitments and this means that you can borrow off all of the payday firms to pay back each one.  In so doing, you just become more and more of a victim, and that’s what happened to Steve.

He ended up borrowing off other firms to keep up and make the payments to the first.

So then came Lending Stream.

Steve borrowed £200 off Lending Stream in June 2010 and, by November 2010, owed them £1301.10 on borrowings of £640.00.

The interest was more than double the borrowings in just under five months.

He borrowed from several other firms and found each had nuances by which they made more or less money.  

Over a period of 21 months, Steve ended up borrowing from 12 payday loan companies, who made and approved 64 individual loans to him with no knowledge or interest in each other’s activities or his other financial commitments.  The result was that he had to repay £21,707.49 on loans of £14,886.00.

Now Steve admits he was a mess … but he became a much worse mess due to the unregulated state of the UK’s payday loans markets.

As Steve says: “It has been apparent throughout, a fact in which I have never denied, that I am the chief architect of my own demise.  Whilst I felt I had no other avenues to take, the harsh reality is that I chose on each of those occasions to take payday loans and sign agreements stating immediate repayment on the set payment dates.  However, responsibility of borrowing of this magnitude, on this scale cannot possibly lie totally at the feet of the desperate borrower.  A fact that cannot be ignored is that on 64 separate occasions, over the period of just 21 months, a total of 12 different payday loan companies were more than happy to instantly approve loan payments to me, with no questions asked.”

So what should be done about this?

For me, the #1 issue is uncapped interest rates.

Most countries  impose limits on the interest payday loan firms can charge.

• 37 American states allow payday lending, whilst 13 have made it illegal; 
• In those American states where it is legal, there are hard interest rate caps;
• In Canada, any rate of interest charged above 60% per annum is considered a criminal act, according to the Criminal Code of Canada; and
• The Australian states of New South Wales and Queensland have a 48% APR maximum loan rate, including fees and brokerage.

In the UK, 1.2 million people took out 4.1 million loans in 2009, four times the level of 2006,with total lending of £1.2 billion.  The average loan size is around £300, and two-thirds of borrowers have annual incomes below £25,000.

And there are no restrictions on the interest rates payday loan companies charge.

Steve makes many more recommendations which you can read in his 70-page overview of the UK industry (provided on request). 

These include:

• More qualification of the borrower and their other financial exposures, particularly for repeat customers;
• Capping of the amounts that an individual can borrow, not just from a single lender but from across the industry; and
• Better structuring of rollover of interest and transparency so that the vagaries between lenders is clearer.

The net:net is that as Vince Cable talks about the banks' “rip-off culture”, maybe he ought to look here a little too?

Meanwhile, I won't damn the industry completely as Wonga have proof that sets them apart from the payday pack.  That proof shows that they are not one of the bad guys, which I'm pleased to hear as I've watched them from their first days of operation and was surprised to hear they were making eye-watering margins.

They're not.

I will explain more about Wonga's operations on Monday.

Nevertheless, the core debate here is whether these markets are working well and whether customers are being protected from potentially damaging practices by some of these firms.

My view is that they are not in the UK.

This means that these markets need regulating and regulating fast.  

And that is a fact.

 

Postnote:

Follow Steve Perry on Twitter and/or  join his campaign - Say No To Pay Day Loans.

 

How much have the bank bailouts cost UK taxpayers?

This was a question posed to me by Sky News, and the answer is: however much you want to report.

This is based upon the fact that there are lies, darned lies and statistics, and you can manipulate the spend, exposure and loss for each taxpayer any which way you choose.

For example, the National Audit Office said that we spent £850 billion on the bank crises in 2009.

That would equate to a £26,562 and fifty pence spend by every taxpayer in the UK.

Those figures are broken down into:

• £76 billion on the shares in RBS and Lloyds;
• £200 billion for liquidity support through the Bank of England (Quantitative Easing);
• £250 billion in guarantees on banks’ borrowings;
• £40 billion in loans to Bradford & Bingley and others; and
• £280 billion in providing insurance cover for banks’ assets.

But the £26,562.50 figure is a total exposure, not losses or actual spending.

So then we can parry this down and look specifically at figures such as the share prices of RBS and Lloyds.

Again, there are different stats, e.g. £76 billion above, £65.8 billion in other news reports and £62.62 billion according to the UKFI.

These figures vary as the share prices are based upon differing amounts gross versus net, with the UKFI taking the net figures in their annual report (well worth a read), so I’ll do the same (in the Sky interview I was using other stats).

According to those figures, the UK taxpayer owns £45.22 billion of RBS (83%) and £17.42 of Lloyds (41%).

RBS shares were trading at 50 pence per share when the government intervened, and Lloyds were 74 pence.  The shares are now 32 pence and 40 pence respectively.  So you could say that the loss on paper for just these two banks is:

• RBS is down 34% and so the loss is £13.566 billion; and
• Lloyds is down 46% or just over £8 billion.

So, on paper, these two banks have lost over £21.5 billion, or around £700 for each UK taxpayer.

Then there’s Northern Rock, Bradford & Bingley et al on top.

So the figures of how much this crisis has cost can vary from anything as low as £700 to over £26,500 per person.

The truth is that it doesn’t actually matter but, for the sake of argument, Sky News put the figure at over £3,500 per person.

This is based upon:

• £45.22 billion in RBS shares;
• £17.42 billion in Lloyds shares;
• £27 billion in loans to Bradford & Bingley; 
• £20.7 billion owed by Northern Rock; and 
• £1.4 billion invesated in Northern Rock's high street business.

The figures all come from the UKFI report, and work out to be £3,562 per taxpayer in exposure.

Bear in mind however that these are not losses, but the cost to the taxpayer which may be recouped.

So you can see the lies, darned lies and statistics view of the world.

I could spin the numbers to be anything from a few hundred pounds lost for each taxpayer to over £26,000 exposure for everyone.

The more important question is when will the government and taxpayer recoup these costs, if ever.

I have said in previous posts: just before the next UK general election.

I’m now not so sure as, to recoup the investment made, the UKFI originally stated that the average buy-in price for Lloyds would need to be at £1.226 per share and 50.5 pence for RBS.

Hmmmm ... we are a long way from those numbers right now and the question is will they reach these levels any time soon?

I originally thought yes but, with a double dip recession and other clouds on the horizion right now, it’s more likely that this will be a waiting game.

A long one.

 

 

 

In the bleak mid-summer

It seems like a long bleak summer in the financial markets, as banks are reporting dire results.  It’s a combination of investment banking in the second quarter suffering serious damage across all fixed income desks, along with the Eurozone and American debt crises.

There is no certainty in such times.

For example, banks that usually do well are reporting red.  Goldmans Sachs led the way:

Goldman said its net income in the second quarter of 2011 was $1.05 billion, more than double the figure from the same period last year, but well below analysts' consensus forecasts.  Revenues were $7.28 billion, down 18 per cent from the second quarter of 2010 and 39 per cent lower than in January-March of this year, Goldman said. Analysts had projected revenues of $8.14 billion. Earnings per common share were $1.85, substantially below the consensus analyst forecast of $2.27.

But there is worse. 

After first quarter revenues at:

• JP Morgan were down 1%;
• Goldman Sachs was down 7%;
• UBS investment bank was down 11%;
• Credit Suisse was down 6%;
• Barclays Capital was down 14%; and
• Citigroup was down 25%;

now, in the second quarter, UBS are already in trouble:

UBS Chief Financial Officer John Cryan told analysts, "UBS faces weaker second quarter earnings after capital markets turbulence led to a sharp slowdown at its investment bank and lower activity by rich clients".

Result, they are laying off 5,000 staff whilst Goldmans are laying off 1,000, and several other banks are in trouble:

Credit Suisse is expected to suffer the steepest percentage fall in revenues from its fixed-income, currency and commodities division of the big four European investment banks, with Morgan Stanley forecasting a 41 per cent quarter-on-quarter decline.

A significant rise in mergers and acquisitions activity and underwriting of debt and equity issues will partially plug the gap for European banks, analysts said. Globally, investment banking fees were up 23 per cent year-on-year in the first half, and 26 per cent in Europe, according to Thomson Reuters.

Overall, investment banking revenues at Deutsche Bank, UBS and Credit Suisse will be down by an average of 25 per cent from the seasonally strong first quarter, while net profits are expected to have tumbled by an average of 49 per cent over the same period, according to analysts at Citigroup.

In the UK, investment banking revenues at Barclays and Royal Bank of Scotland Group revenues are expected to be down about 30 per cent from the first six months of 2010, with pre-tax profits falling a similar amount on average.

Meanwhile, there is still a crisis in retail banking due to non-performing loans, as evidenced by AIB’s results this morning:

Allied Irish Banks (AIB) unveiled a 2.6 billion euro($3.7 billion) underlying first-half loss as more loans turned bad, but said it expected 2011 to be the last year of major loan writedowns.

Alongside such news is the challenge banks are experiencing in capital raising in order to shore up their capital reserves to comply with the EBA stress tests announced a week last Friday.

The EBA data showed Europe's banks held €98.2 billion of Greek sovereign bonds at the end of December, with two-thirds of that held by Greece's banks, 9% by German banks and 8% by France's.

Banks' exposure to Irish sovereign debt was €52.7 billion (61% held domestically) and to Portugal it was 43.2 billion (63% held domestically).

This sovereign debt data has been crunched by analysts at big banks over the weekend in tests that were toughened up with default scenarios – something the EBA was barred from doing by nervous EU finance ministers.

Europe's banks would need €41 billion to keep their core capital ratio above 7%, the new global minimum from 2013 under the Basel III accord and already required by markets in practice, according to Reuters' calculations.

This compares with the 5% pass mark in the test.

JPMorgan's Abouhossein said a tougher test of 27 of the bigger banks using EBA data would show 20 are a combined €80 billion short of capital.

His test applied a haircut to sovereign bond holdings in the banking book and required banks hold core capital of 7%.

Credit Suisse analysts said applying larger haircuts on peripheral eurozone bond holdings, including for Italy, as per current market prices, would leave a €45 billion deficit for 49 banks it tested.

But capital raising isn’t simple, as the Bank of Ireland is about to find out. 

Bank of Ireland is trying to raise 1.9 billion euros ($2.7 billion) in a rights offering that closes on July 26 … the government will likely end up controlling as much as 65 percent.

So we have investment bank revenues and profits collapsing, retail banks still finding bad loans on their books, and Europe’s banks seriously challenged in shoring up their already crippled balance sheets.

Combine this with the who-will-chicken-out-first game in the USA over their debt crisis, and times aren’t great.

That's all past and present however.  

Looking forward, add on a few more jitters by thinking about a Q3 that is normally quiet, low M&A activity, more challenges in equities and fixed income, a euro crisis that rolls on and on and on, and you can see why I’m not a happy bunny.

These are a few of the thoughts I shared with Bloomberg this morning.

The only ray of light is JPMorgan and Deutsche Bank who consistently seem to over perform.

Will Deutsche continue to do that as their boardroom battle comes to a head?

Will JPMorgan be the last bank standing?

 

Postnote (26th July 2011, 08:29)

Times change fast.  After writing this yesterday, today Bank of Ireland have sold their rights issue to private investors and avoided state control and Deutsche Bank have confirmed their succession planning.

Bank of Ireland Sells Stake to Investors
Business Week

Deutsche Bank names new chief executives
The Independent

 

But, as expected, UBS report they are going to cut costs heavily in light of bleak trading conditions.

 

UBS expected to cut jobs as it seeks to save $2.5bn

BBC

 

Playing ping-pong with bank's yachts

After my note the other day about the thoughts of folks in transaction banking,  followed by the results of the US banks that shows a big slowdown in equities, fixed income and commodity trading, it struck me that like a double-dip recession we are now in a ping-pong interregnum.

What do I mean?

During a period of long-term stability, like the early to mid 2000s, where results were relatively predictable, markets were resilient, conditions were benign and the headwinds favourable, all the banks invested in innovation programs for growth.

Then we hit the turbo turbulence of the Global Financial Crisis and everything went bananas.  Nothing was certain, everyone was panicking, markets were tumbling, and everything was going south, all the banks invested in cost cutting and risk management.

By the end of last year, things seemed to have come back to some kind of norm and so the talk of growth and investment was back on the agenda.

Now it’s going off the agenda again, as headcounts are being shed and cost cutting is back.

In other words, the uncertainty of markets is causing many banks to have strategies that are about as robust as a yacht with a sail full of holes.

The yacht’s going nowhere, regardless of the wind’s direction.

Last quarter, it’s growth and innovation.

This quarter, it’s cost cutting and risk.

Next quarter it’s growth and risk.

The quarter after that, it’s innovation through cost cutting.

Who knows what strategy some banks are following, as it’s just completely tactical and reactive.

The thing is that you cannot have a wholly reactive strategy.

A wholly reactive strategy is a strategy shot through of holes.

So what do banks need to do in these turbulent times?

Well, they need to have a strategy for a start.

The strategy has to be where they want to get to in the next few years

We could talk missions and visions, objectives and key performance indicators but, more importantly, we need to talk about a direction.

A place the bank wants to be.

At least if a bank has that direction, then they can change the yacht’s course to suit either wind: the strong headwind that wants them to turn or the supportive tailwind that sets them on their way.

After all, with a direction, at least the bank can turn from the headwinds but still know what course they are going to charter, rather than these ping-pong strategies that just say speed on, turn back, speed on, turn back.

Guess what?

That gets you nowhere.

 

Shocker: Skinner thinks EBA stress tests not worthwhile

In my usual quiet way, I was interviewed by Bloomberg last Thursday in anticipation of the European Banking Authority (EBA), previously the Committee of European Bank Supervisors (CEBS), about the forthcoming stress tests released on Friday.

Last year, these tests were quite laughable and this year I expected more of the same.

Here's the whole ten-minute interview and, for those who missed it, I loved this article in the Telegraph:

Europe's bank stress tests as bad as 1979 Irish driving test

Seeing large numbers of his fellow citizens failing their driving tests, Mr Barrett – in a quick bid for votes – declared that anyone who had taken their test twice and not passed would automatically qualify for a licence.

The consequences were predictable. At any one time, about 40pc of the Irish population were allowed to drive on the roads without ever actually having passed a test. Traffic accidents went up and insurance costs followed.

Andrea Enria, the chairman of the European Banking Authority, may not like the comparison, but the limited bank stress test results he unveiled on Friday are born of a similar motivation that led directly to Ireland’s until only very recently dysfunctional driving test system.

Like the Irish government 32 years ago, the EBA and the European Union are under the impression that their power to pass and fail banks will translate directly into making them better at what they do.

The fallacy of this approach is as obvious as the needlessly ruined lives and extortionate insurance premiums that once-blighted Ireland will attest.

 

Review: The Independent Commission on Banking Interim Report **

 

** out of a possible *****

 

And so the long awaited Independent Commission on Banking (ICB) produced it’s report yesterday, and we all went … hmmmm.

Some went hurray:

Shares in Barclays and Royal Bank of Scotland topped the FTSE 100 yesterday, as the interim report of the Independent Commission on Banking stopped short of recommending the break up of high street banks.

And some went boo:

Lloyds Banking Group lashes out at plans by the Independent Commission on Banking to make it divest more than the 600 branches.

Some think it’s good for the economy:

Chancellor says Independent Commission on Banking findings have justified coalition decision to set it up

And some think it’s bad:

In effect, the banks got off scot-free. The British economy and the nation’s taxpayers will be the big losers.

And some think it was just mush:

When it comes to justifying the decision to stop short of recommending a full separation of investment and retail banking the ICB descends into intellectual mush.

Me?

I think it’s a political compromise that assuages the banks whilst showing the governments trying to force a strong hand, when it doesn’t have one.

In essence, after a nine-month long gestation period, the report is like a pregnant pause. A moment of held breath that, when you release it, shows there was just a silent moment with little changed.

The report does have some good things in it, like the idea that banks should be fire-walled to allow the bit that can fail to do just that, but the overall view has to be that it’s just BAU (Banking As Usual).

Barclays share price bounced strongly upwards having dropped heavily last week. This was due to the expectation that prop trading, the Volcker Rule and even a return to Glass-Steagall would be incorporated in the ICB’s report, leading to a breakup of the bank.

That hasn’t happened.

What happened instead is that the banks have been told that they must ring-fence the risky bits of banking – trading and investing – from the bits that need to be safe – retail and commercial.

This is so that if the risky bits fail in the future, they can be allowed to without impacting the safe bits.

I see it as like separating the jungle from the farm.

The jungle is the investment bank; the farm is the retail bank.

The jungle is full of dangerous animals that can kill you; the farm is full of nice things, like chickens and cows, which you control.

The jungle is full of risk and excitement and, if you come out the other end intact, you can reap big rewards; the farm is open and easy, with everything under control and reliable results the expectation.

What we had before is a single landscape within a bank – a Universal Bank – where the jungle and the farm existed on the same plateau. Hence, when the jungle went out of control, the wild animals ate all the ones we were trying to nurture for sustenance, and the whole bank failed.

Under the ICB’s report, the two must now be kept distinctly different. Therefore, two separate plateaus and a big chasm – or firewall – in between.

It sounds ok in theory.

It doesn’t go as far as Glass-Steagall, but it does go to the extent of making clear that if the jungle catches fire, then the farm is easy to save.

But that’s got nothing to do with long-term bank stability.

HBOS was a farm.

Northern Rock was a farm.

They both burnt down due to using the jungle for support and leverage.

Under the ICB view of the world, these farms would be safer because they would not leverage or use the jungle in quite the same way; and they would have far more capital in reserve, should the occasion arise, to survive a meltdown.

That cost of capital reserving will add about £5 billion to the bill for banking according to the FT, or even more than double that according to Oliver Wyman, which is why costs to customers will increase.

Meanwhile, the idea that the ICB has stimulated competition by making accounts easier to switch and telling Lloyds Banking Group to shrink further is also contestable.

Customers don’t switch accounts today. Is that because it’s hard, or because there’s no reason to bother?

Does the report make it easier for new banks, like Metro Bank, to launch?

Will a smaller Lloyds be any different to a bigger Lloyds?

Does it really make the banking world better?

Probably not.

That’s why I said last week that the Treasury Select Committee (TSC) had laid a bomb for the ICB. In that blog entry, TSC member John Mann called it “a whitewash”, published with conclusions made by “a bunch of elites coming up with something palatable to banks.”

Many would say he’s right, but then what can the ICB and Chancellor do?

Be radical and lose the banks support for the UK completely?

Lose all those tax pounds and pence?

No.

So the result is that Lloyds are a bit miffed as they are the target of being too big to retail, whilst the rest are fed up that Barclays has won the day.

For me, it was just another day in the jungle.

Watch your back.

Summary of the ICB report’s main findings nicked from Cicero Consulting:

Need for reform

• Banks tend to fail together and their liquidity and funding can be affected by a lack of confidence in financial institutions;
• A bank’s solvency can be threatened by a relatively small proportion of its assets going bad;
• Effects of bank failure are especially detrimental when it comes to the bankruptcy of systemically important institutions (SIFIs);
• Banks need to be allowed to fail and the probability and size of macroeconomic shock need to be reduced;
• Competition needs to be increased, especially in the field of SME lending and Personal Current Accounts (PCAs) where the market is most concentrated;
• The currently concentrated retail banking market in the UK can lead to poor outcomes for customers, as a larger bank has a lower incentive to offer good deals;
• No further action from the Commission to be taken on wholesale and investment banking operations, but more transparency is called for.

Current reform initiatives

• The Commission’s work reflects wide changes to capital requirements, such as Basel III;
• The FSA is expected to publish a consultation paper in the latter half of 2011 setting out its recovery and resolution plans;
• The Financial Stability Board requires the authorities of international financial institutions to meet annually in cross-border, firm-specific ‘crisis management groups’;
• The Basel Committee on Banking Supervision has introduced qualitative measures to improve liquidity risk management by requiring banks to establish a liquidity risk tolerance level;
• More regulatory oversight needs to be paid to the shadow banking sector to avoid transferral of riskier activities;
• The regulation of derivatives has been based on standardising OTC derivatives and clearing them through Central Counterparties (CCPs);
• The new tripartite institutional supervisory system in the UK will allow for timely identification of emerging risks to the financial system.

Reform options - financial stability

• Banks differ from other commercial institutions in terms of their vulnerabilities, and ability to leverage risk;
• The Commission is considering whether the Basel capital ratios are appropriate for SIFIs;
• The optimal capital ratios set out by the Commission as between 7 per cent and 20 per cent.
• The Commission is looking at a SIFI surcharge of 3 per cent, bringing the credible minimum SIFI capital ratio to 10 per cent , but accepts the need for international agreement;
• To tackle the issues raised by universal banking, namely the high impact of failure, the increased risk of system failure and increased risk taking, the Commission sets out the concept of a retail ring fence;
• Without safeguards, the Commission concludes, universal banking increases the risk of the failure of the financial system;
• A retail ring fence would strengthen the UK banking system and make the sector better able to absorb shocks;
• Whilst full separation would guarantee seperability during a crisis, the Commission feels that it would also remove all bank diversification and therefore increase risk ;
• Contingent capital (CoCos) has benefits, but the appetite for such capital is questioned;
• The Commission states that implementing the Volcker Rule in the UK would be unlikely to have a significant impact and would fail to address concerns about conflict of interest;
• The Commission sees little evidence to suggest that these changes would have a significant impact on competitiveness, and will be broadly neutral in effect in an international context ;
• Domestically the Commission accepts that there may well be employment and tax loss as a result of some of the proposals, and whilst there is a paucity of evidence the Commission feels that any impact would be small.

Reform options - competition

• Structural and behavioural changes are necessary to deal with the lack of competition in UK retail industry operations;
• Enhancing divestiture is an economically efficient way to promote competition; the Lloyds divestiture in particular could give rise to a new challenger;
• Barriers to entry into the banking market need to be lowered;
• Consumer choice needs to be improved significantly, real and perceived complexities in switching accounts and comparing products need to be rectified; and
• Competition in the banking sector must be subject to active monitoring and improvement by the FCA

Download and read the full ICB report here.