Introduction

Let’s face it guys, bank regulation in the US is a total mess. Mind you, this is not really surprising, for any system left to its own devices and desires will eventually fly off the handles into the proverbial décor. Like the rest of Wall Street, and mostly unbeknownst to themselves, regulators large and small have wandered into enemy territory without proper ammo and are now operating purely on gut instinct. Ask any hedge fund manager when he’s a little tipsy, and he’ll be glad to tell you how much money he’s already lost with his “gut”. Unfortunately, there is nothing more dangerous than high-level functionaries out of their comfort zone. When they have time to breathe at all, these bold defenders of the realm must be wondering how things could get so out of control, so fast. Like the Eagles in their hit-song “Lying Eyes”, we too wonder how it ever got this crazy. Did we get tired, or did we just get lazy?

Turf wars and power grabs are just the last refuge of the damned. Likewise, concentration of regulatory authority is not the remedy, but merely the symptom of a fundamental sickness gnawing away at the banking system. In the end, Murphy’s Law is the only credible maxim in this topsy turvy bunker.

Is there a sane way out of this dreck? For starters, this is not America’s first crisis. Neither is it its last. Based on statistics alone, it would thus appear that the answer to our rhetorical question should be a resounding ‘yes’. Yes, but how? Pretty much everything else has been tried and failed, from battleship QE2 to European threats and intimidation of rating agencies. Y’a les cons, y’a les super-cons, et puis après, y’a les agences de notation! By the way, the next time you speak to a rating agency analyst of the old school, just remember that the man or woman trying to tell you about your own future doesn’t have one.

Is it really better to have tried and failed than never to have tried at all? When you don’t understand finance no, it’s not better. Perhaps Janis Joplin was right after all when she said freedom is just another word for nothing left to rate, so to speak. At this point, we are happily and busily fooling ourselves to the Doors’ refrain of “this is the end” of the recession, while Angst and primal fear remain thinly disguised as “enforcement” actions. As Pyrrhus said long ago, one more such victory over the Romans and we are through.

Over the past 30 years of regulatory experimentation, we have scarcely moved beyond the momentous Basel 1 Accord. Regrettably, we crashed and burned on our way to Basel 2. At this very moment, as Nietzsche would no doubt diagnose, we are living dangerously between Basel 2 and some mythical, yet TBD Basel 3, and calling that Basel 2.5. The substance of the current proposals seems to be 7% capital everywhere, and either 1% or 3% more for “systemically important banks”, whatever that may eventually signify.

This silly fight about 3% reminds one of the old Soviet-era joke in which Tsar Nicholas II and Vladimir I. Lenin meet in Hell after the latter’s untimely demise. This is a rough translation of the ensuing conversation:

Tsar Nicholas: Vlady baby, why don’t you tell me about Mother Russia!
Lenin: It would be a great honour, your erstwhile Majesty. What may I tell your Lordship?
Tsar Nicholas: Well, do we still have censorship of the press?
Lenin: Censorship! We’ve got censorship coming out the wazoo!
Tsar Nicholas: OK fine, but what about bread lines and food shortages?
Lenin: Majesty, you will be pleased to know that people are starving in greater numbers than ever before. Don’t sweat it; we’ve got that one covered too.
Tsar Nicholas: Great, and is our vodka still 95% proof?
Lenin: I’m afraid not Majesty. It is now 98% proof.
Tsar Nicholas: Vlady, was another 3% really worth a Revolution?

One can easily foretell that soon, every money center bank will be forced to engage in a childish form of self-deprecation and debasement, claiming to be “systemically unimportant” or some similar hogwash, just to make sure they end up at 7%. Most likely, lobbyists will prevail and 7% will be the “right” number on Wall Street for the foreseeable future. Since Basel 1 was 8% flat, we have gone basically nowhere, save for the 1% of course, over the past 30 years, and this after mountains of literature and dozens of incomprehensible formulas apparently necessary to come to grips with the product of three real numbers [EAD, EDF and LGD.] At this juncture, capital rules are by far the most complicated no-brainers in the world. Yet, they have failed across the board, and definitely across the Street, to keep us “safe and sound.”

Fundamentally, 8% was designed to address two operational modes and, to our utter amazement, it did so brilliantly. In most cases, it was way too much, except in the rare instances when it was way not enough. In other words, 8% was wrong all the time. This will not change because we use 7% or 10%. Finding the right number is a false, Wittgenstein problem, a red herring, for there ain’t no such thing. This is like a man looking for the right woman. Rather, the crux of the issue is how capital ought to adjust dynamically to keep up in lock-step with an objectively measured risk conjecture in the field, not what the static value should be. Besides, this elusive static level could be determined easily by reference to rating agency corporate-bond default studies, which address the residual risk inherent in corporate and other exposures given their industrial affiliation.

For example, the label “AAA” is not intended to refer to a company in trouble among its peers, but to a relatively well-functioning organization in a given context, which context then defines its average, not its current risk profile. Static capital allocations under enlightened regulation need to be pegged to this a priori construct since banks presumably make loans with this situation in mind. Should the target’s risk conjecture change meaningfully however, allocated capital ought to adjust automatically and objectively to reflect such changes. This is what safety and soundness truly means, i.e. the government should not punish banks for making risky loans, for we should all be happy that they can do so profitably, but only when they are unable to collect them.

In this context, 1% could be more than enough a priori when a bank makes short-term loans to investment grade obligors, while 5% could be less than appropriate for one with a large portfolio of long-term, sub-investment grade exposures on steroids. Once the reward side of the coin is included in addition to that of risk, everyone ends up on a level playing field seemingly by magic. The way things now stand perverse and powerful incentives are created daily whose objective is simply to arbitrage irrational capital rules using various Viagra-laden contraptions masquerading as “transactions”, for instance unsupervised synthetic CDOs. These so-called “deals” were fatally flawed simply because the problem they addressed was fatally posed.

Speaking of Lenin, we are also tempted to ask: Что делать?

The following paragraphs are a fledgling attempt by a humble servant of the people to answer this difficult question. We propose a rational and workable regulatory schema aimed at restoring the public’s confidence in the fundamental safety and soundness of the financial system, one where even Devils now fear to tread.

Despite its simplicity, in truth because of it, we believe the following proposals go a long way towards resolving inter-agency turf battles and provide well-defined and transparent areas of responsibilities with no direct jurisdictional overlap. Were they one day to be implemented, granted this is a scenario with vanishingly small probability, we would venture that a crisis of magnitude 8.0 on the Richter scale like the current one would soon acquire the same probability. This is because there are three kinds of people in finance: those who make things happen, those who watch things happen and those who wonder what happened. We are merely suggesting that regulation ought to be able to let regulators move temporarily to the first in order both to be able to soon return to the second, but mostly to avoid having to live through yet another close encounter of the third kind.

The New Federal Reserve: the Unknown Ideal

The basic model for bank regulation was created in December 1913, i.e. the Federal Reserve. The latter came into being to address one issue only: liquidity in the banking system. The Fed was supposed to operate on auto-pilot, at least according to its creator, the suave, worldly and debonair Paul Moritz Warburg. Warburg had immigrated to America from Germany by accident, some mauvaises langues would even say by mistake, as a result of his marriage to Nina Loeb, the last remaining single daughter of Solomon Loeb, a former managing partner at Kuhn, Loeb and more famously John Pierpont Morgan’s arch-rival on Wall Street. Trained as an aerospace engineer, Warburg was intimately familiar with non-linear feedback systems and their criticality in control theory. By contrast, today’s Fed Governors are not exactly transcendental engineers like Warburg. By and large, they are garden-variety economists unable to grasp that pumping cash into the system is not a “solution” to a credit crisis, but strictly to a liquidity crisis. If the first core dump fails to do the trick, who knows, maybe the second one will. Yeah, right!

The original intent behind the Fed was to allow the market to regulate itself except in rare instances during which a temporary imbalance had disrupted the equilibrium, i.e. whereby liquidity was lacking and banks needed to scramble to borrow from each other without the proper means to do so. By formally pooling liquid resources, a conduit could be established that would allow them to borrow from Daddy Warbucks, albeit at a rate higher than the market’s equilibrium rate, the so-called discount rate. Otherwise, banks would be tempted to borrow from the Fed constantly, thus defeating the purpose of the entire enterprise. In passing, this system (the Real Bills Doctrine) was already in use at Germany’s central bank with which the Warburg family had long been associated. Therefore, the Fed was never intended as a government take-over of the banking system, but merely as a liquidity-pressure release valve. In most cases, the open markets were to be left undisturbed, and the money supply was not to be manipulated for political purposes. Needless to say, later, Warburg-less Feds quickly moved as far away from this attainable dream as they possibly could, as Warburg himself eventually discovered when he tried to cancel the Minnesota Fed shortly after becoming chairman. However, the fact that the Fed has wandered away from its true mission is by no means an indictment of its essentially righteous intent and purpose, for the measure of a man lies not in what he achieves, but in what he longs to achieve.

Our first conclusion is that the Fed is a wonderful institution as long as it sticks to its originally appointed sphere of excellence: managing liquidity on behalf of US commercial banks. It should not be involved in either regulating credit risk or in examining banks that assume credit risk, which means anybody and everybody. Frankly, wouldn’t you also like to be examined by someone who fundamentally believes that everything you own is a Treasury bond? Don’t bring a knife to a gun fight.

Despite its notable failings and missteps, the Federal Reserve has shed more blessings on the American people than anyone could reasonably expect. What is truly wondrous, rather, is not so much that the Fed stumbles on its way up the Golgotha, but that it keeps walking at all, bearing as it is the collective weight of our financial sins on its noble shoulders.

Therefore, our second conclusion is that one cannot do much better than the Fed’s apparatus, at least in this insane world of ours, to address the main risk inherent in the banking system: credit risk. In other words, credit risk needs its own “Fed” if it is to perform as well as the first one in fulfilling its appointed duties. To this, our chief proposal, we now turn.

The New FDIC: the Fed for Credit Risk

Our proposal is exceedingly simple in concept: to transform the FDIC into the Fed for credit risk. The FDIC now acts as the mortician to the banking system, presumably enjoying funerals more than weddings. We note that the structure of the FDIC is ideally suited to credit risk management simply because it is already an insurance company, i.e. the type of entity sorely needed in times of crisis. Although we do not have the space herein to go into details, the concepts are clear enough and the resolution exceedingly simple to execute, perhaps too simple.

Basically, it would work as follows. Banks would be forced to partition their allocated risk capital into its long-term and short-term components, something they already do anyway. Short-term capital would be both more expensive and more deeply subordinated than long-term capital. Under normal, equilibrium conditions commercial insurance companies would be called upon to provide this portion of any bank’s capital needs, most likely in the form of SLOC instruments, and at a price freely negotiated between the respective parties. The FDIC’s price for the same instrument, i.e. the discount rate for credit risk, would normally settle at a level higher than the free market’s equivalent rate for the same bank. Of course, a bank could easily self-insure, thus obviating the need to procure an external SLOC with its attendant standby fee in addition to the standard draw fee. However, doing so would quickly turn out to be more expensive than using external sources. After all, does anybody you know self-insure her house against fire? On a normal basis, a bank’s capital charge would be linked to its current balance sheet, and additional capital would be required only if it became aggressive in its lending practices, with feedback for such behavior provided daily via automatic random sampling of its loan or exposure book by the very same, IT-savvy FDIC.

Under this system, a well-functioning bank would be slightly over capitalized since it would usually prefer to procure excess long-term capital rather than rely on instantaneous draws on expensive short-term lines, unless of course by conscious action. Thus, the optimal capital mix would tend to favor tiny excesses of aggregate current risk capital allocation. In the final analysis though, this situation would not be as traumatic as it sounds since banks would quickly figure out how they could alleviate their excess capital burden while increasing earnings by lending it to other banks rather than having it lay idle on their books. This would be the credit-risk equivalent of the Federal Funds market.

Some readers will have already recognized that, in essence, the foregoing amounts to a rebirth of the CDS market in a more organized and stable form. Obviously, the instrument we are describing is none other than a uniformly-structured CDS contract issued by banks and freely traded among them. Ladies and gentlemen, commoditization is a necessary and sufficient condition for the existence of liquidity.

This is all well and good you might say, but what about the FDIC’s role in all this?

In the rare cases where some random bank would be playing fast and loose with credit risk, in no time at all free market players would set their credit discount-rate significantly above the equilibrium level where it previously hovered quietly. This would happen because such bank would now suddenly have to draw on its hitherto dormant SLOC in order to satisfy its mandatory capital allocation. This would force it to have recourse to the suddenly cheaper FDIC-issued and standardized CDS contract instead of accessing the open market. Any bank making sudden and ample use of such instruments would show up on the FDIC’s radar immediately, since it would be unusual for any institution to raise risk capital at such a high cost. The FDIC would then be put on notice that the target institution may be entering a danger zone, and this would happen long before it is, in fact, in trouble. This signal would not arise via examination or meddling into its affairs, but strictly from the free interplay of market forces. Since the FDIC would end up with the tab in the event the bank failed, it would quickly engage in a dialogue with it. Maybe there is a good explanation to all this, but then again, maybe there’s only a bad one. Either way this proactive action would be initiated with a lead time sufficient to ensure that no real crisis had a chance to develop. Even better, this would take place one bank at a time, not system-wide.

If the bank decided to pay for the risk it is taking anyway, then it might find itself worse off than before and would quickly and voluntarily recoil from the abyss. Conversely, if it could no longer pay the resulting CDS premium, it would stop doing whatever it is doing without coercion or regulatory fiat. As we all know, the best regulation is self-regulation. Effectively, such bank would be brought face to face with its own Kantian categorical imperative, and would soon be contemplating its own death. Either way, the equilibrium would be re-established quickly and the system would remain unscathed.

Clearly, our approach would require some major rethinking on the part of the FDIC’s senior managers, not to mention a face-lift and most likely, a name change. However, by the same token its area of expertise would be squarely delineated as credit risk and nothing else. It would not have to “examine” banks, but simply enforce uniform rules in credit-risk capital allocation. Although this may seem overly complicated, a country as diverse as Brazil largely succeeded with the promulgation of Regulation 2682 by the Brazilian central bank [BACEN]. Given the current soul-searching environment in Washington, this type of forward-looking rule-making ought to become a model to be emulated by the rest of the worldwide banking community. In fact, through direct experience we can tell you that Brazilians could teach us a trick or two about money, and then some. One can say many things about Brazil, but one cannot claim they have no experience with credit risk.

The New OCC: Examinations and Operational Risk

The last pillar of our proposal is the OCC, the institution that now examines Federally-chartered banks. In doing so, it has been relatively successful, although the complexities of transactions undertaken by its client-banks immediately prior to the crisis did tax its ability to keep up in real time with purported risk-transfer mechanisms. This is something the OCC brass would freely admit, at least in private.

Under our framework, the OCC would take over all banking examination nationwide and would focus primarily on operational risk, i.e. things like Herstatt risk, clearing and settlement of CDS contracts, the integrity and reliability of IT systems, “model” risk, conflicts of interest, etc., and in general, on the “policies and procedures” inside its supervisees. Unlike credit risk, presumably now under the exclusive purview of the born-again FDIC, operational risk is an area much more amenable to meaningful analysis within an examination context. This is in sharp contrast to the bottomless pit of credit risk when looked at without a comprehensive view. Given the average complexity of even a small bank’s balance sheet, credit risk analysis is well beyond the synthetic capacity of most human beings, and should not even be attempted outside a fully empirical and statistical framework.

The authority of the OCC would be enhanced in that it would become the sole direct point of contact with bank personnel, as is the case now with respect to the largest US financial institutions it regulates. In addition, thanks to its newly circumscribed set of roles and responsibilities, it would be able to cast its regulatory shadow in a much more pervasive and long-lasting manner vis-à-vis the safety and soundness of the system via its influence on the various checks and balances based on which a bank’s well-being may be conditioned and from which its relative health-indicators can be measured.

The OCC’s apparent reduction in credit-risk related supervisory influence would be more than compensated by its newfound ability to make meaningful and lasting contributions to areas of financial activity that have hitherto been sadly neglected. Its relationship to its supervisees would clearly change and become much more consultative and collegiate. Because the OCC would no longer be in a position to pass judgment on the perennial and always thorny issues of credit and liquidity management, it would be regarded by the banking community as an enabler of enhanced access to credit and liquidity, something all banks seek to preserve at all costs.

The Supervisory Trinity and its Übermensch

Thus far, we have outlined conceptually, albeit superficially, how the US regulatory apparatus for banks ought to be reorganized both for the sake of capital efficiency, and in order to restore financial markets to their original function and purpose. We used existing institutions that are now operating more or less successfully and attempted to give them back their true self while adhering to the ubiquitous political realities under which we all live.

As stated, the proposed framework establishes the following supervisory Trinity:

Type of Risk Management-Supervisory Responsibility
Liquidity-The New Federal Reserve
Credit-The New FDIC
Operational-The New OCC

The three members of the Trinity are to be regarded as forming a whole. None of them is more “important” than the others in properly regulating the banking system. But acting as a whole is not something that would come naturally. On the contrary, we can expect that such essentially self-contained and insular centers of regulatory power would normally operate independently and rarely, if ever, coordinate their actions. Coordination requires external reinforcement in the form of a supervisory committee, some sort of institutional Übermensch sitting atop these institutions to ensure that no regulatory “black hole” exists in which a client-bank could eventually and comfortably fit.

It would be pointless to belabor this issue at this juncture, but one can easily imagine a 5-member board consisting of one member with demonstrable expertise in each of the three newly-minted regulatory functions, but without explicitly belonging to the associated institution, plus two outside appointees. Most of the time, the committee would be idle but would spring into decisive action in times of trouble. One of its first tasks would be the diagnosis of the current problem. As any doctor knows, a misdiagnosis is usually worse than the disease itself.

In a nutshell, we are proposing to do for bank regulation what was done at the dawn of the 20th Century in the area of corporate governance. The framework proposed hereunder originated in the military with the notion of the “General Staff”’. Some readers may not recall that, prior to the origin of inherently neutral “boards of directors” as we have come to know and love them, all major US corporations were managed based on a different organizational principle, one that might be called the “departmental” principle.

Under this now obsolete framework, each corporation was led by a committee on which sat one member of each functional unit or department. These are things like purchasing, manufacturing, marketing, sales, et cetera. Although this made perfect sense to an outsider unaware of political behavior, the upshot could easily have been predicted. As soon as a significant problem arose in any area, it became basically impossible for the chair to do anything about it. For instance, if something was amiss in marketing, either in truth or perception, other committee members were forced to stand by and smile, just as they do now in DC, while the head of marketing explained in excruciating detail to a crowd necessarily mesmerized by his marketing talent that, in point of fact, there was “nothing wrong” with marketing at all and that in any event, what could anyone else present at the meeting contribute to the discussion since “you know squat about marketing” was the usual pushback. Yet, each department had to be allowed to operate monolithically and relatively unfettered if it was ever going to achieve the level of functional cohesion and unity required for the proper operation of any reasonably large enterprise.

What was needed, it was felt, was a body no longer subservient to defensive departmental attitudes but, rather, motivated by the welfare of the corporation as a whole. Prior to that time it had been thought, wrongly as it turned out, that if each department head cared deeply about his own area, somehow the corporation would be just fine. The epiphany was the realization that the sum of the parts and the whole are not the same, i.e. that linearity and non-linearity are fundamentally alien. Of course, the average CEO had no clue what to do about this, but the Dupont Corporation was not run by the average CEO. He had a military background he was able to bring to bear on the situation.

The problem back then had been the same, i.e. the Navy would favour the Navy, even at the expense of either victory or an increase in expected casualties. No doubt, the same was true of both the Army and the Air Force. This was a much more serious problem than marketing widgets, so the resolution came quickly with the creation of the General Staff (labeled the JCS in the USA), a body supposedly motivated primarily by the wellbeing of the country and its armed forces without regard for potential glory. At least, that was the military’s best shot within a human, all too human world.

The application of JCS-type thinking to corporate life gave rise to the reorganization of senior management into a body similar in its intent, one that we have come to know as the “board of directors”, i.e. a purportedly independent set of individuals solely concerned with maximizing “shareholder value”, a term taken to mean general corporate health in some global, timeless and non-local sense.

As stated above, each of the three regulatory silos outlined above would soon become exceedingly protective of its own turf and area of expertise, as it should be, and would not be willing to entertain easily the notion that it might be deficient in discharging its functions properly. At that moment, it would be incumbent upon the supervisory committee to arbitrage the differences, real or imaginary, in the perception of the origin of the problem. It is quite acceptable and understandable for people responsible for credit or liquidity risk management across a country like ours to develop a certain degree of pride and arrogance vis-à-vis those challenging its premises. We should all encourage public officials to build esprit de corps and cohesion within their ranks and to think of their particular department as an elite body responsible to no one but itself. Rather than destroy such unity of purpose, our aim is to harness it appropriately.

For some time now, the world of modern finance has been too interconnected and too fluid to allow risk to escape notice through some inadvertent faux pas, which is exactly what happens all too often under the current system, if we may even label such a disparate collection of sundry objectives and worldviews a “system.” We live in a community in which one pseudo-savvy banker can play one regulator against another with impunity within some sordid game of credit risk hide-and-seek. The global village no longer tolerates partition into fiefdoms where Renaissance men and women apparently ply their trade in splendid isolation. What the US banking system needs badly, now more than ever, is a unified view vis-à-vis each of its three main functional areas, one that enables a comprehensive approach to the regulatory dilemma free from dilettantism. What is amazing is not the plain fact that capital rules are now a ship without a rudder, wandering aimlessly from failure to failure, but that the system “performed well” apparently until recently, since its false premises and preconceptions have remained unaltered for over a century. In reality, it was nothing but the historical disconnectedness of the world’s financial centers that was chiefly responsible for the fantasy that global stability was a natural outgrowth of the existing paradigm, instead of what it truly was, i.e. an sheer miracle predicated on the Balkanization of the financial landscape, and slowly simmering in the cauldron of cultural reluctance cum bureaucratic inertia. Our goose started cooking the moment “globalization” became a worldwide leitmotiv. By the way, as far as we can tell globalization is usually a meaningless term based on the notion that a Chateaubriand à la Hollandaise and a Big Mac are both “food”. In case of disagreement, anyone with too delicate a palate can be handled via judicious use of surgical marketing.

Although it is true that the existing regulatory bodies already coordinate their functions and actions to some extent, this is not done with a view to delineating responsibility by functional area the way we have outlined hereunder. Instead, it is simply an attempt to partition the workload by size, scope and political sensitivity. Everyone is still responsible for everything, and this is why things fall between the proverbial cracks. The current system is squarely departmental and therefore, the US needs to move to the “board of directors” concept that seems to work more or less efficiently in the corporate context. In fact, the type of institution we are proposing already exists in the United Kingdom [Board of Banking Supervision] and has performed fairly well throughout the recent turmoil.

Parting Words

If you are still reading, thank you. Admittedly, the foregoing was a bird’s eye view of what we are proposing. If you were looking for meat on the bone, you are no doubt disappointed, but rest assured that technical implementation is the least of our problems compared to the political heavy-lifting needed to convince Congress to re-organize the three august agencies at issue. Believe it or not, the proposed framework is much less onerous in terms of actual and political costs than the existing one. Most of the action happens behind the scenes and, as a result, bankers have a lot more time to do deals than they do now, assuming there are deals to be done at all. As JR Ewing was fond of saying “I reckon I’ll go to my office, while I still got an office!”

Most of the structural elements of our plan are already in place and apart from a change in thinking, something always difficult to achieve inside any institution, only a few administrative and cosmetic changes would be required. Although we have little hope that our framework could ever come to pass, by no means would such failure imply that our spirit was somehow misguided. In fact, if the truth be told, it would mean exactly the opposite.

In the meantime, the American jobs-clock will keep on ticking.

M is exactly right. But, a good start towards structural evolution would be to embed a quality signal in price. That is what ratings are supposed to do.

R&R Consulting in DealBook

DealBook – R&R Consulting Sets Sights on Being a Credit Ratings Agency.

http://dealbook.nytimes.com/2011/12/08/a-would-be-ratings-agency-without-rose-colored-glasses/