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.

 

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.”

 

 

MiFID II: the post-trade agenda

One of the big topics in capital markets is intra-day liquidity and post-trade transparency.

Such discussions are far more noticeable now because the whole reason for this crisis, according to some, was the loss of trust between counterparties. That loss of trust was based upon counterparties not having enough liquidity to cover their positions. After all, if Lehmans could collapse with billions of dollars of debt – and they were AAA rated – then anyone could collapse.

We then had this dialogue around the right levels of counterparty cover and collateral required in the markets at start of day, end of day and intraday to enable effective trading.

There were discussions of whether it should be like the Russian markets, where collateral has to be pre-posted every morning to cover the day’s trading.

Or whether there was a way to just put circuit breakers on the markets, like the Eurex Clearing model discussed last week, although that liquidity control is based upon self-management.

There have been other discussions about regulatory controls of liquidity risk, such as those provided by the UK’s FSA that requested real-time reporting of liquidity positions, at an estimated cost of £2 billion in new technology spending.

Meantime, Europe announced the de Larosière reforms a year ago, and these reforms are now coming into play as the three new regulatory authorities- the European Banking Authority, the European Insurance Authority and the European Securities Authority - come into play.

And, of course, America is trying their darndest to sort out the mess of OTC Derivatives and fragmeneted trade reporting.

So, in summary, we have global, regional and national regulations working together and apart to try and lock down this space, as illustrated by this slide (doubleclick image to enlarge):

Stolen from Harald Keller’s (Senior Manager, Payments Markets, SWIFT) presentation – for more click here

Overall, the focus of all these regulatory changes is around liquidity risk, which brings in several other key elements including collateral management, clearing and settlement and post-trade reporting.

For example, at last week’s meeting in Germany, Robert Barnes of UBS kept using the line: “post-trade reporting is the next pre-trade”.

What he meant by this is that if you have real-time trade reporting, then that helps the markets with transparency of investment strategies and where the next trades will come from. Therefore, if you can immediately see who traded those two million Apple shares on the dark pool, then you can immediately alter your algo strategies to suit.

Bring in the algo news feeds et al and he’s right.

The trouble with this is that post-trade reporting is good if people do it, but a lot of trading operations ignore trade reporting. In fact, the only post-trade reporting market that seems efficient is London thanks to Boat. In some other markets, T+3 is the order of the day ... or even worse.

So one thing that MiFID II is likely to do is to bring in some mandatory trade reporting requirements that strengthen the moves where the first version of MiFID failed.

Another facet to MiFID II will be some form of mandatory real-time reporting of trades, and a clearing and settlement directive incorporated as part of this.

Now that’s a leap of imagination –real-time trade reporting, real-time liquidity positioning and real-time clearing and settlement.

I’ve blogged about real-time opportunities before, and do NOT think that the European Securities Authority, the European Commission or the ECB would be silly enough to mandate real-time everything, but I do think they will want to see true interoperability across all clearing systems.

The LinkUp Alliance and Code of Conduct has gone some way down this route, but the situation is still pretty fragmented as can be seen from this chart, courtesy of Robert Barnes at UBS:

Sure, this is slightly out-of-date, but things haven’t changed that much and so transparency of trades, simple and straight through clearing and real-time liquidity management are definitely order of the day for the regulatory agenda.

This is Part Four in a Series of Posts on the Regulatory Agenda for Capital Markets:

• Part One: SEC to crackdown on HFT?
• Part Two: What was the cause of the 'flash crash'
• Part Three: Exactly what is and how big are 'dark pools'?
• Part Four: MiFID II - the post-trade agenda
• Part Five: Best Execution and Global Trading

These items also build upon a series of posts about the Deutsche Börse:

• If you can't afford the tech, get out of the market
• Circuit breakers on the Deutsche Börse
• Forget Frankfurt, I'm moving to Basildon

Goldman Sachs ... or Sack Goldmans?

There are so many articles and analysis into Goldman Sachs practices at the moment ...

... that I’m not going to write a lengthy analysis to add to all of these, but have picked a few of the best articles at the end of this blog entry.

What I would like to say is that the Goldman Sachs area of this blog shows that the SEC’s actions announced last Friday could be easily anticipated. From their near admittance of market manipulation in July 2009, followed in August 2009 of talk about the SEC looking at their flash trading practices; to the comments I made in January about the fine line “between making markets and moving markets that Goldman walk. It will be interesting to see how Goldman and company make markets in the future, between the Obama tax and the new regulatory regime.”

This was followed by the way they had to defend themselves recently, as evidenced by Chief Executive Lloyd Blankfiend’s letter to shareholders earlier this month.

Now the USA’s SEC has announced their formal investigation of Goldman Sachs, followed by the UK FSA's agreement to coordinate this investigation across borders.

There has to be a concern about their future.

Here’s my take on it.

The case for Goldman Sachs

• They are the world’s most successful investment bank
• They are the world’s best order execution broker
• They are able to create incredible profits from complex instruments
• They are the preferred choice of most clients for investment advice for these reasons, and this is why they maintain their success

The case against Goldman Sachs

• They are the world’s most successful investment bank ... and most of their brethren – Bear Stearns, Lehman Brothers, Merrill Lynch have imploded through this crisis
• They stitch clients up
• They are purely driven by greed and pay massive bonuses
• They manipulate markets in their own favour

Sure the list could be longer, and sure we can argue the toss over some of these points, but overall there could be a case of saying the investigations into the bank are all driven by schadenfreude and political motivations. For example, Barack Obama presents his financial reform bill to the Senate this week, so what better timing.

Nevertheless, for the SEC to have “Pit Bull” Richard (Rick) Simpson in there litigating against the bank, means that there has to something in this and that must be a worry for them. Equally with the share price dropping 13 percent on Friday and further again today, even with their stunning results of $3.6 billion profits and $5.5 billion in bonuses for the last quarter, the reputation of the bank is taking a battering.

The core of this debate is the question: does Goldman Sachs make stunning profits – over $100 million every day for 131 trading days last year – by betting against clients?

If the answer is yes, then it’s more a case of Sack Goldmans rather than Goldman Sachs.

Best of the media coverage from The Week, via the NY Times, Reuters, Naked Capitalism

Why the SEC is going after the Wall Street powerhouse, and what it means for the financial industry

The Securities and Exchange Commission took on Wall Street titan Goldman Sachs on Friday, filing a potentially explosive civil lawsuit accusing the investment bank and one of its mortgage traders, Fabrice Tourre, of fraud. (Watch a CBS report explaining the SEC's charges.) Here's a brief rundown of the charges, and what they could mean for Goldman, Wall Street, and financial reform legislation:

What is Goldman accused of? 

The SEC says that Goldman created and sold a package of mortgage-backed securities to investors in 2007 without telling them that the person who picked or approved the securities, hedge fund manager John Paulson of Paulson & Co., was betting heavily that they would fail. Goldman brought in independent fund manager ACA Management to help pick the portfolio, allegedly to make the deal seem more trustworthy. But the SEC says Goldman misled ACA, too, not disclosing that deal "sponsor" Paulson was betting against, not on, the investments. Paulson's role was withheld from investors, too.

What's Goldman's defense?

That the investors who bought the securities were given "extensive information" about the securities they were investing in, and were "sophisticated" enough to know that somebody was going to take the opposite side of their bet. Also, Goldman says that while it earned $15 million in fees, it lost $90 million in the deal, although it didn't explain how.

Who else lost, and made, money on the deal?

The investors collectively lost $1 billion, with the primary losers being ACA Capital and German bank IKB. Paulson & Co. earned almost $1 billion in profit.

Is Paulson being charged?

No. Legal scholar Alan Dershowitz thinks that was a somewhat arbitrary choice by the SEC, though, saying in The Daily Beast that Paulson "could easily have been charged with conspiracy to defraud."

How damaging is this for Goldman?

Analysts say the hit to Goldman's "seemingly invincible" reputation could be much worse than any punitive damages. Given how important trust is on Wall Street, "it's very bad for business" if your clients think "you are doing shady things," says NYU law professor Marcel Kahan. And while any SEC fine would be "really small potatoes" for the firm, Goldman's stock price tumbled 13 percent on the news Friday, erasing more than $10 billion in market capitalization. Also, Britain and Germany are mulling their own investigations, based on the SEC allegations.

Are other Wall Street banks facing similar SEC charges?

It's certainly possible. SEC enforcement chief Robert Khuzami says the agency is stepping up its anti-fraud actions, and specifically looking at "similar deals" involving other Wall Street firms. Until Friday, Goldman employees were able to "sleep soundly after collecting their huge bonuses," says The New York Times in an editorial. Since Goldman wasn't the only bank betting against its own mortgage products, "others on Wall Street may have a harder time sleeping" now, too.

What are the politics of this case?

The SEC is an independent agency, but political strategists and banking lobbyists say the Goldman fraud allegations could help the Democrats pass a financial reform bill. The House passed its version last year, and the Senate finance committee recently sent its version to the full Senate (on a party-line vote) for debate this week. Some Republicans and TV pundits suggest that the announcement was timed to help secure the bill's passage. Business Insider's Henry Blodget says the SEC also might have rushed out the lawsuit to divert attention from a damning internal review of the agency's enforcement over the past few years.

Other recommended articles include:

• Goldman Sachs profits top $3bn - BBC
• Goldman Sachs charged by the SEC – the Economist
• Did a Clever SEC Bait Goldman Sachs Into Compounding Its Legal Problems? – Seeking Alpha
• Goldman Sachs: the bank that thought it ruled the world - the Telegraph
• And more in today's "things worth reading"

A Single Customer View? Codswallop!

The UK Government recently ordered changes to the Financial Services Compensation Scheme (FSCS), as announced in the Banking Bill of 2009. The Bill resulted in a new regulation from the Financial Services Authority (FSA), Policy Statement 09/11 (Download FSA PS09/11).

PS09/11 rules that, from 31 December 2010, all financial firms must provide a Single Customer View (SCV) of all accountholders, so that they can pay back all deposits, regardless of debts, to those accountholders within seven days of a bank default. It also demands that banks keep a SCV in order that any customer with holdings over £50,000 across all bank operations, including all subsidiaries, are informed and aware of these holdings all being with the same bank. Finally, this is required so that the FSA can demand a list of all customers’ deposit holdings on demand and within 48 hours should a bank fail.

In practice, this is going to cost the UK’s banks millions of pounds, as the cost of the SCV demands major system changes across all core systems including data cleansing, tagging, linking and increased storage costs to accommodate new data fields. These fields, there are 25 of them, create a standardised aggregate view of all deposits across businesses, products and relationships, for all financial firms (in the UK).

According to the FSA’s consultation process: “the set up and maintenance costs of new IT systems for quick claims processing are estimated at £891.8m over five years. Firms' obligations to tell customers about the FSCS scheme, along with telling customers which trade names are covered by a particular authorisation, would have estimated set up costs of £34.6m and ongoing annual maintenance costs of £4.2m.”

For full details of the cost implications of this change to the Scheme, read Ernst & Young’s 67 page analysis.

Meanwhile, adding insult to injury, not only is this new reporting going to be checked for the quality and method of implementation across UK financial firms, but it will also be used to assist examining a banks’ liquidity (PS09/16 www.fsa.gov.uk/pubs/policy/ps09_16.pdf), stress testing (PS09/20 http://www.fsa.gov.uk/pubs/policy/ps09_20.pdf), living wills and more.

By 31st July 2010 firms must show their plan for the SCV to the FSA and by 31st January 2011, they most provide a customer report illustration to the FSA.

Great.

And they are not alone.

The European Union has proposals for a similar Deposit Guarantee Scheme, as does Australia (APRA’s proposed scheme, Download DP-FCS-for-ADIs-Jan-2010) and the USA.

Again, a range of disconnected global activities in response to a once in a century occasion when the banking system collapses.

So is it worth it?

This was the core of a debate we had at the Financial Services Club last week with:

• Peter Taylor, Director, Retail, British Bankers' Association;
• Martin Gibbon, Head of Risk Technology, Financial Services Risk Management, Ernst & Young; and
• Rekha Modi Gomes, Compliance Director for the EMEA Consumer Region, Citi;

Chaired by PJ Di Giammarino, Chair of the Capital Markets Chamber at the FSClub.

Various issues were identified, with the over-riding problem being the timescales and the clarity of the required change. This is not unusual, as all regulations are too aggressive in implementation timeframe and too poorly understood to be clear, and this one is no exception.

For example, many banks have multiple systems developed over decades, with some sourcing customer addresses as a data field from a core shared data dictionary whilst others have the field stored as a customer code in a flat file, for example. Integrating such disparate systems in a short timeframe is going to be nigh on impossible.

The core therefore is not the addition of new data fields or reporting customer details, but the changes to the enterprise customer data model, the restructuring of the operating model for data quality and verification, the model for resolving technical issues and providing technical support and more.

Equally, if this was required by a bank, why haven’t they done it before?

Because there’s no business case.

And, because there’s no business case, it is incredibly difficult to build momentum to support such a massive data restructuring project for simply achieving a regulatory tick in the box. Therefore, there has to be a need for using this change program to improve a bank’s ability to cross-sell, up-sell and deepen the customer relationship.

But again, this has never happened in the past.

For example, I worked with a bank in 1989 to re-engineer their mortgage process to gain a SCV. The mortgage process was chosen because it went across all divisions – credit, insurance, deposit accounts and money transmissions.

We gave up after a while because it was too difficult: “too many disparate systems across too many silos” was the response from the Executive. In fact, the real reason was that the silo-owners, the functional heads, were resisting the change as they felt it would lose their powerbase. That was even thought the CEO supported the project!

I bumped into the Board Member of the bank in question recently and asked if they had ever tackled that mortgage process. “No”, he said. “Still too many different products across too many different systems and divisions with too many baronial empires”.

Similarly, I used to market data warehouses that were building enterprise SCV for 1:1 marketing, cross-selling and up-selling.

Did anyone want one?

Not really.

Sure, they could all see the advantages of a SCV, but the internal empire barriers were too great to ever achieve an ENTERPRISE anything.

Maybe this time, it’ll work because the regulator demands it but this will still be a challenge.

But I do wonder when one panellist stated that the banks view this as a regulatory change with no business case, and that the regulator only has a narrow SCV of the customer’s deposit holdings, with no interest in their credit exposure.

In other words, this is disjoined-up regulation at a domestic, regional and global level.

Shucks.

So why aren’t there solutions out there to make this easier?

Probably because the operating model of days of old prohibited the SCV. For example, most large banks are the result of the merger and acquisition of lots of smaller banks in the past. That’s why there are so many disparate old systems around, is the excuse of many.

So what’s the result? Where’s the answer? How do we solve this?

Although the debate never got around to an answer on this, my own answer comes back to data standards and reference data. The fact that the UK is adding 25 new data fields is great, but we’ll probably find that each European member state adds 15 to 31, dependent upon their country (a bit like IBAN and BIC); whilst Asia and America do their own thing.

We need to co-ordinate global standards, particularly as the banks that are too big to fail are the ones with a footprint across all of these regions. Are we seriously asking these global banks to make multimillion dollar changes to their core systems that are different and distinctly separated in every country and region?

Ridiculous.

No wonder the debate concluded with over 60% of the audience rejecting the idea of SCV being achievable.

More Background:

• The Banking Bill
• FSA tells UK banks to spend a billion on technology
• Robbing the prudent to protect the irrational
• Building Societies hate our compensation scheme

Is MiFID working?

Just had an enjoyable morning floating around the City and talking with folks about MiFID 2. Now you may think that’s not so enjoyable, but it has been interesting.

For a while now, MiFID has been of concern as it has not achieved what it set out to do, namely to improve trade execution by providing guarantees of processing in terms of the best price, cost, speed of processing. The fact that the Directive celebrates its third year of operation without a single major best execution case or fine shows how effective that has been, particularly as best execution is known to be way off. For example, Equiduct showed a year ago that of the €97 billion trades completed in January 2009 across the most liquid 500 stocks, a third (33.4%) could have achieved a better price on a different venue.

But other things have taken priority over best execution, such as survival and bonuses.

So MiFID has failed in one of its core tenets. It has also failed in another: the transparency of trading.

According to a CFA Institute survey published last month, 68% of respondents felt that market fragmentation has created difficulties in trade reporting obligations.

Although the survey finds no empirical evidence that the fragmentation of trading and pricing has been detrimental to price formation, it does highlight the number one issue for most market constituents, which is the need for a consolidated tape for quote and trade data for European equity markets. You see there are so many trading venues now, each reporting their trades to their own chosen public reporting sites, that users have to increase their connectivity to a much wider range of venues than ever before. With each connection costing around £10,000 per month, that’s a high cost.

This concern has been picked up by Thomson Reuters who have produced an interesting white paper on European data consolidation this month. Their paper provides three key conclusions:

• “The buy side considers the cumulative cost of fees charged by exchanges, and trade reporting services is a significant barrier to adoption of a consolidated tape, and a detriment to overall transparency. We suggest there should be a more modular approach to data pricing that is underpinned by regulatory intervention.

• “The coverage and quality controls around MiFID trade publication need to be formalized and enforced to instil market confidence and trust. We make several suggestions to improve trade publication. To be successful, the institutional buy-side, brokers and trade reporting services will need to reach agreement on standards, and these rules will need to be codified through MiFID 2 regulation.

• “Best execution monitoring has been hampered by shortcomings in the provision of the source data contributing to a consolidated tape and by inconsistencies of approach to benchmark calculation between information vendors. In this document, we openly share our TCA (Transaction Cost Analysis) formulas and methodology. We now call upon other vendors to join in defining industry standards for data consolidation and TCA measurement.”

The consolidated tape is the priority for MiFID 2 therefore, along with sorting out the issues of best execution and pricing.

What else might be in there?

Dark pools?

Sure, they are a big issue aren’t they? The CFA survey found that 70% believe dark pools are problematic for price discovery, and the Federation of European Stock Exchanges (FESE) estimates that as much as 40% of trading takes place in the dark.  That means the general investor does not get to see these prices and orders until they are filled in a ‘hidden’ dark world.

FESE says that is wrong.

The banks say it’s just the Exchanges trying to create a smokescreen and that there’s no way the trading in dark pools is at that sort of level. In fact, the FSA has found that it is only about 2.5% of OTC (Over-the-Counter) trades that take place through dark pools whilst, across Europe, CESR estimates it to be more like 1.25%.

Interesting times and I could write a lot more, and will in the future.

Right now though, between the MTF impacts, the increasing use of dark pools, the lack of consistent trade reporting, the increasing use of flash orders and high frequency trading, the need for best execution and price transparency, and more, the regulators have still got a lot on their plate for this MiFID review.

Crisis or no crisis.

Europe's new regulatory agenda

We had a fascinating and packed meeting at the Financial Services Club this week with David Doyle, EU Policy Advisor, discussing the challenges of the new Barosso European Parliament and their legislative drive in financial services.

David is a regular visitor to the Financial Services Club, and runs our European Financial Regulatory Advisory Group.

In a broad and wide ranging speech, he presented key views around MiFID, the PSD, Solvency II, UCITS IV, Basel III and more, as well as commentary on Jacques de Larosière’s committee and the appointment of Michel Barnier to succeed Charlie McCreevy.

Here’s a summary of the key points David made.

The Commission is taking a 'safety first approach' to regulating capital markets and market actors, and will fill in the gaps where European or national regulation is insufficient or incomplete.

The over-riding principles of their approach are that:

• All that is of systemic importance should be regulated and supervised;
• There is a need for a better well-capitalised finance industry, with less leverage;
• The Commission must leglislate to avoide the perverse incentives in the financial sector that encourage excessive risk taking or over reward;
• Supervision should have the right tools to grasp complex, inter-connected and globalised financial activities; and
• To restore trust, investors and consumers should benefit from clearer, more coherent and effective safeguards.

At this point, audience members asked lots of questions about whether the European approach would be the same as, or coordinated with, the US approach.

David’s feeling is that it is being co-ordinated on the big ticket items – risk, leverage, capital, bonuses and such like – but the rest is still open competition in terms of the way payments, capital markets and specific aspects of the market are operating, such as hedge funds.

There are then the key changes that should be introduced by the new Barosso team in the near term as a result of the Jacques de Larosière. Of these changes, David believes that the new supervisory bodies:

• European Securities and Markets Authority (ESMA)
• European Banking Authority (EBA)
• European Insurance and Occupational Pensions Authority (EIOPA)

Will be the key here.

These new authorities will have teeth, and will be responsible for ensuring that any EU member states who are not following the line of regulatory oversight are brought to order.

This will be in play within two years:

2009-2010 ►national FSAs powers strengthened + focus on harmonising national rules to reduce cross-border differences

2011-2012 ►implement Pan-EU-wide supervision via ESMA/EBA/EIOPA

and will mean that the large states who are proactively interpreting directives will be in a far stronger position than those states resisting such supervision.

In practice, this means the UK, Netherlands are going to be fine; France and Germany will have some wrinkles to iron out; other nations will get a note to say they need to fine tune some stuff; and Spain and Italy will get a large wet fish slapped around their chops.

After all, every Directive I deal with – MiFID and the PSD in particular – it’s Spain and Italy who always seem to be dragging their heels.

David also made an interesting point here, which is that not only will the new regulatory bodies have teeth to drag member states before Brussels to explain why they are dragging their heels, but also resources to assist when assistance is needed. Therefore, in the case of Sweden where their key person for transposition of the PSD left at a critical juncture, this future structure would allow the EBA – the European Banking Authority which is not to be confused with the EBA, the Euro Banking Association, that operates STEP2 and EURO1 – to provide people to fill the gaps. These people may be promoted in from regulatory authorities in other EU member states for example and, in so doing, it will fill the gaps.

David then rifled through all of the areas for legislation and key directives including:

• The Payment Services Directive
• MiFID and Market Abuse updated rules
• Capital requirements Directive III & IV
• Remuneration
• Pan-EU Supervisory Mechanisms
• Hedge Funds & Private Equity
• OTC Derivatives
• Solvency II – Insurance
• Responsible Lending & Borrowing
• Packaged Retail Investment Products
• UCITs IV
• Credit Rating Agencies

It was real insight and incredibly useful stuff.

Unfortunately, if you want to know what he said about the above, you’ll have to hire our experts in the European Financial Regulatory Advisory Group or join the Club.

It might be worth you doing that anyway as our next meeting is on SEPA!

Part Two - John McFall and the return of Glass-Steagall

At the Financial Services Club in Central & Eastern Europe (FSClub CEE) meeting, you may be wondering what John McFall doing there.

The meeting was held at the British Embassy, our usual location for these meetings, and coincided with a tour of the region by some members of the Treasury Select Committee, who had spent the day with the European Central Bank to hear their concerns and priorities – “risk”, “moral hazard”, “recovery”, etc – and those of other countries in the region including Austria and Hungary.

Several members attended our little conclave including Nick Ainger, Andrew Tyrie and Sir Peter Viggers.

Meantime, John McFall kindly agreed to join the panel – he last spoke at the Financial Services Club in September 2004 - and was asked to explain a bit about the work of the Treasury Select Committee to the assembled throng.

Here’s what he said (loosely written, so none of this should be taken as direct quotation):

The UK Treasury Select Committee is a Governmental Select Committee established to look at the future of banking in 1989. It has particularly made progress since 1997, when the Bank of England was separated from the Treasury, as it is now playing a key role in scrutinising the activities of the Treasury, the Bank and the FSA.

We have been sitting near enough in permanent session since the collapse of Northern Rock in August 2007, and ours has been the only body to sit as a direct interaction between Parliament and the public in terms of how we are able to communicate the issues to the people.

For example, we had the Chancellor of the Exchequer, the Governor of the Bank and the Head of the FSA appearing together before the committee recently and our website received over 6,000 questions from the general public just for that one meeting.

This shows that they are so interested in this issue, and we give them a voice to talk to the tripartite authorities that run the financial system.

We focus upon financial stability and have established new financial stability procedures.

There are two issues here that we are particularly concerned with. First, the excessive attitude towards risk that we have seen over the past decade, as epitomised by HBOS and particularly the lending practices of the Bank of Scotland; and the lack of corporate governance in the sector, as shown specifically by the Royal Bank of Scotland’s Fred Goodwin.

This resulted in the new Banking Bill as announced in the Queen’s speech last month, which will give the FSA stronger powers and as this is meant to be “more intrusive regulation.”

Another big issue is what we call “regulatory badging”, where a company can stand back from their operations and duties of governance by saying, if it gets into a mess, that it is the fault of the FSA. This is why the area of corporate governance still needs addressing further.

With regards to the future, in the New Year we are going to be looking at the potential for “narrow banking”. Last year, this fell off the agenda when Lord Turner (the Chairman of the FSA) gave his report, but we want to bring this discussion back.

The focus of the narrow banking review will be to find the answer to the question of how to avoid the public taxpayer having to pick up the tab if the financial markets go wrong.

In other words, whether we need to be bring back the Glass-Steagall divide or not.

Mervyn King, the Governor of the Bank of England, has lobbied for the return of the Glass-Steagall Act - the post-Depression legislation in the USA that separated investment and retail banking, repealed in 1999 by the Gramm-Leach Bliley Act.

This way we could let an investment bank fail whilst the remainder - the payments processing, retail and commercial parts of the bank which must not fail - could be protected.

Lydia later asked John how the crisis had changed the UK’s views of its financial system in the context of European trade.

For the past ten years, the UK’s growth strategy for trade and investment has focused on financial institutions’ profits rather than their risks, but the UK trades in far more than just finance.

For example, the UK has a major range of service sectors and is the largest exporter of services in the world covering financial services, but also media and culture, construction and architecture, and more.

Take hi-tech engineering services as an example, and you will see that there is a trade balance between Britain and Germany.  This reflects that we get their BMW’s, and they get our JCB’s.

So the financial crisis has given us a chance to look at this range of services and consider how we might go around rebalancing this portfolio of services to reflect a more even spread across all the sectors rather than the ballooning effect that financial services had on our portfolio.

In this sense, Adam Smith’s hand – both his visible and invisible hand - has been driving the market.

And with this we need to remember that globalisation is the shadow behind all of these issues. This means that in the hi-tech and services areas, we believe that the UK has a major opportunity to compliment what they are doing in China and elsewhere in the world for export purposes.

 

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Gordon Brown's Tobin Tax ... duh?

Many of us thought it a bit weird that Gordon Brown suggested bringing back the Tobin Tax last weekend during the G20 summit.  The idea is to tax every financial transaction, just a little bit, one or two cents on each ... this way you can build up a fund for any future financial shocks.

The reason it's a bit weird is that any action by governments need to be co-ordinated across all G20 nations - unilateral activities will just cause banks to relocate elsewhere - and Gordon had zero support for this idea from his usually supportive key allies.

As with the bank bonuses debate, the issue of unilateral versus collective responsibility is a big concern and is why the UK and USA have been acting in close harmony, like Siamese twins, during this crisis to make sure they’re co-ordinated in all announcements.

So it was very strange that Brown would suggest the Tobin Tax when Tim Geithner came out five minutes later, saying that it was not something the USA would consider.

But what was even weirder, as pointed out by Private Eye this week, is that the Government and Gordon Brown have consistently rejected the idea of a Tobin Tax for the past decade.

For example, in May 2002 when Gordon Brown was Chancellor, he made this statement to the Parliamentary Committee for International Development:

“The problem is that each of the other proposals, like the Tobin tax ... has very substantial drawbacks and they have failed to command the international support that is necessary for us to raise the level of finance over a short period of time so that we can achieve the Millennium Development Goals.”

Or take this extract from the Guardian in July 2002:

“Chancellor Gordon Brown cold-shouldered anti-globalisation protesters last night as he rejected calls to penalise currency speculators to raise cash for developing countries. Appearing before the House of Lords economic affairs committee, Mr Brown said this so-called Tobin tax on foreign-exchange transactions had ‘big problems attached to it’. Increasing the flow of aid to developing countries ‘came down to whether there is political will on the part of governments to contribute more to international aid’, not to levying new taxes.

“The Chancellor's chief economic adviser, Ed Balls, added that the Treasury was ‘very unpersuaded’ that a Tobin tax would help to limit the kind of damaging currency speculation that fuels financial crises. ’It's not at all clear the Tobin tax is stabilising; in fact, it could well be destabilising,’ he said. ‘Well-designed, short-term capital controls could actually be more effective.’”

Hmmm ....

The rich vein of anti-Tobin views continues through the ensuing years as, just last December, Gordon Brown was asked in Prime Minister’s Questions whether he would support such a tax:

”There are many proposals to deal with the reform of international financial institutions to make them more able to deal with the problems that the world faces, not just the financial stability problems, but climate change. One such proposal is the Tobin tax, which has been found by many people who have looked at it not to be implementable.”

Even in August, when Lord Turner of the FSA mentioned the idea, it was pooh-poohed by the Chancellor.

Nevertheless, this was the same dialogue by Lord Turner where he used the phrase “socially useless”. Ever since, we’ve all been wondering what role for the future for banks in society, and the idea of bringing back the Tobin Tax on Financial Transactions has obviously seeped into Brown’s armoury.

So maybe Lord Turner has convinced him to make a u-turn on Britain's anti-Tobin Tax feelings.

Now, there’s no reason why a politician shouldn’t do a u-turn. It doesn’t look good but, bear in mind that back in 2002-2003, Gordon Brown also refused to believe there was a credit bubble burgeoning in Britain.

This is the famous discussion between Vince Cable and Gordon Brown, recorded by Hansard, on 13th November 2003:

Vince Cable: “On the housing market, is not the brutal truth that with investment, exports and manufacturing output stagnating or falling, the growth of the British economy is sustained by consumer spending pinned against record levels of personal debt, which is secured, if at all, against house prices that the Bank of England describes as well above equilibrium level?

“If the Bank of England is correct in its expectations of a market correction and rising interest rates, what action will the Chancellor take on the problem of consumer debt, which is rapidly rising, with 8 million annual visits from the bailiff?”

Gordon Brown: “The honourable gentleman has been writing articles in the newspapers, as reflected in his contribution, that spread alarm, without substance, about the state of the British economy.

“As the Bank of England said yesterday, consumer spending is returning to trend. The Governor said: 'there is no indication that the scale of debt problems have… risen markedly in the last five years.' He also said that the fraction of household income used up in debt service is lower than it was then.

“I suggest that the honourable gentleman look at the overall picture of the British economy.”

So times have changed and obviously Gordon Brown is not a soothsayer or Nostradamus or Warren Buffett ... and so he might be right in performing a u-turn on this tax on transactions.

The only mistake he made was not running this past the Americans (and Canadians, Russians and IMF) beforehand as they all rejected it out-of-hand, as he probably knew they would.

If you ask me it was just a cunning plan, as Blackadder would say (see end), to get more support for Tony Blair in the new EU roles of European President.

After all, the Tobin Tax is specifically supported and promoted by the French and Germans. Showing support of their policies may well be a political play that Gordon thought a good one.

Unfortunately, he’s not quite Blackadder either.

*

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The future vision for trading

At the Deutsche Bourse Open Day for IT, I chaired a panel comprising senior figures from Eurex, the International Securities Exchange and IBM.

The focus of the panel was the future of trading technologies, and was a wide ranging discussion covering everything from dark pools to high frequency trading (HFT).

Questions were abounding, such as:

Question:

Is HFT good or bad for liquidity as it gives large players an unfair advantage over small to mid size players and allows market abuses such as flash orders and front running?

Answer:

As long as everyone has equal access to the markets, then it is no issue. The fact that some traders cannot afford the technologies to deal in flash orders is not an unequal market perspective; it’s just that some are better at doing this and can afford the systems to do it. There is no barrier to entry however.

(BTW, I totally disagree with that view)

Question:

At these speeds, is it technically impossible to do compliance? For example, Barclays Capital are just one illustration of the markets becoming more difficult to manage when they are fined for not even being able to get the timing right on a trade execution.

Answer:

Yes, this is more difficult but time stamping trades is an essential core competence of any trading house. The issue lies with low latency and how a broker deals with order flow. If you cannot time stamp effectively when an order is received, filled and executed throughout the trade flow then you are not delivering on that core competence.

This happened recently with TD Securities who were accused of front running trades, and yet how do you prove you weren’t front running when everything takes place in a microsecond? TD Securities fought off a recent investigation to prove they were not front running by being able to demonstrate timings through their order flow, and so yes, keeping time is a basic requirement today.

Question:

What about the whole aspect of the changing regulatory regime with the new rules being developed by the G20, the de Larosiere report, the confirmation that there will be a MiFID II, etc. In fact, MiFID II, according to a speech by Charlie McCreevy in Dublin recently*, will incorporate OTC Derivatives in its next iteration. What does all of this mean for trade execution and technologies?

Answer:

The markets are ready for more regulation although it is interesting that most regulation creates unintended consequences. For example, the law of intended consequences is demonstrated by MiFID where the aim of the regulation was to have more transparency and openness and what did we get? More opaqueness, price fragmentation and a growing off-exchange trading environment using technology to create dark pools. This is the key to the technology used in the trading environment- to create arbitrage, risk and profitability for the client.

Meanwhile, everything will move towards real-time reporting. For example, Eurex is already able to provide real-time clearing at trade execution.  Firms will move towards this model for real-time trade reporting and real-time risk and liquidity management.

Question:

What about Social media & Twitter? Don’t these tools support insider trading? Do we end up with all traders being searched for personal communication devices before they enter the trade floor?

Answer:

No, you don’t need to go to that extent. Facebook and Twitter are electronic communication tools however, so they need to be brought under the controls and disciplines of compliance regulations or be blocked and, if a trader is found in contravention of such in-house policies, then it’s a disciplinary dressing down and possibly termination of employment. But you can do things about these areas. For example, research into this area (download report) clearly shows that the US regulatory rules apply just as much to tweets as they do to email. And there are tools you can implement to monitor such activities and store and forward such information, which is the right approach to take.

Question:

How do you see the development of Cloud Computing in the trading markets?

Answer:

In the US, we have seven major exchanges and I can see the world developing into one where those seven exchanges all place their servers in a massive server farm, co-located with market makers and brokers, so that the systems can deal in real-time. That’s where we are almost at today and certainly will be moving in that direction more and more over time.

The answers above were my own take on the discussions by the way, and not quotes from the panellists, but you get the idea of the flow.

We finished with a vision of the future of trading which I will sum up as being a world where each continent has a massive data centre of co-located servers representing the main trading venues of each economy.

The European data centres will naturally locate in London, Paris and Frankfurt; America’s will be in New York, Chicago and possibly San Francisco; Latin America’s in San Paolo and Buenos Aires; Asia’s in Mumbai, Tokyo, Shanghai, Hong Kong and Australia; and Africa and the Middle East will be based in Johannesburg and Dubai (or Bahrain or Qatar dependent upon how the region’s financial centres compete for dominance).

Fourteen massive data centres with mirroring and backup for each other.

Effectively a massive cloud of trade execution.

And yes, that’s where we move towards – a secure global cloud computing environment, all linked by dark fibre between fourteen massive data centres.

The data centres house the world’s exchanges and their broker dealers.

They can transact in microseconds within exchange and, thanks to terabit lines, can send a trade execution around the world in under a millisecond.

Lightning dealings in order flows through smart order systems that allow billions of offers and bids to be matched in a millisecond.

All of this liquidity flow being watched under a traffic light system of liquidity risk and market monitoring, such that market abuses are visualised and captured during the trade flow in real-time.

The G20 agreements on co-located data centre environments dealt with that one after the financial crisis of 2013, when the dark fibre smart order routers allowed Goldman Sachs to front run ...

Aw shucks, now I’m just getting cynical again aren’t I?

* In his speech to the EU Public Affairs Ireland Conference on 18th September 2009, Charlie McCreevy, European Commissioner for Internal Market and Services, stated:

“There appears to have been a significant migration of share trading transactions from the more regulated MIFID venues to the unregulated over the counter broker dealer venues where substantial unregulated dark pools of liquidity have built up. This gives rise to questions as to whether there are unfair commercial advantages for the operators of these venues and whether the trend undermines price discovery, market integrity and efficiency for the market as a whole. The MIFID review will address this issue.”

*

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Lord Turner and the G20's new bank regulations

I was asked to comment on Lord Turner’s speech today, which he made at the Mansion House last night.

Lord Turner is the Chairman of the Financial Services Authority (FSA), having taken over a year ago from Callum McCarthy, just as the crisis reached boiling point.

Reading through the transcript of the speech, it is clear that he is announcing the new regulatory drive in anticipation of the agreements to be announced this week by the G20 (he did the same in March, just before 1st April G20 meeting).

The speech can be summarised as follows:

People think I’m a heretic because I said parts of banking are ‘socially useless’ but I should know what I’m talking about as I was on the Boards of Standard Chartered and Merrill Lynch.

And look, Stephen Green who heads up HSBC and the British Bankers’ Association agreed with me, as he also said that ‘in recent years, banks have chased short-term profits by introducing complex products of no real use to humanity’.

But then both Stephen and I trained and worked at McKinsey together, and that shows we know what we’re talking about.

So when some City oik says he's not happy - in fact he's ‘appalled, disgusted and ashamed’ at my comments about the system being socially useless - I think about the victims of this crisis.

Don’t they have the right to be ‘appalled, disgusted and ashamed’ with you? (applause)

What this means in the future is that I want banking to be socially useful.

How are we going to do that?

By ensuring banks are:

1. More risk averse;
2. If they take bigger risks, they reserve more money to cover them; and
3. We’re going to be breathing down their necks to make sure they do.

The reality is that banks must avoid over-complex products that have no direct value to society so, if they can’t explain what they’re doing in words a ten-year old can comprehend, then we’re going to shut down those risky products.

The question I ask is how does a regulator work out what is more risky and then how do they calculate how much a bank has to reserve against those more risky products?

I also loved the FT’s Alphaville review of the speech, which mentioned that a mystery man gave out leaflets detailing the FSA’s own bonus culture during his speech. Apparently, the FSA paid out £19.7 million in bonuses in 2008 — or about 15% of its staff costs.

No wonder Lord Turner is saying that, as long as a bank can prove it has reserved the right levels of capital, then whatever bonuses they want to pay staff is up to them.

There will be no cap.

I’m not so sure the French would agree.

*

*

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Sir Howard Davies on leverage, the crisis and the FSA

Just found a great YouTube channel called the Banking Conversation and run by my mate Emmanuel Daniel, editor-in-chief of the Asian Banker.

Interviews include Stephen Green (Chairman of HSBC), Craig Donahue (CEO of CME Group), Dick Kovacevich (Chairman of Wells Fargo),  Chuck Prince (former CEO of Citigroup), Fan Gang (Director of the Institute of Economic Research of China), and more.

One that caught my eye is a half-hour interview with Sir Howard Davies, former Chairman of the UK's financial authority and now a Director of the London School of Economics.

The interview is in three parts.

Part One

Part Two

Part Three

He also wrote an opinion piece for the Japan Times that supports the views expressed in the interview and refers to analysis that shows that if "you had placed a long-term bet on financial equities in 1900, along with a short bet on general equities — in effect a gamble on whether the U.K. financial sector would outperform the market. For the first 85 years, this would have been a very uninteresting gamble, generating an average return of only around 2 percent a year.  But the period from 1986 to 2006 was radically different. During those two decades, your annual average return would have been more than 16 percent."

Fascinating stuff ...

MiFID's progress: slow, but sure

It's been a while since I wrote about MiFID and so, when I was asked to provide an update recently, here's what my take on the world of European trading is like two years on.

Two years after the Market in Financial Instruments Directive (MiFID) came into force in Europe and not a great deal has changed ... or has it? There are certainly new exchanges and new clearing systems, but the general landscape of Europe dominated by the three largest exchanges – Deutsche Bourse, NYSE Euronext and the London Stock Exchange – remains unfazed ... or are they? Certainly there are many pretenders to these giants’ thrones, but are any of them really up to the job?

In November 2007, MiFID’s rules on transparency of trading came into force. The idea was that we would have a pan–European investment market that would be as open and seamless as the US markets. Various players threw their hat into the ring to shake things up and, two years later, only one is making any major inroads: the Instinet subsidiary, Chi–X. Meanwhile, the other pillar of MiFID’s intent lies untested and unchallenged, namely the focus upon best execution. However, for anyone to believe that MiFID is a damp squib would be wrong. It has shaken the foundations of the European investment industry by bringing in new technologies, new focus and new pricing systems that, over time, will demonstrate a radical restructuring of the European markets.

Before we delve deep into this territory, let’s look at the new competition first.

The first mover to leverage MiFID’s opportunities was Chi–X, the pan–European equities exchange geared towards algorithmic trading. The fact that Chi–X was first mover, opening for business in April 2007, meant that by the time the second movers came into the market – Turquoise and NASDAQ OMX started trading effectively in September 2008 – there had been an 18 month cycle of gaining liquidity which has proven hard to break.

Under MiFID’s rules, there is meant to be a requirement for best execution based upon the price, speed and cost of processing, but this rule has never been tested and, more often than not, trades flow to where the market knows. Therefore, Deutsche Bourse, NYSE Euronext and the LSE are still thriving, and the only new entrant to make any headway has been Chi–X.

Chi–X do claim that this is based upon more than just being first mover, as they do offer very low latency (high speed) capabilities for high frequency traders. For example, the cycle time to process an order through Chi–X is around two milliseconds, compared to around six for Turquoise and significantly slower cycles through the traditional exchanges.

This low latency capability has been critical for the main market makers, who see speed of trading as a key factor for exploiting market opportunities and leveraging their algorithmic trading systems.

In addition, the second movers launch in September 2008 was just bad timing as this coincided with the market crash caused by Lehman Brothers collapse. Launching new equities exchanges just as all market trading volumes declined significantly was just poor timing.

It does not mean that the new entrants and market restructuring has finished though, as other trading facilities have launched since September 2008 including Equiduct, BATS and Quote MTF. In fact, according to the Council of European Securities Regulators (CESR, soon to become the European Securities Authority), there are 125 Multilateral Trading Facilities (MTF) that have registered for licence with them since MiFID came into force.

And most of these facilities have one thing in common: low latency technologies at low cost.

For example, the average order cycle, including clearing, is 10 basis points on the new exchanges, compared with 70 or more on the old exchanges. They also have a model based upon a higher fee for those who take liquidity versus those who bring liquidity. Finally, they are highly geared towards dark pool trading activities and electronic liquidity providers through advanced technology services.

This last point is a key one as, alongside new equities exchanges, the other major change in European trading has been the rise of dark pools, where orders can sit waiting to be filled unseen. Turquoise was the first aggressive play in this space, backed as it is by the major market makers. Since Turquoise launched, we have seen several others rise including Smartpool from NYSE Euronext and Baikal from the LSE.

Nevertheless, these dark pools may encounter a few issues in the future as the USA is the model they are based upon, and Wall Street traders have recently found themselves in hot water over the use of dark pools and low latency to potentially manipulate the markets using flash trades, also known as ‘gaming’. The way this works is that, through the automated systems for trading, dealers can see a large order entering an exchange a half a second before it is filled. That half a second allows them to rapidly process hundreds of orders for the shares about to be traded using algorithmic low latency processing. The result is that by the time the buyers’ order is filled, the pirce has risen by a cent. Perform such trading regularly through the day, and those cents soon add up to a tidy profit for the brokers and dealers using such trading facilities.

These practices are about to be banned by the SEC, although NASDAQ has already said it will not allow them. Just as NASDAQ makes this announcement, NYSE Euronext's new data centre to support high frequency trading facilities is soon to open in the USA. Therefore, the market will move to support liquidity, and if the liquidity is legitimate then there will always be at least one exchange who will support it.

This is concerning the European Commission, even more so with the fact that pricing has become fragmented across so many pools of liquidity, many of which are dark. This is potentially the rule of unintended consequences and the rumours of a MiFID II to resolve these issues abound.

Meanwhile, all of this fragmentation and dark trading is having a major impact on the traditional exchanges.

The traditional exchanges spent many years protected by concentration rules that forced traders in each country to process orders through their national exchange. These rules were removed on November 1st 2007, when MiFID came into force, and has opened the exchanges to major new competitive forces unseen before.

Although these new competitors have struggled to take liquidity, the fact is that some are. Chi–X for example, is processing an average 20% of FTSE 100, DAX 30 and CAC40 shares these days, and Turquoise claims a further 5%, even nearing 10% of the FTSE 100.

A quarter or more of the most liquid shares trading on the traditional exchanges moving to the new exchanges in a couple of years is a concern, and each exchange has taken a different route to meet these concerns.

Deutsche Bourse saw a 7% drop in Xetra and 14% decline on Eurex trading in Q2 2009 compared with Q2 2008, with only Clearstream’s custodial services delivering a bright spot. NYSE Euronext made a $182 million loss in Q2, mainly due to severance costs with LCH.Clearnet over their acquisition of LIFFE, the London–based derivatives exchange. And the LSE is in a right muddle, with former leader Dame Clara Furse leaving in a cloud of issues over their strategy and new CEO Xavier Role announcing a radical departure in approach.

The last point was the most shocking in fact, as ex–Lehman banker Xavier Role intimated that he was going to dump their flagship system, TradElect. TradElect was developed by Accenture and Microsoft as a next generation trading system that went live in the summer of 2007 at a cost of £40 million. The system was developed before the impact of dark pool and low latency trading however, and has never been able to compete with the order speeds of Chi–X and their clan.

Therefore, after only two years, the system looks to have had time called in order to create a real next generation trading service that processes at lightspeed.

Even so, one fact about the system has proven how difficult it is to take liquidity away from a trusted venue. Just before Lehman Brothers collapse, the LSE had a software failure for several hours on September 8th 2008. During this period, it should have led to major moves to the new exchanges as trading was stymied on the LSE for almost a day. It didn’t happen however, because most of the pricing feeds at that time were tied to pricing on the LSE and, with no price feed from the LSE, there were no pricing deals to be done on the alternative exchanges.

This will change in due course, as the new players find their niche, but today it is still the case that most traditional exchanges own their markets, or a large part of their markets. Yes, it is being eroded, but only slowly.

Which brings me to a final point. The erosion of tradition exchanges dominance of their country’s investments and trading is tied heavily to the openness and access to clearing and settlement in each constituency. Without easy securities settlement at the post–trade end of the process, the new exchanges are effectively frozen out of the markets.

The new exchanges have achieved a fair amount in resolving this issue, with new Central Counterparty (CCP) clearing systems from the USA, in the form of the EuroCCP a subsidiary of the DTCC, and in Europe with Fortis’s European Multilateral Clearing Facility (EMCF). But there are still many issues in interoperability and access to clearing and settlement in many countries, as evidenced possibly by the strong results of Clearstream in the Deutsche Bourse’s reporting this year.

Until the European Commission eradicates the Giovannini barriers – the barriers to cross–border securities settlement identified way back in 2003 and still unresolved today – and create a truly open and transparent post–trade system for Europe, the pre–trade equities exchanges can make inroads, but they will only be narrow roads rather than expressways.

In conclusion, two years after MiFID, Europe has a buoyant and lively marketplace for trading and investment that is gradually moving towards the European Commission’s vision of an open and transparent pan–European trading regime. The new MTFs have managed to gain a quarter of the most liquid stocks trading activity, and this will grow even further over time. Meanwhile, the traditional exchanges are rethinking and redeploying new technologies to compete.

The result at this stage is that the liquidity pools of Europe are running deep ... and dark.

A useful chart (doubleclick to enlarge):

For those interested, the book on MiFID gives a comprehensive review of the Directive with chapters written by many of the market experts.  This article is also a useful backdrop to compare the state of the MiFID markets in April 2009.

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FSA "passing the buck" on bank bonuses

For those on holiday or not in the UK, there was a fascinating interview on yesterday's Andrew Marr Show - BBC's Sunday morning political and business review - with Hector Sants, the head of the FSA. 

Here's the piece I particularly liked:

"If you think about the bonus question, really it's helpful to disentangle it into three different questions. It's not as simple possibly as the media sometimes portray.

"I mean, first of all, there is the question of are the way that those bonuses are calculated incentivising people to take unreasonable risk and put their institutions at risk of failure?

"Secondly, there's a question of in the aggregate are the banks distributing too much money for their own health? That's the total amount of money they pay to their employees.

"Then there's the third question, which I think occupies a lot of media debate: somehow or other are those individual payments unreasonable, particularly at a time when obviously the state sector, the taxpayer is extending quite a bit of support to banks?

"The first two questions are the questions for regulators to address and our code next week will address those questions and make absolutely clear that you cannot calculate bonuses in a way which encourages unreasonable risk taking and puts the institutions at risk, which was the case in the past ...

"The question of how the total pot of profits should be split between the shareholder and the employees is one primarily for the shareholder to answer.

"We can take a view on how much should be distributed in relation to maintaining the banks' stability, but the question of how that amount is then split up between employees and shareholders is one primarily for the shareholders.

"And of course in many cases now, the government is the shareholder. So I think that is a question for government and politicians. Asking the regulator to solve that, I would say is arguably passing the buck."

Hector had a lot more to say.  To read the full transcript of the interview, click here.

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FSA liquidity regime in jeopardy

Further to the discussion about liquidity last week PJ Di Giammarino, Chairman of the the Financial Services Club's Capital Markets Chamber, released his firm’s findings about liquidity views in the City today.

PJ’s company, JWG-IT, polled over 30 financial institutions and 10 vendors on their implementation readiness for the FSA’s new rulings in the spring and twice more in July.

The results showed that banks are not ready for the new liquidity regime, and that the FSA’s attempts to set and communicate an actionable implementation plan for liquidity risk have so far failed.

Part of the issue appears to be the differing opinions on how to run the banks in the future, with disagreements between the FSA, Bank of England and Treasury causing uncertainty of approach.

That’s fine, except that the FSA’s aggressive timescales now leave banks less than 75 work days to implement a data-intensive approach to liquidity risk management.

Bearing in mind that their own estimates show that the price tag for this regime will be well in excess of £2 billion, that’s a problem.

JWG-IT’s research found that senior management within banks are only just beginning to understand the magnitude of the upgrades required for liquidity risk. The main findings from the research include:

• Awareness: Only 41% had heard of the FSA’s liquidity risk standards consultation paper (CP 08/22) which were released in December 2008
• Systems: 64% of 20 bank respondents indicated that their existing systems could not be easily adapted to the new liquidity requirements.
• Data quality: 41% of bank respondents indicated that meeting liquidity data requirements would be their biggest implementation challenge.
• Controls: 33% of respondents ranked liquidity risk systems and controls as their top issue - carrying the highest risk and requiring the most resource to resolve
• Resources: 28% of respondents indicated that no resources had been allocated to their top 3 issues of scenario/stress testing, risk modelling/analytics and data.

For further information see JWG-IT’s analysis report, “Winning the risk governance battle”, which was released last week. 

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Liquidity Management ... what's all that about?

After talking about Wall Street's liquid workers, liquidity risk, liquidity reporting and liquidity management on several occasions, we had a big debate about it in the Financial Services Club a couple of weeks ago.

It interests me because it is such a wide-ranging subject.  For example, liquidity in trading is all about having liquid assets to invest or cash.  Liquidity in exchanges is all about having volume and market share.  Whilst liquidity in payments is all about the management of cash pools.

As a result, any discussion about liquidity tends to draw a wide and diverse crowd, and this meeting was the usual eclectic mix of payments people, technologists and buy and sell side.

The meeting was titled: "This house believes new liquid architectures will dominate strategic plans for 2010", and was chaired by PJ Di Giammarino who heads up our Capital Markets Chamber. 

Panellists included Rick Weinstein, former Head of Global Structured Credit, Dresdner Kleinwort; Andrew Carter, former CRO at Zurich Financial Services and former Head of Group Operational Risk at NatWest; and Don Deloach, CEO of Aleri.

The meeting itself got a good write up in A-Team insights, so I don't want to repeat the whole summary again.  In fact, I would recommend that if you're interested in MiFID, liquidity risk and capital markets, you subscribe to their service.

Meanwhile, here's an edited version of their summary of events:

“The ‘huge price tag’ involved in the UK Financial Services Authority’s (FSA) incoming liquidity regime was a key topic of discussion at last week’s Capital Markets Chamber in London. ‘Although senior management is starting to get on board with the changes, operations people have yet to get involved in these projects in most cases,’ said PJ Di Giammarino, Chairman of the Chamber.

“There is a considerable lack of understanding about the details of the regulation and its potential impact on the financial services industry. This is gradually changing, however. The very fact that the room was filled to capacity (much like other recent events on the subject) indicates that the industry is starting to take notice of the impending regime changes.

“In order to educate attendees further, Di Giammarino, discussed the main requirements of the new regime, including the new regulatory reports and stress tests that must be introduced. ‘The systems and controls requirements will put huge pressure on firms’ data systems because of the level of granularity and the speed involved,’ he said.

“The panel discussed the potential to spot the next Lehman as a result of these new measures and it was generally agreed that although the regime may help banks to react to risk exposure in a more coordinated manner, it could not prevent another crisis.

“‘There’s no way this would help a firm to spot the next Lehman. The whole idea of objective, scientific data is a nonsense,’ said Rick Weinstein, former head of global structured credit at Dresdner Kleinwort. ‘However, it will help you see who your large exposures are to on a global basis.’

“The most controversial aspect of the new regime is the introduction of so-called liquidity buffers, which are due to be introduced in the first half of 2010 during the second implementation phase. ‘The idea of a liquidity buffer is a nonsense, the FSA instead needs to ask banks to hold higher capital reserves,’ said Weinstein. ‘Banks also need to have formal best practice procedures for how to go into liquidation in an orderly fashion.’

“Andrew Carter, former chief risk officer at Zurich Financial Services and member of the Liquidity Risk Action Network (LiRAN), warned attendees that for now they cannot ignore the impact the liquidity risk regime will have and that they must take action now. ‘Regulators are going to come down like a tonne of bricks on senior management that do not have an understanding of their liquidity risk exposure,’ he said. ‘We need to get away from the complacency that is displayed to do with risk information, boards will need to be more engaged and proactive in dealing with the implications of this information.’

“Firms have the option to respond strategically or tactically, added Don Deloach, CEO of risk management system vendor Aleri. ‘It would be a shame to miss the opportunity of aggregating this risk data at the atomic level by opting for a purely tactical response’, he said. ‘Risk management systems can give firms a competitive advantage over other players in the market by allowing them faster speed to react to market events.’

“Around 60% of the audience members indicated that they believe liquidity risk will dominate banks’ budgets for next year. The 40% that did not believe it would be the top of the budget list indicated that this was largely due to the confusion still remaining about what exactly the regime will mean for banks’ daily practices. ‘The fact that the FSA has issued so many consultation papers on the subject has not helped matters,’ added one audience member.

“The audience and panellists agreed that the make up of the board is also likely to pose problems with regards to understanding risk. ‘Most board members are the top sales people that have been promoted up the ranks of an organisation and not necessarily those that are best placed to understand the business. It also doesn’t help that the average term of a CEO is shorter than that of the implementation of a regulation,’ said an audience member.

“So, it seems that a lot of problems and challenges are still ahead of the banking industry with regards to getting on board with the FSA’s new regime. Although there is a general understanding that tough times are ahead, there is a considerable amount of confusion about the details of the regulation.

“What is certain is that it’s going to be costly and the industry can’t afford to ignore it.”

During the discussions however, I kept asking myself various questions.

For example, we now talk about global markets needing global solutions and global regulations yet, as demonstrated by the spat between Britain and Brussels, we cannot even agree national and regional regulations, let alone work on global systems and supervisory structures.  If we cannot even agree on a competent authority and supervisory structure in a country, who thinks they can get one to work globally?

Similarly, the discussions are around being regulated by a competent authority, but what is a competent authority?  The FSA is not a competent authority, as discussed on Monday, so what is?  And what is the consitituency, profile and structure of staff and management at a competent authority?

Specifically, for real liquidity risk management you need real-time processing, management and reporting.  The FSA wants this and the technology to do this exists and has for a while ... but what's the motivation to spend the cash to achieve this?  Investing for risk management is far less conducive historically for a banker, when compared with investing for revenue growth or cost reduction.

And in some ways you could believe that it's good to be too big to fail.  If you're too big to fail, you know you'll get bailed out if you do fail.  So what does too big to fail do to your attitude towards risk and risk management?   There is no risk.

There are many more comments, questions and thoughts.

The trouble is that it's all well and good to come up with questions - what about answers?

My first answer (written in September 2007!) was to have a global data warehouse of data being traded to monitor risk.

And the DTCC is finally coming up with an answer on that one, so at least there's a start.

Unfortunately, Europe appear to want their own repository however, so this debate will rumble on (and on and on) for a long while to come.

  

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The end of the FSA

For years, the Financial Services Authority (FSA) has been lauded and applauded by Europeans and Americans as a model of supervisory structures. 

After the collapse of Northern Rock and the huge liquidity risk exposures demonstrated by Royal Bank of Scotland and HBOS, the institution became tarnished and is now viewed by many as a failed system.

So much so, that the Conservatives have announced they are going to kill it when they ascend to power next year, which is highly likely, and reconstruct the FSA's powers between the Bank of England and a new Consumer Protection Agency, similar to the one announced in the USA last month. 

A few of us might say that they are doing this because the current Chancellor has done the exact opposite, removing power from the Bank and giving it to the FSA ... but that would be churlish, wouldn't it?

However, those of us who remember that far back, may remember the previous regime where each part of the industry had its own self-regulatory body: the Securities and Futures Authority (SFA), the Investment Management Regulatory Organisation (IMRO), the Personal Investment Authority (PIA) and more.

In fact, many of these were supersets of former authorities.  For example, the Personal Investment Authority was the successor to the Life Assurance and Unit Trust Regulatory Organisation (LAUTRO) and the Financial Intermediaries, Managers and Brokers Regulatory Association (FIMBRA).

All in all, you therefore have a system that has evolved, morphed and grown over time from self-regulating bodies that didn't work, to regulatory bodies that didn't work, to super-regulatory bodies that didn't work.

How the heck anyone thinks the Bank of England will do a better job than these dedicated regulatory bodies, that didn't work, is beyond me.

Will have to read the Conservatives ideas very carefully as I'm already wondering what a Consumer Protection Agency has got to do with Liquidity Risk, Credit Default Swaps, Securitisation and more.

The danger here is that they replace one broken system with something worse.

  

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A compliance culture or function?

Over a dinner this week, there was a fascinating discussion about the role of compliance.

Compliance.

A culture or a function?

A view of complying and being subservient or of being proactively compliant.

Compliance as a painful enforced change or an opportunity to re-engineer and improve.

Compliance.

Threat or opportunity?

To be truthful, compliance can be all of the above or none. It is all down to attitude.

During the discussion, it reminded me a lot of the recent spat over our political affairs.

Our politicians have been caught with their hands in the till.

They haven’t been fiddling expenses as it has all been within the rules ... except that this policy may be within the rules, but not within the spirit of the rules.

And this is the heart of compliance.

Interpreting rules as both the meaning and the intention.

This is why the phrase “legal but not legitimate” came up several times during the conversation on compliance.

The leverage of the bank was legal but not legitimate.

The CEO’s lack of knowledge of investment markets allowed products to be sold that were legal, but not legitimate.

The intention of best execution was to sell products that were appropriate, not high risk products that were legal but not legitimate.

And so on and so forth.

So the core of compliance is to look at the rule in both its meaning and intention, as well as its working.

This, to me, was the spirit of principles-based regulation but that’s gone away now.

The light touch approach is no longer relevant.

It’s gotta be hardline now.

But what is hardline?

The FSA define it as focusing upon outcomes-based regulation, rather than principles.

And complying with outcomes-based regulation means seeing the end-goal and working to achieve it, rather focusing upon the idea, the theory, the principle.

But whatever the approach, compliance can never really work whilst people see the ways to interpret the rules and bend them to their own way of working.

Like the politicians who can buck the system by working within the rules but not the spirit of the rules, compliance has to be more than just an idea, a theory, a principle.

It has to be a culture.

It has to be led from the top.

It has to be endemic to the whole way the institution works.

You see a business rots from the head, just as a fish does.

If the head of the business believes it is ok to buck the rules and interpret them to your own maximum advantage, then the culture of the business will be the same.

If the head of the business believes it is ok to use the expense system to line his or her pockets, then everyone who works for the business will be told this is the way to do things.

If the head of the business believes it is a good thing to leverage the bank to the hilt to gain maximum returns at maximum risk, then the rest of the business will do the same.

This came home to me when i think of our politicians, but also our banks.

For example, i worked with two banks last year that were merging.

One had a Chief Risk Officer (CRO) who made the final decision on every major investment or trade finance agreement with the bank. The CRO would be where the buck stopped and the CEO would defer to their judgement.

The other bank had a CRO who made a recommendation to the CEO on every decision of the bank, but the CEO made the decision.

The latter bank acquired the former.

The latter bank is now defunct.

It failed because the CEO was an ultimate risk-taker and, as it turns out, megalomaniac.

This is why compliance and risk need to be viewed as one and the same.

Compliance.

It is a culture, not a function.

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BBC's Robert Peston presents ...

Robert Peston, the BBC’s lead reporter on the banks throughout this crisis and author of: Who Runs Britain?, presented a discussion I attended the other night.

Robert surprisingly used a PowerPoint presentation to talk through this theme. I say surprisingly as we’re so used to seeing him sit and talk for soundbite minutes, that a 45 minutes keynote seemed unusual. And with slides too!

Robert’s presentation was titled “The new capitalism: The cost of men behaving badly” and, just to be clear, he presented under Chatham House rules so the summary below is purely my spin on what he said and not his words.

First, an estimate of the losses to date.

$4 trillion.

Actually, no, it was $9 trillion.

That's $9,000,000,000,000.

If a dollar was equivalent to one second, it would take about 11.57 days to get through a million dollars, 31.7 years to get through a billion and back to the birth of mankind 32,000 years ago to get to a trillion dollars.

That's $1 trillion.

$9 trillion.

$9 trillion of losses.

$4 trillion came from the banking industry.

$4 trillion of bailouts, cash injections, support and relief.

Then a further $5 trillion of corporate losses in lost output through lack of access to liquidity, loans, working capital and trade finance.

$9 trillion.

About 300,000 years of spending a dollar a second.

That’s 25% of the world’s global output.

A quarter of the world’s output lost due to this silly crisis created by what?

Bad maths.

This is best illustrated by the example of Goldman Sachs' Black box event back in August 2007.

This is where David Viniar, Goldman Sachs' CFO, said: "We are seeing things that were 25-standard deviation events, several days in a row. There have been some issues in some of the other quantitative spaces, but nothing like what we saw last week."

A "25-standard deviation event" only happens once every 100,000 years or more according to the models built into the systems, but then they occurred several days in a row and the Goldman Sachs fund lost $1.5 billion.

In other words, banks were organised and managed using bad science.

Now, was that down to too little regulation – ‘light touch’ – or just bad regulation?

To be truthful, it is an indictment of regulation that didn't work combined with a failure of Alan Greenspan’s science.

You see, Greenspan prayed to the lords of securitisation and light touch regulation. He believed markets regulated themselves through competitive forces and securitisation worked because it distributes risks widely across the markets.

But there were two errors in Greenspan’s thinking that went wrong.

The first was the belief that banks only lent money after checking that a borrower had the ability to pay it back; and the other was the belief that banks would lay-off risks to others and spread the risks widely across the markets.

The banks did not do this. In fact, they retained risks because, once this was repackaged and given a AAA rating, it was easier to keep on the banks’ books as assets rather than spreading them around outside the markets.

And in all cases, the regulators missed this trick because they were looking for crooks rather than idiots. This was not criminal activity, just incompetence and the FSA and SEC just thought management of these firms were regulating their staff misbehaviours rather than looking for such malfeasance.

This is why we expect too much from regulation as, to be honest, there was more regulation than you could shake a stick at before this crisis, and much of it was on a statutory footing.

So this was a failure of regulators, regulation, management and markets ... but the overall failure was not caused by these factors but more by a failure of theory.

This is because conventional analysis saw the housing and market bubble as harmless, and the theory was that the housing market wouldn’t need to be propped up by bank of England. But that theory was wrong due to the fact that there was far too much lending at far too cheap a price, and the theory that liquidity would remain stable and available was wrong.

The result is that we borrowed more than 100% of GDP and personal sector borrowing today is running at around 170% of GDP.

That’s ridiculous and has increased by around 70% since 2000, and it was unhealthy back in 2000 as a result of eight years of unparalleled growth in the economy.

So here is the horrible paradox: compliance meant that any banker would tell you that regulation was severe and intrusive. The result is that we bred a culture of compliance where, if the boxes were ticked and all ok, then the deal was ok. This meant that no one asked whether the deal was sensible or ethical, in a more fundamental sense.

It was this culture of box ticking that resulted in the biggest regulatory failure any of us will ever witness.

But it was more than this, because the box ticking issue lay with the false comfort provided by experts.

The credit-rating agencies priesthood meant that even the Bank of England paid homage to these priests. They gave the best AAA ratings, which were meant to be for the nicest investments, to the stinkiest investments. The AAA rating was given to stinky products because of lousy data and a confusion between solvency and liquidity.

The primary thing they got wrong was using data for defaults and repayment difficulties from the 1990s. This data was created when the market was only worth a few billion dollars and it said the market default rate for mortgage repayments would be the same for a massive market, doubling every year, as it was for this tiny market. In other words, the data was extrapolated from a very small sample to a much bigger one.

In retrospect, it was a classic error.

Another part of the error was the assumption was that an investment could be sold at any time to create solvency. This belief was that money tied up in assets could be turned into cash fast … but you cannot do that when liquidity disappears, which is why the losses and rescues occurred because banks thought solvent were not. The belief they were solvent was based upon a belief in their asset liquidity, which just wasn’t there.

This is due to the alphabet soup of CDOs, CLOs, SIVs, ABS, RMBS, CMBS, CDS.

These instruments all packaged up risk and allowed banks to borrow short and lend long. There’s the rub, because if everyone wants their money back you don’t have it, with all of these Structured Investment Vehicles exacerbating it all.

The capital question is also of huge importance to all of us, even though almost no one took any interest. This is because most people don’t understand how banks work.

Under international rules, banks can lend a part of their capital but must keep some back in case it was to the wrong people.

The issue with this is that no single issue in bank regulation is more important than this one, and yet no-one knows the answer as to what is the right level of capital a bank must retain.

We’ve had Basel and Basel II, and still there was a shortage of capital. That shortage is the reason for this crisis. Have you ever heard a politician discuss bank capital before this crisis?

This failure to debate the most basic question in our system has been the core of this crisis. Those basic questions are how much capital should banks hold, and how much capital in total do banks need to retain to cover their total lending?

This is why liquidity was ignored as no-one believed liquidity could just dry up.

And what happens if everyone asks for their money back all at the same time? Especially if your counterparties ask, which are those who have the major exposures to each other?

That’s what the issue was, and this is what caused the biggest run since 1913 on the financial system.

It was because liquidity dried up, all the counterparty banks asked for their money back, and many banks just did not have the capital or access to assets for solvency to cover their exposures.

There were other factors but, generally, the false comfort of statistics and maths was a systematic distribution of common sense. This is why people didn’t ask the stupid questions such as: if we are lending two to three times the buffers of capital we used to, why? Where’s the protection in that?

RBS were leveraged by a factor of 40, and their board thought there was no subprime exposure because they had the illusion of insurance. But their exposure was to insurance, not subprime lenders which is why they thought this. And the insurers didn’t have the resources to make good on subprime loans if the worst happened, so they were taking false comfort too.

The lessons of this crisis are therefore:

Don’t be in awe of experts;
Challenge the science; and
Common sense normally trumps statistics.

Oh yes, and the reference to men behaving badly ... interesting note: did anyone notice that not one leader who has been named and shamed in the banking industry has been a woman?

They're all men!

But then, these facts and quotes from a recent article in the Independent explains it all:

• almost half the women in senior positions in investment banking have no children, according to research from Cranfield University.
• the wage gap in the banking sector is about 40 per cent, almost double the national average of 23 per cent.
• most investment banks now recruit almost equal numbers of men and women graduates, but at managing director-level, women account for between 5 per cent to 15 per cent of staff.
• almost three-quarters of City professionals believe the recession will be an opportunity for women to change careers, while 60 per cent think it will reinforce the glass ceiling.

"Work by a team from Cambridge University who measured testosterone levels in a small group of male City of London traders at 11am and 4pm on a number of days, and matched the results to the same days' levels of profit or loss. They found that testosterone levels were significantly higher on days when traders made more than their average profit.

"Financiers are like sportsmen, the study suggested. On days when they have testosterone coursing through their veins, their confidence rises and they produce the results expected of them. But the research pointed to a downside to trading floor frenzy. Too much testosterone can be addictive, driving over excited males to take more and more risky decisions.

Insider Trading and Twitter

I wondered recently about the potential of market abuse in new social media.  This was inspired by an April Fool from the Insurance Post, which had the headline: "FSA proposes ban on social networking sites".

"The Financial Services Authority has called for a ban of social networking sites such as Twitter and Facebook for all its regulated and authorised firms.

"The FSA has launched consultation paper CP01/0409 following a series of allegations of sexual harassment of female members of staff in the financial services industry.

"An FSA spokesman said: 'The consultation was launched following a series of concerns expressed by senior management about the productivity of staff who have constant access to social networking sites. It was found that limiting access during working hours was counterproductive, and in some cases certain members of staff were believed to be cyber-harassing other employees.'

"Under the proposals, only authorised personnel with permission from the FSA – known as 'minded to socialise' - may use social networking sites, and failure to comply will result in fines. The initiative has been supported by the Government, who will shortly be introducing legislation to the public sector."

This was a joke but I have a growing feeling that Twitter is a great medium for generating market abuse through insider trading.

For example, using a duff email address - it's easy enough to get one on AOL or Yahoo! - you could create your Twitter pseudonyms and then merrily exchange insider news and views completely out of the loop of the regulator's eye.

I just created one a minute ago for a laugh:

Now ok, this could just be me mucking around but how would they know?

And if they did find abuse and wanted to track me down, how would they do it?

Through my IP address?

You see even if the regulator could track down exchanges, could they track those Twitters back to me if I were using a pay-as-you-go mobile or blackberry?

No ID, no address, no nothing.

Just a thought.