Introduction

Large bank fines for manipulating currency rates are in the news. One reaction is “great, the bank regulators are finally cracking down with heavy fines.” I have a different take:

• Bank regulation will never work;
• Banks will continue to manipulate prices and take large risks;
• Bank regulators will always be two steps behind the banks;
• When and if banks get caught violating “rules”, they will pay the fines (not gladly but as a cost of doing business).

There is a better way to deal with this problem. Bank incentives and the markets in which they operate have to be changed. In the following, I explain why the regulation/fine model will never work using Greece as an example. I then set forth what this means and use the Greek situation to illustrate my conclusions.

Greece – Who in Their Right Mind Would Have Bought Its Debt?

Table 1 provides economic data for Greece. Anyone taking the time to look at these numbers should have seen that by 2008, the wheels were most definitely coming off. By then, the government deficit has grown to almost 10%. And while the deficit probably kept the unemployment rate from growing more rapidly, this was clearly not a sustainable economic path.

Table 1. – The Greek Economy

Source: IMF

And yet, there were still plenty of buyers for Greek debt. Table 2 gives interest rates on Greece’s 10 year debt for the years in question. Note how low they were until really spiking in 2012. Who were the buyers and why? To answer this question, a brief primer on required bank reserves is in order.

Table 2. – Interest Rates on 10 Year Greek Debt

Source: Investing.com

Primer on Required Bank Reserves and the Greek Example

Banks attract deposits (liabilities) and use them to earn income. These income earning vehicles and cash constitute bank assets. Regulators insist that banks maintain certain minimum liquid assets (such as cash) to cover fluctuations in other deposits. As bank investments have become more complex, regulators have attempted to adjust them by risk. The more risky an investment is, the less of it will be allowed to count as part of its liquid reserves.

Table 3 provides an example of how this works. Suppose we have a bank with investments “valued” at $120. The regulators require a risk adjustment for each type of investment. They then decide if the resulting risk adjusted assets provide the bank with an adequate reserve cover. In the example, the regulators allow the entire $10 of cash as reserves but only 10% of the bank’s derivatives.

Table 3. – Risk Adjustment Example

Consider now the Greek case. The regulators “in their wisdom” allowed banks to treat Greek government debt in the same manner as cash! That is, the Basel II rules allow national regulators to treat government debt as risk free! And this means banks do not have to hold any capital against it in to be in  compliance with global rules.

This explains the demand for Greek debt. The banks say why hold cash we can buy Greek debt and get a healthy return. You might wonder why the banks’ “risk officers” did not point out just how risky Greek debt was. But they were overruled. Senior bank officials saw the higher return they could get on the debt and purchased it. This is no different than what happened in 2008. I feel certain risk officers continually reminded senior bank officers just how risky the packages of mortgage-backed securities were. But they were ignored until the market for these securities vanished overnight. And the regulators – where were they?

 The Bank Regulation Model Will Not Work

The above highlights the shortcomings of bank regulators. They are no better than you or me in judging risk. In an earlier piece, I suggested that the Bank for International Settlements (BIS) is the most dangerous institution in the world. Why? Because it is intended “to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.” This all sounds quite reasonable and good. So why is BIS so dangerous? It is the most dangerous institution in the world because through its “Basel Accords”, people are led to believe banks’ “gambling” with depositors’ funds can be safely regulated. This is nonsense. Banks cannot be effectively regulated even with all three Basel accords up and running.

Under these accords, we had the bank collapse of  2008. Why? Because the regulators did not recognize just how dangerous real estate derivative packages had become. We then had the European bank bailout resulting from the regulators encouraging banks to buy Greek debt. And this saga is not over. Greece will shortly default again on its debt and the banks will have to be bailed out once again. Bank regulators will be horribly distressed by these charges, but their actions have made it clear they cannot judge risk.

I offer one further example on this matter. The following is a table from the 309-page Citigroup 2014 10-K report to the SEC. The table is supposed to explain how the bank complied with “Basel III Advanced Approaches with Transition Arrangements.” To provide a bit more flavor, I have added three of the 16 footnotes to this table.

Three footnotes to the table:

(8)        Of Citi’s approximately $49.5 billion of net DTAs (deferred tax assets) at December 31, 2014, approximately $25.5 billion of such assets were includable in regulatory capital pursuant to the Final Basel III Rules, while approximately $24.0 billion of such assets were excluded in arriving at regulatory capital. Comprising the excluded net DTAs was an aggregate of approximately $25.6 billion of net DTAs arising from net operating loss, foreign tax credit and general business credit carry-forwards as well as temporary differences, of which $14.4 billion were deducted from Common Equity Tier 1 Capital and $11.2 billion were deducted from Additional Tier 1 Capital. In addition, approximately $1.6 billion of net DTLs (deferred tax liabilities), primarily consisting of DTLs associated with goodwill and certain other intangible assets, partially offset by DTAs related to cash flow hedges, are permitted to be excluded prior to deriving the amount of net DTAs subject to deduction under these rules. Separately, under the Final Basel III Rules, goodwill and these other intangible assets are deducted net of associated DTLs in arriving at Common Equity Tier 1 Capital, while Citi’s current cash flow hedges and the related deferred tax effects are not required to be reflected in regulatory capital.

(15) Under the Final Basel III Rules, credit risk-weighted assets during the transition period reflect the effects of transitional arrangements related to regulatory capital adjustments and deductions and, as a result, will differ from credit risk-weighted assets derived under full implementation of the rules.

(16) During 2014, Citi’s operational risk-weighted assets were increased by $81 billion, of which $56 billion was in conjunction with the granting of permission by the Federal Reserve Board to exit the parallel run period and commence applying the Basel III Advanced Approaches framework, effective with the second quarter of 2014. Further, an additional $25 billion was recognized during the last six months of 2014, reflecting an evaluation of ongoing events in the banking industry.

This is the information the bank regulators are supposed to use in determining bank compliance with regulatory rules. It is a real stretch to think the regulators understand all of this. It is more plausible to believe the banks hire a cadré of MBAs and lawyers who spend their careers writing reports concluding what the banks want and the regulators do not understand. And like the fines the banks pay when they get caught for doing something illegal, the compensation they pay this cadré is just another cost of doing business.

Suggested Alternatives

So if the bank regulatory/fine model is not workable, what should be done? Two strategies make more sense: use market mechanisms when available and realign bank incentive structures.

Consider first the item most recently in the news – the fines levied on banks for currency manipulation. Will these fines stop currency manipulation? No. So the important question is what sort of reform would insure there is no more currency manipulation. The answer should be quite obvious – do not let a set of banks rig things. Instead, create an auction for currencies just as we have for stocks and let the market dictate currency values. And if there are concerns about big players trying to manipulate values, limit the size of purchases and sales allowed.

Next, let us consider what can be done to keep banks from taking too much risk. Right now banks make a lot of money via packaging financial products, selling them and taking a commission fee, and trading them. Note that these money-making activities do not require the banks to be concerned about risk. The bank mentality is “as long as other financial houses will continue to buy these packages, we can trade them and make money.”

Question: do we deposit our money in banks so they can gamble. No we put money in banks for safe keeping. So how could we get banks to worry about risk? There is one elegantly simple way to do this: require banks to hold all the loans they make to maturity and end their trading activities. This can be simply enforced: limit FDIC insurance to banks that hold their own loans to maturity and do not engage in trading.

People say we need funds for risky investments. Let insurance companies, pension, hedge, private equity, and and venture capital funds take the risks.

Investment Implications

Some writers are excited about signs of growth in the Eurozone. As I have been saying since 2012, the Eurozone remains a disaster area. Stay away. It will not end well.