Thursday, December 23, 2010

SOW - Rory McKeown

Individuals and companies have been incentivised perversely across the banking industry, and being led by a corrupt banking ideology, Australia has paid a price for this. It could should shape itself as a role model for banking leadership by implementing the following proposals, and creating incentives for small banks, and securitized bonuses. Until these factors are dealt with the banking industry will always claim more free market economic is a good thing. Unfortunately when it goes wrong, free market economics is the last thing they are prepared to confront. Their logic went something like this:

• we have assets on our books that are not what we thought they are, we are now undercapitalised.
• If people know this, they will remove their money from our bank, this will cause a bank run. 

• If we collapse, banks X and Y will collapse as well because they have assets we sold to them.

(IV) If we all collapse, your banking system will collapse.

(V) If the banking system collapses, your country will collapse. Therefore, you must help us.

Any cohesive solution to preventing this occurring again must deal with preventing this logic to ever hold true.

• How did the banks end up with these “faulty” assets?

A big topic, but lets consider a simple process. A retail bank lends to customers to purchase a house. The securitizers at an investment bank then buy these loans and package them into an issue, create the securizitaion vehicle and sell tranches to other institutions. Based on a rating given by an “authorised” entity banks and other institutions then pay an appropriate risk premium for the bundle of coupons all the individual retail borrowers pay. The advantage of this is that pension funds and insurance companies can invest in these assets which claim to be as secure as corporate bonds. At every point in this process, an individual is basing his expected year-end bonus on these deals going through: the retail bank adviser, the securitiser. the ratings agency advisor,the fund manager. However the security is expected to last on average 20 years.

Hence there is a duration mismatch in the risk profile of the individual and the institution. Any solution to the current banking crisis must minimize this risk.

The retail bank and the securitising institution should be forced to take a substantial piece of any “synthetic” product (e.g. 20% each). These “mirco-issues” should contain a piece of each tranche, in effect replicating exactly the payoffs for each institution. Bonuses for their employees should be paid annually from the coupons of these micro-issues. If the bank wishes to pay them more, then let them take a bigger share of the coupon, however they should be very aware that their own personal wealth is intimately linked to the product that they are creating.

(II) How can a retail bank end up with assets of ambiguous quality on it's books?

Were a retail bank to package and hold it's own debt, the loan quality of the book should be clear. They verified and created the mortgages. Instead were third parties are used to sell mortgages the quality is likely to decrease: the downside incentives for third party individuals are massively outweighed by volume related pay incentives. Hence a loan book of false creditworthiness and overestimated earnings claims.

The other side of this is large retail banks wanting to play in the interbank markets, buying and selling securities in a hope to create “alpha”. This has been sanctioned by executives at the top level who see peers performances and bonuses and hope to create the same for themselves. Buy buying poor quality opaque products with artificially secure ratings and apparently high yields, these executives encouraged their own staff to take bigger risks.

All of this was implicitly made possible by banks trusting ratings that proved to be in the short term “cheap”, but in the long run very expensive.

The rating agency model is completely conflicted where an agency is authorized by the government to define the quality of a securitized product. As the rating individuals involved see their year end bonus defined by the quality of the ratings they give, clearly they will always be proposed to “do business”, rather than “do analysis”. As they are government sponsored, a competing independent agency is always considered a lesser value analysis. The author proposes an end to “certified ratings agencies”, and an open platform for securitisation vehicles to present the credit worthiness of their underlying mortgages. Hence independent analysis houses can access this information and provide independent reports to funds and banks who are interested in these products. The increased competition and reputational damage of poor analysis would likely cause margins to drop, and prosecutions for misratings are much more likely to happen in the free market. Suing the government is generally an exercise in futility, as each department displays no fault with bureaucratic aplomb.

(III) & (IV) Why are the banks so interconnected, and how can this be prevented?

The banking system is highly connected via the repo and swaps markets. The fall of one institution could mean the fall of all, as the asset book of a bank becomes less determinable as it's counter-parties default. As it becomes less determinable, the reserve ratio requirements and mark to market accounting become even more problematic. The bank is essentially bankrupt. For a small bank, this is a problem for counter-parties, but for a large bank, it is a system threating collapse.

The author proposes that banks be taxed not in proportion to their size, but in proportion to their connectedness to the market. Each trade entered into must be registered with a central institution, where the deal is valued in terms of risk and size. The total risk to the system of an institution should be composed of it's own outstanding debt, and a proportionate amount of it's nearest neighbours.

Hence as interconnectedness in terms of size and risk increase, the institutions forming this risk nexus should be taxed appropriately more.

A tax such as this on profits before wages that is relative to the proportion of risk that the institution poses to the system, not to itself. Given the current scale of the banks, this taxation would effectively be extremely punitive on bank earnings, however as executives realize a small institution is more profitable to them as an individual, they would be incentivised to start their own small banks.
The overall effect should be to force bankers into competition rather than into collaboration by preventing large institutions from making huge profits.

Trading with institutions in a jurisdiction which does not manage risk in the same way should be allowed, but have an extremely high risk profile to reflect the risk of the unknown.

Without uniformity in global systemic risk management, a crisis in one area can cause a crisis in another. It could be argued that America exported toxic debt and fetid banking. If a jurisdiction (aka fiscal area) is not prepared to impose risk curbs on its bank, local banks should be incentivised to avoid trading within the region.

• How can any country become so dependent on one industry?

Money has been the lifeblood of economies across the world for centuries. However if the control of money is centralized, the greater the risk a failure at this control point will effectively destroy the system. As discussed above the scale of large banks is now an implicit threat to any country that allows them to grow out of proportion to the economy that they exist in. And it must be asked how much do the executives know about their business? How can they continue to work in the financial services industry while overseeing a period that has effectively jeopardized the whole system? The claim is that who else can understand the complexities of modern finance? It's obvious that these people cant.

Bankers must face serious financial and personal losses in the face of failure.

The author proposes a stringent set of examinations similar to an actuary or a barrister for any person who wishes to become an executive of a bank. They should include banking history, economic theory and financial mathematics. Qualification should come at only serious personal cost (i.e. many years of personal study), and should be stripped away immediately in the event of failure. Top bankers should by law have undergone a training regime as rigorous as top surgeons or judges. As the recent crisis has shown, their role in society is in many was more powerful than other people in serious positions of responsibility.

To conclude:
Measure and tax systemic risk
Align incentives to financial products sold and created across their lifetime
Ensure that bankers know their business, and are barred from the industry on failure.

In any other business, most notably the current wave of environmentalism, taxation and responsibility are seen as good things. Why not banking?

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