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.
http://bracken.uk.com/wp-content/uploads/2017/07/logo-2.png00Malcolm Brackenhttp://bracken.uk.com/wp-content/uploads/2017/07/logo-2.pngMalcolm Bracken2012-09-08 20:55:002017-07-21 01:43:25Compliance and the Myth of Goldilocks