Compliance and the Myth of Goldilocks

So far, in the last few years, there have been a number of co-incident enormous financial scandals, which reached from the macro, to the micro, top to bottom. You have various mis-selling scandals. Zero-Dividend preference shares, Endowment mortgages and PFI insurance to name a few. You have LIBOR rigging. You have sub-prime mortgages in the USA, and “liar’s mortgages” in the UK. You have a BASEL II capital adequacy regime. You have mega-mergers and the growth of international financial institutions with liabilities so large, they bankrupt the states which stand behind them.

All of this happend despite the rise of the most intrusive compliance regime the financial industry has ever had to endure. There were rules from everything to the type and amount of assets to be held on the balance sheet, measured in billions, to how quickly any given institution answered the phone. To argue therefore the catastrophe which has engulfed global finance since the 2007 is the fault of de-regulation, is absurd. 

I argue the opposite. I argue the strict compliance regime is the ultimate CAUSE of the crisis. Because banks went bust occasionally in the past: BCCI, and Barings, as the result of fraud or rogue traders, but they did not pose the systemic risks of RBS or Lloyds.Why not? 

To understand, we need to go back to  The US savings and loan crisis of the 90’s, which triggered the recession of 1990-1991. The end of the recession in 1992-1993 following the state bailouts of large numbers of institutions may have made the recession less severe, but it sowed in the mind of the people lending money, that the Government would ride to the rescue. Having ridden to the rescue, Government for it’s part decided to interefere in the lending decisions of banks.

Bureaucrats have tidy minds. To them, the chaos of the market is riskier than the ordered marching of Giants. Since 1990, the number of financial institutions lending money, halved. Regulators encouraged mergers. Savings and loans and regional banks were gobbled up into behemoths. A process which was repeated with equal enthusiasm on our side of the pond. Slowly, the institutions grew. The housing market picked up steam, and ushered in the Clinton “goldilocks” economy of the 90s. 

Almost every financial asset class became more expensive. Bonds had been enjoying a bull market since the late 70’s carried on running, and the yields kept falling with low interest rates. On those, more later. Equities ran up towards the bubble, which eventually popped in 2000. Property rose steadily from the early 90’s. Money flooded into Government coffers. People felt wealthy on their rising property and took on more debt.

Regulators and politicians congratulated themselves on this state of affairs. They responded to the Stock-market crash of 2000 with lower interest rates, to keep the economy going as investment from the private sector dried up. Instead of allowing the mal-investment in the lastminute.coms and other businesses valued on insane multiples of EBIDAWM (Earnings before Interest, Depreciation, Amortization, Wages and Marketing, AKA “sales”) to be purged, that mal-investment was replaced by Government spending, most of which disappeared into lower productivity and higher pay. Low interest rates stoked a property boom all over the world. Banks kept getting bigger, with more liabilites. And with scale came Government interference.

In the USA, banks were instructed to lend to poor credit risks, through the community re-investment act. Bush senior and Clinton allowed banks to securitise these mortgages, and other non CRA “sub-prime” (which then had a more positive meaning – just below prime, ie good). Slowly institutions relied on the prop of the rules. The packaging and re-bundling of debt was a creature of the abnormally low interest-rates driving a frenzied demand for credit, right through the income spectrum. UK banks relied on wholesale markets rather than their depositors. Anything which was allowed was OK, without any real understanding of the risks. Everyone assumed, just like those selling endowment mortgages in the 90’s that the assets would just keep going up.

Volatility was taken as a proxy for risk. The CAPM and VAR measures took volatility for previous years and fed it into a model, which spat out acceptable numbers. Of course, as Naseem Taleb explains so elequently, Returns are not normally distributed, the key assumption behind CAPM. Tail risk, the risk of massive unforseen losses are orders of magnitude more likely than predicted by Gaussian mathematics. “6 Sigma Events” like black Wednesday, the LTCM crash and the .com bust which should happen once every 100 million years or so, happen every decade. Just because the distribution of natural phenonomena from penis length to life-span obey Normal Distributions it does not follow that financial markets do so.

However with the regulator happy with ever increasing risk, and everyone from individuals to Governments frenziedly gearing up with debt, the regulatory bureaucrats were applying box-ticking metrics without really having any deep understanding of the businesses they were regulating. Banks got on with making money, but like all institutions became too big to manage effectivly. And they were making money in an environment where the political pressure was entirely RISK ON! While CRA mortgages in the USA were not the worst from a default point of view, the environment in which the legislation was created was one where the politicians encouraged banks to lend in order to get voters onto the property ladder. The because the politicans had achieved growth without inflation, they thought they could “eliminate boom and bust” and encoruaged the banks and regulators to behave as if they had.

Certainly that’s what Gordon Brown thought as he, most egregiously, spent the tax-recipts from a booming economy, and borrowed even more, and spent in the assumption that his genius would keep the wheels turning, turning the most solid balance-sheet in the developed world into a social democratic Euro state with fat welfare and soggy competitiveness, like Germany (who in the mean-time was keeping interest rates up, and wages down, marching in the opposite direction).

Of course the .com bust in 2000 heralded the end, though it took 7 years for the ever lowering interest rates, which was the inevitable response to every piece of poor investment or GDP data, to lead to a crash, it is this that is responsible for the property boom, the government overspend and the catastophic finanacial crash. And this was made all the worse for because a system with a few large, systemically important institutions may appear easier to regulate, but is in fact more vulnerable to the storms.

The .com crash caused a recession that never happened as private sector investment dried up, to be replaced by government spending on war and diversity outreach co-ordinators. The boom continuing on Government spending and consumer debt. Debt that ultimately sat on banks’ balance-sheets either as “capital” – Government bonds, or as books of loans.

And because of the tight regulation, they were all carrying the same assets, in the same proportions according to the same risk metrics as each other, funded largely from wholesale markets. And when HSBC announced that a surprising number of its US mortgages were going bad in 2006 (about when “sub-prime” took on its current meaning), the writing was on the wall. Those books of loans propping up the system were not worth what people thought they were worth.

Financial markets are prone to panic. It is a chaotic system, and as such does not lend itself to regulation, especially if that regulation is based on volatility. Beta, in a crisis, tends towards 1. This means all financial assets, however diversified in normal times, crash toghether as everyone tries to unload them at the same time. It takes two views to make a market. Regulators, however insist on one view in a catastrophe, and often make things worse. Instead of attempting to remove risk by making entrepreneurs and risk-takers behave like civil servants (they won’t), better to let them face the consequences of their actions. Regulation should instead focus on making the system resilient to the inevitable storms. And that means smaller institutions, and more acceptance of differing approaches, the absolute opposite of 15 years of financial regulatory practice. Instead, every bank in the world tried to do the same thing at the same time and the finance system dried up.

No-one is suggesting NO regulation, but ultimately the best regulator is the market. Perhaps a bit more diversity in the system, and more but smaller institutions would be more resilient? The only thing I am sure of is what ever the answer may be, regulators do not have it. Unfortunately they think they do, and seek to impose the same solutions on everybody.

At present, my little corner of the industry is undergoing a bout of regulatory hyperactivity. The retail distribution review is busy setting out what can be sold to whom. Customers are being categorised by risk appetite. Those with low risk appetites are expected to invest almost entirely in Government bonds.

I am being made to sell Government bonds yielding 0% at the 2-year point guaranteeing a 3% annual loss to inflation because Government debt is RISK FREE. Of course we only believe that because we’re at the end (inevitably…) of a 30-year bull market. Just as the misselling scandals and credit crunches are a creature of the regulatory environment, I can see the howl of pain when interest rates start to go up again, from Governments paying the interest, and those investors whose “advisers” have  been forced to sell them shitty Government stock. I can see the misselling scandal on the horizon.

Retail financial regulation should be someone slapping customers with a fish, while shouting “CAVEAT EMPTOR” through a loudhailer. Macro-regulation should ask one question: “how fucked are we, if this bank goes bust?” If the answer is “very”, then break the bastard up, and say “NO!” When it tries to buy NatWest. Regulators should not try to run banks or investment portfolios. They should protect the investor from fraud, and the tax-payer from “too big to fail” and that’s it.

Instead, why are people still getting paid out on RBS bonds? Why does RBS even still exist to pay Hester his bonus? The only people who should have been bailed out, are the depositors, not the management caste. QE? Only benefits the banks, whose top executives are still being remunerated in bureaucratic style, according to headcount. The only guy to crash through the system and save his bank from the tax-payer in spite of the idiot regulator, was Bob Diamond, a hero and worth every penny of $20m. Yet he’s painted the villain!

Why not try a helicopter drop? defend depositors, smash investors in banks. Instead of supporting institutions which failed, why not support people? In every instance, the regulators favoured the tidy, mega-institution, rule-based status quo, when they should have let the market do its savage work. Markets encourage diversity and strength. Regulators create a monoculture, vulnerable to the first illness. 

Markets kill bad banks. Regulators prop them up. Here endeth the lesson.

9 replies
  1. Simon Jester
    Simon Jester says:

    "the distribution of natural phenonomena from penis length to life-span obey Normal Distributions"

    Surely willy size has a skewed distribution, having (ahem) a long tail? (Maximum size being significantly further from the median than minimum size.)

    Oddly enough, in 2000 I was working for a dotcom that was trying to develop a risk management system for securitisation. In the end, they couldn't find anyone who wanted to buy it. I doubt it would have made any difference to the companies affected by the crisis, and would probably have been blamed by some people for the crisis, but I personally could stand a little vilification, in return for even a relatively small slice of the securitisation pie.

  2. Malcolm Bracken
    Malcolm Bracken says:

    I have not undertaken a review of the literature concerning todger size, but I doubt the max is farther from the median than the minimum: the minimum is 0" the median (assuming I'm normal) is 12", and I've seen 2ft cocks in pornos so…

  3. Odin's Raven
    Odin's Raven says:

    What a difference a couple of centuries makes, from 'my word is my bond' to 'fraud IS the business model'.

    In the absence of honesty, greed is only constrained by fear. The banksters have had no fear of the regulators or the politicians, whom they cozen or bribe.

    Hanging 20 bankers at the end of every street, interspersed with complicit politicians,(yes Tony, that means you) publicists, lawyers and bureaucrats, and repeating the exercise regularly and frequently could change attitudes and behavior rapidly, and be more effective than any amount of box-ticking.

    Politicians and regulators would not need a deep understanding of the business. There could be 'light touch' regulation when things go well, switching swiftly to flogging, torture,execution and confiscation of assets including those held by friends and relatives, when the mood of the public sours.

    That way, the politicians and bureaucrats could always appear as good guys, aligned with the public; whilst the 'creative' financiers would have enough fear induced by recent examples to keep most of them on the relatively strait and narrow.

  4. Anonymous
    Anonymous says:

    "Why not try a helicopter drop? defend depositors, smash investors in banks."

    I sometimes wonder about that. And it occurs to me that perhaps many of the investors are actually the pension funds, maybe even causing some of them to go belly up, and crashing the retirement plans of hundreds of thousands of folk of modest means.


  5. Malcolm Bracken
    Malcolm Bracken says:

    The problem is that banks have no incentive to not cut their ratios to the minimum allowed by regulation.

    If investors faced a huge loss, there would be pressure demanding capital adequacy ratios were kept up, to keep costs of finance down.

  6. Ralph Musgrave
    Ralph Musgrave says:

    I quite agree that bond and shareholders should be wiped out where a bank fails. However, taxpayer funded backing for depositors, while letting banks do what they want is just an invitation to banks to take big risks and make a killing if the risks pay off, while having taxpayers foot the bill when it all goes wrong. We’ve had enough of that.

    There is a vastly simpler set of regulations than anything dreamed up by Basle, Vickers, etc. It goes like this.

    Where a depositor wants 100% safety, they can have it, but the only way of ensuring 100% safety is not to invest the relevant money at all. So that money is safe, but those depositors get no interest.

    Alternatively where a depositor wants to act in a commercial fashion and get a “dividend” or interest on their money, they can so**ing well carry the risk normally involved in acting in a commercial fashion. I.e. if the investments or loans their money is placed in do badly, they take a hit. The bank as such does not take a hit. Or if the loans/investments do well, the relevant depositors make a profit.

    And in the event of widespread poor bank performance, as in the recent crunch, lots of depositors (who would in effect be similar to equity holders) would lose. But that would be little different to a stock market set back. And as Mervyn King, governor of the Bank of England said, “…we saw in 1987 and again in the early 2000s, that a sharp fall in equity values did not cause the same damage as did the banking crisis.”

    The only small problem with the above is that getting a loan would be more difficult. But that’s easily dealt with by having government print and spend more money into the economy. The result is that everyone would have more cash, and thus would not need to borrow so much.

    The above system is the one advocated by Laurence Kotlikoff and Positive Money / Richard Werner / New Economics Foundation. For the latter, see:

  7. Malcolm Bracken
    Malcolm Bracken says:

    The purpose of a bank is to move customer's money from where it's sitting idle and investing it (by lending) to industry. It also leverages that, increasing the money supply.

    Depositors don't care about this, but the economy does. If you make them choose, most won't and will end up doing nothing. Thus vast funds will be unavailable to the economy, guraranteeing a depression.

    The reason bond-holders should be screwed is they are IN THE BUSINESS of investing, where retail depositors aren't. As you're effectively compelled in the modern world to have a bank account, it makes sense to protect the depositors.

    The New Economics Foundation are morons.

  8. Ralph Musgrave
    Ralph Musgrave says:

    “The purpose of a bank is to move customer's money from where it's sitting idle and investing it (by lending) to industry. It also leverages that, increasing the money supply.”

    Answer: we don’t need to rely on commercial banks to “increase the money supply”: part of the money supply comes from central banks, and the ENTIRE money supply COULD COME from central banks. Moreover, given that every pound of money created by the private bank system comes with an extra pound of debt, just how responsible has the private bank industry been in increasing this “debt-money”? Well they expanded it in a TOTALLY IRRESPONSIBLE manner in the years leading up to the crunch, which resulted in the worst recession in living memory and catastrophic levels of unemployment.

    I’d describe that system as pure insanity.

    “Depositors don't care about this, but the economy does. If you make them choose, most won't and will end up doing nothing. Thus vast funds will be unavailable to the economy, guraranteeing a depression.”

    Answer: Obviously if the large majority of depositors put their money into safe accounts the effect is deflationary. But that’s easily countered by having government / central bank implement some stimulus. The latter would result in private sector entities owning or possessing more cash, thus they wouldn’t need to borrow so much, which in turn would lead to a contraction of the banking industry.

    Given that this industry has expanded TEN-FOLD over the last fifty years relative to GDP (and to what benefit, I’m not sure) I see nothing wrong with contracting this industry. As Adair Turner said, most of this industry’s output is “socially useless”.

    “The reason bond-holders should be screwed is they are IN THE BUSINESS of investing, where retail depositors aren't. As you're effectively compelled in the modern world to have a bank account, it makes sense to protect the depositors.”

    Answer: I’m all in favour of screwing bond-holders. Re your claim that depositors are not in the business of investing, it is not fashionable to see them that way, but in practice they are into investing. That is, if someone deposits money in a bank and wants a dividend or “interest” on that money, they know perfectly well that the bank can only earn the interest by lending on or investing the money. I.e. depositors are just people who get others to invest for them: much like those who invest in unit trusts. Then they cry wolf when their investments go wrong. My heart bleeds for them.

    Re “makes sense to protect the depositors”, I’m all in favour of offering ordinary people 100% safe bank accounts – as long as they don’t try to have their cake and eat it: i.e. play at “investing” while pretending not to and all at the taxpayer’s expense.


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