Much has been written recently about JP Morgan’s $3B CDS loss and Morgan Stanley’s Facebook
IPO debacle. We also have many in Congress and other parts of the government again raising a
stink about banks “there they go again”. Their answer: Rules, rules & more rules.
Let’s state the obvious: If, even after 5 years, the most sophisticated financial institutions on
the planet constantly adapt to new sets of rules and STILL make a mess, how in the world can
governments even THINK that any new set of rules can work? Albert Einstein said the definition
of insanity is doing the same thing over and over but expecting a different result.
So, in the face of all this, what do we do about the banks?
This is more than a discussion concerning derivatives. It is more straightforward than the 2300
page magnum opus that is Dodd Frank. (By contrast, Glass Steagall was only 37 pages) It goes
to the core of what is needed for a 21st century financial system and establishes a framework for
Disclosure & Oversight and Segregated Capital
Disclosure & Oversight
The lack of transparency with respect to bank balance sheets compounded by lapses by the
accounting profession and rating agencies not only make it difficult for analysts and investors
to evaluate risks and rewards but it also makes it difficult for regulators to, ex-ante, evaluate
institutional and collective systemic risks.
Furthermore we live in a time where governance of financial institutions may be capable in the
main, but at multiple points in time and often in the most critical circumstances, each one of
these institutions failed to achieve their mandated roles. Why did they all fail and continue to
fail precisely at the moments when they are needed the most? The more critical and important
question is, how can we expect future financial stability in the face of repeated governance
A major part of the problem lies with the fact that sets of rules vary by country. Another part of
the challenge is inherent in the fact that there is no global standardized set of disclosures that each
financial institution must report. With an asymmetry of data that are asymmetrically applied it’s
no wonder we’re in the mess we’re in.
It is in everyone’s best interest to have an optimally competitive banking industry. However,
banks can take a page from the insurance industry: On a quarterly basis, in addition to voluntary
segment and loan aggregate exposures, banks should electronically publish in pdf and xls form,
a list of securities owned specifying the security identifier number, cost and value. Some banks
already provide detailed disclosure in their 10Q filings but it is not standardized and there is often
no aggregation of country exposures as well as no delineation of derivative exposures, notional
and value at risk. The proposed asset list would be released 60 days after a quarter end (i.e. a 60
day lag) such that competitive advantages are maintained. Just ask leading mutual fund companies
if their competitive advantage has materially suffered or pension funds if beneficiaries have been
harmed by such a disclosure lag.
Quarterly reports also need to be accompanied by basic risk disclosure: What is the impact to the
bank if interest rates change, volatility changes, equity markets change, residential and commercial
mortgage defaults change, etc.
What this provides is three things specific to individual banks: Determination of potentially bogus
asset valuations, identification of potential problems due to concentration of risk types and asset
classes and makes banks officially declare what their levels of risk actually are. While it doesn’t
prevent asset losses, a natural and expected consequence of the banking industry, it does allow
a larger number of constituencies than currently exists to evaluate the quality of assets and the
rigour of their valuation. Think of it as institutionally crowd sourced oversight where the larger the
number of self interested evaluators, the fewer the opportunities for obfuscation and outright lies.
Additionally, the disclosure process allows regulators and congressional oversight an early
warning signal. It becomes easier to aggregate the totality of asset class risks and break them
down by bank and product type e.g. local vs global, mortgages vs corporates, equities vs fixed
income, equity derivatives vs swaps or CDS. It also allows non-politically driven groups to draw
attention to problems just in case regulators are asleep at the switch.
Standardized disclosure consistent with the highest standards of transparency thus allows for
rigorous oversight whereby each financial institution is evaluated and each group can make their
own judgments. Here hedge funds and other institutional investors play an important additional
oversight role. It is a far more effective and long lasting result if large investors can consider the
implications of risk management in order to reign in abuse, however you define it. In the long
run, if investors don’t like the way a bank is run, they can exit by, at the very least, selling their
shares or if they want to be more activist, short the stock. Yes, shorting a stock allows investors
to call supercilious management to task and challenge abusive corporate practices. Alternatively,
they can amass stock positions and create a proxy fight as in the case of CP Rail. You may not
like activist investors but if you don’t think these are effective practices take a look at the charts
of Green Mountain Coffee Roasters, Herbalife or JP Morgan. This is made far more effective by
quarterly asset holding and risk and valuation disclosure. Regulators should focus more energies
on collective delineation of necessary components of standardized disclosure.
I am also proposing that the industry establish a global oversight valuation group that would
examine major components of assets within specific categories to determine whether additional
capital needs to be allocated to such asset classes. The insurance industry in the USA has
established such an oversight infrastructure called the Securities Valuation Office of the National
Association of Insurance Commissioners. While its role is constantly being updated, it is an
example of how, proactively, a uniform group of standards can be applied to an industry that is as
diverse in size, competitiveness and quality as banks.
We now come to the heart of what to do about banks. While disclosure and increased oversight
can be effective in their own right and implemented immediately, they are incomplete without
a fresh look at capital allocation and segregation. A major issue today is that, from a regulatory
point of view, banks use the same capital to cross support a multiplicity of businesses. In this
regard, Commercial Banking, Asset Management, Investment Banking, Retail banking and
Treasury all benefit from the same capital base making it a very efficient use of capital.
Academically, capital market theory argues that this is beneficial because capital efficiency
reduces risk to the system. However, it has been proven over the past 5 years that when there
are systemic problems, capital efficiency morphs into capital insufficiency. Basel III only looks
at the level of capital inside a financial institution not how that capital is applied by business
segment. It does not consider the risk reality of a business segment’s assets, liabilities or cashflow
against which capital must be allocated. For example, Basel III STILL does not require capital
to be allocated against the holding of ANY sovereign bonds. There is a zero risk weighting
and no capital allocation regardless of whether a bank invests in Greek vs US vs Eritrea bonds.
Furthermore, it treats all derivatives as capital market instruments. It needs to recognise that a
listed call option on a stock that settles and is margined by a Clearinghouse is hugely different than
an over the counter Credit Default Swap which may be settled in the future by a Clearinghouse but
is not purely a derivative but functions more like a reinsurance contract.
It is too easy to say: “Let’s go back to Glass Steagall”. Such a comment does not recognise
the necessary evolution of the modern financial institution and how we all (corporations and
individuals) have come to rely upon it. For example, for corporate loans, banks charge interest on
a floating rate basis (usually LIBOR plus a spread). This is because it’s how the banks themselves
are funded. But this often exposes the corporate borrower to often unwanted interest rate risk.
It’s tough enough for a company to take the operating risks of building a plant, creating jobs and
making a profit from the products they sell. They operate on budgets. The risk of rising interest
rates can materially and negatively impact their ability to execute their business plans. Thus they
must necessarily enter into an interest rate swap whereby they lock in a fixed rate. It presupposes
that the financial institution with whom they execute the swap has the necessary capital to support
it over a 5-10 year period of time. Another example is the home owner who desires a fixed rate 30
year mortgage. Whether they know it or not, they have entered into the same kind of swap that the
corporation above has done. This implies that banks must link the credit decision of making a loan
to the capital markets derivatives (swaps are derivatives) decisions desired by its clients. Simply
put, going back to Glass Steagall means trying to put the genie back into the bottle i.e. not going to
happen and more importantly counterproductive and potentially disruptive.
It is right to think that proprietary trading and derivatives can be dangerous. But again it’s
too simplistic to say “Let’s stop bank proprietary trading” i.e. implement the “Volker Rule”.
Nevermind that some of the smartest financial people on the planet, Mark Carney (Canada),
Stanley Fischer (Israel), Augustin Carstens (Mexico) and Kiyohiko Nishimura (Japan) have
pointed out how the Volker Rule can result in hamstringing the liquidity of the world financial
system at a time when its fragility is being supported by such liquidity. The Volker Rule by
definition would also reduce the amount of market making in bonds that banks can do. This is the
lifeblood of the institutional fixed income investment world. It is not sexy and doesn’t provide the
media talking heads with their headlines of fear and greed. It is, however, the necessary lubricant
that supports investments by all the major pension funds for most every citizen in the developed
world. Once you restrict such capabilities, costs go up and risks that regulators thought they were
controlling actually go up. No wonder these leading global financial minds reject the notion of the
Volker rule as it is currently constructed.
Bottom line, there is lots of risk in the capital markets. But so is making loans to people and
corporations who can’t afford them. So, how do you define danger? Is it that JP Morgan loses
$3B? Is it proprietary trading? Private equity? Not really. Danger is when collective activity
requires bailouts by taxpayers. So, what is to be done?
First as Basel III requires, Tier 1 capital needs to increase. That’s a start. However we must go
further than that. Banks should segregate their businesses not simply from a financial reporting
point of view but formally and from a segregated capital perspective as well. It is not enough
to “allocate” capital to a business segment. Most banks and the Fed already do that. It must
be both very specific AND walled off. The big change here is that there will be no more cross
support i.e. the capital used by the asset management segment for example will not be used
to support the investment bank. If it turns out that the investment bank needs more capital, it
will have to be provided either by the holding company or by its own means. This will require
that each segment be managed like the businesses they are. If the investment bank takes more
risk, they need more explicit capital. Notice we are not going back to Glass Steagall but are
recognising that there was some wisdom in separating the functions at least from a capital
Additionally, since the investment bank has materially different risks than many other segments,
I propose that there be created a separate board of directors where some of them are “outsiders”
and some come from the bank holding company board and include both insiders and outsiders.
There should also be a separate risk committee of the investment bank that presents its findings
to the main holding company board on regular specified occasions. It is critical that these risk
committees comprise people who are professionally familiar with risks.
Regulators must establish standards such that each of the investment bank, retail bank, asset
management, commercial bank and treasury departments need to have their own explicit and
segregated capital allocation. This may include triggers for additional capital, limitations on
dividends to the holding company, etc. The purpose is to reduce the chances that an impairment
of one segment impinges on the others’ abilities to operate. It will allow regulators and investors
to distinguish capital requirements in a way that allows for differentiated risks to be covered and
fosters business segment diversification. Segregation and business segment reporting should
also be specifically identified and discussed in Annual Reports and 10k filings as well as filings
that potentially show material changes in business operations. Not every bank does this today.
Imagine financial statements that treated each bank segment as a separate company. It would
be a whole lot more straightforward to analyse. This fosters the culture of oversight described
previously herein and allows anyone to review the required rate of return on capital for each of
the business units. It also allows Boards of Directors and shareholders peer to peer transparent
reviews that are consistent with standards in the market given the risk adjusted required return on
capital. The implication of this means that with respect to JP Morgan, a further loss in Treasury
need not impact the business of managing mutual funds or making loans to small businesses.
Those in the Treasury segment will suffer for it and the requisite segment disclosure will allow for
greater transparency in analysing a bank and comparing it to its peers.
Capital segmentation should also be part of an expanded brief for the Basel process. This creates
better standards that can be implemented world wide to prevent regulatory arbitrage. For example,
fee based businesses such as custody, cash management and third party investment management
should have a much lower capital threshold than the capital markets group. Additionally,
expansion of holding company capital requirements is needed for those institutions that are judged
systemically important i.e. “too big to fail” because too big to fail might also become too big to
These are initiatives that need to be taken, now. The message to the banking industry: Either
do this on your own or it will be superimposed on you by regulators who have limited practical
experience, no background in risk and may be politically motivated. The message to regulators:
Beware the law of unintended consequences. Like it or not, there is much interconnectivity to
the financial world. Mark Twain once said: “Every problem has a solution: Neat, Plausible and
Wrong”. The role of regulators should be primarily to engage a financial system that supports
the growth of an economy. Don’t just make more rules. The more rules you make, the more the
banks will slip through your fingers (Apologies to Princess Leia).
Be the moral compass, be the examiners, be the discoverers of trickery and financial baloney.
Watch the watchers, the rating agencies, the accounting firms and the third party valuation
companies. Superimpose a conduct of transparency. Let the world know exactly what each of the
banks owns, what their risk exposures are and work to establish the new global valuation group.
More importantly, and more immediately, make the banks segregate their businesses, publicly
disclose their assets, establish additional governance requirements and help set rational standards
of capital for each of the segments. Grill the banks as to the definition of “segment”. What Wells
Fargo considers a “segment” is very different that Citibank’s view. Both are valid so don’t try
the “one size fits all” approach. That is a very constructive (AND public) discussion. You might
then ask what is a “rational” standard? As the late justice Potter Stewart once said “You’ll know it
when you see it”. Take the lead, then make it global.
DISCLAIMER: Although the information contained herein has been obtained from sources Coherent Capital Management LLC and Miller Tabak + Co., LLC believe to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only and under no circumstances is it to be construed as an offere to sell, or a solicitiation to buy, any security. At various times we may have positions in and effect transactions in securities reffered to herein. Any recommendation contained in this report may not be appropriate for all investors and investors trade at their own risk. Trading options is not suitable for all investors and may involve risk of loss. Coherent Capital Management LLC and Miller Tabak + Co., LLC shall not be responsible for any loss due to inaccuracies in the information provided. An options disclosure document may be obtained from Mr. Jay Stenberg CF, Miller Tabak + Co., LLC, 331 Madison Avenue, New York, NY 10017. Additional information is available upon request. Miller Tabak LLC is a Member SIPC. Member NYSE, NASD, CBOE, PHLX, ISE, NFA.
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