Breaking Up the Banks

By Roy C. Smith 

from Financial News, Nov. 10, 2014

Last month, William Dudley, president of the NY Federal Reserve hosted a “Workshop on Reforming Culture and Behavior in the Financial Services Industry” for about 90 invited senior bank executives, regulators, prosecutors, and academics. This was the concluding paragraph in a lengthy and thoughtful analysis of the dangers of sharp-edged, aggressive “trading cultures” at banks

… if those of you here today as stewards of … large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist.  If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively.  In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively (emphasis added)… The consequences of inaction seem obvious to me—they are both fully appropriate and unattractive—compared to the alternative of improving the culture at the large financial firms and the behavior that stems from it.  So let’s get on with it.  

In other words, if the banks did not change their cultures to prevent “bad behavior”, Dudley warned, they would leave their regulators, alas, no choice but to break them up. 

There is no doubt that in the last decade almost all the major US and European capital market banks were involved in instances of shabby and sometimes illegal business practices, gamed the system to evade the rules and, in the high spirit of the trading culture, did what they could to “rip out the eyeballs” of their “counterparties.” 

Such actions are not to be excused, but the perception of cultural decay and rampant misconduct truly exceeds the reality.  The crash occurred after decades of industry deregulation, consolidation and innovation encouraged by regulators that were inspired by Alan Greenspan to believe that increased competition in financial markets would lower the cost of capital to market users, and that the markets themselves would constrain banks behavior. Consequently, the markets became enormous – the value of securities outstanding in 2007 reached an extraordinary $200 trillion – and liquidity events arising from sudden shifts in such a large market could be overwhelming, as we discovered in 2008.

After 2008, however, it didn't take long for governments everywhere to blame the financial crisis, and the many troubles that ensued from it, on the greedy and reckless cultures of the banks. 

But, how bad was it really, when prosecutors could find no evidence of illegal actions by any senior bank officers, despite extensive investigations. Indeed, most observers of the period now recognize that the banks, notwithstanding their turbo-charging of the mortgage business, were not alone in bringing about the crisis. Regulators and other government officials contributed significantly to the financial meltdown, before, during and after the crisis.

Six years after the event the cultures of the large banks have changed, as Mr. Dudley surely knows. They may not have been fully brought to heel, but certainly they have been defanged. 

Almost all of them have changed top management, purged their ranks of securitisers and others associated with the mortgage business, reduced trading activities, modified their compensation systems, and have tried to persuade shareholders, rating agencies and creditors that they are now better managed, less risky and fully reformed.  

The banks have also had to adapt to the greatest regulatory onslaught since the 1930. One recent report showed that the six largest US banks had already spent $70 billion in complying with all the new rules that affect them, But, unlike the 1930s, banks have also had to cough up $150 billion of shareholders’ capital to settle government lawsuits..

Despite their efforts at reform, most of the large capital market banks’ shares still trade at or below book value and their returns on equity capital remain below its cost.  Such a condition does not bode well for their economic viability or competitiveness  

Indeed, Mr. Dudley really should be more worried about the long-term viability of these banks, which are crucial to the financial system, than the nature of their cultures after all the changes already imposed. 

Further, it is hard to see how the financial system would benefit by converting bank  cultures into ones that are residually risk averse and afraid of getting into trouble.  

When Dodd-Frank was passed, it was criticised for many things, but praised for one – it did not arbitrarily force all large banks to chop themselves up or reintroduce Glass-Steagall to force all of them to leave the securities business.

Its authors understood that the burden of compliance would be high, and may change the industry considerably, but how any individual bank would respond to the new rules was to be left to the bank itself. 

Undoubtedly, some said, the new regulations would result in banks breaking themselves up into more flexible and economically viable units.  One such option was to spin off highly capital-intensive investment banking units, tailoring what remained into a basic, national commercial bank, like Wells Fargo.

So far this hasn't happened. Some banks have pulled back from capital markets, but none have gone so far as to break themselves up.

Knowing this, maybe Mr. Dudley is sending a message that ultimately the banks are going to have to do what the Fed wants them to, which for some of the largest and more complex, is to act more quickly and radically to simplify their basic business models. 

Dodd-Frank has given the Fed a lot of power over banks, and much of it is now being applied on a discretionary basis. It conducts annual stress tests that include qualitative factors that must be met in order to pay dividends and repurchase stock. The Fed also must approve banks incentive compensation plans and their “living wills” for banks to be in good standing (it recently rejected the living wills of 11 major banks, forcing them to resubmit them). 
Now, after Mr. Dudley’s remarks, it appears that the Fed can use any instance of “bad behavior” to determine that a bank is not well managed, “dictating” that the Fed force the bank to “dramatically downsize and simply” itself. With numerous investigations of post-crisis conduct still ongoing (LIBOR, FX), the possibility of more bad behavior surfacing is not insignificant. Such behavior does not have to be proven, or recent, for Mr. Dudley to act.

Though Dudley’s threat was forcefully made, it would be momentous and unprecedented for the Fed openly to force a bank to break up. But the power to do so under Dodd-Frank is certainly there, though the process is complex and can be appealed. 

Mr. Dudley’s cultural workshop may actually be less about culture and more a subtle warning to those banks the Fed considers to be moving too slowly in transforming themselves into the well-managed entities it wants.  Those banks know who they are.  As Mr. Dudley says, they need to “get on with it.”

Will Modi Reset India’s Emerging Market Economy?

By Roy C. Smith and Ingo Walter[

The forthcoming visit to Washington by Narendra Modi, his first since becoming India’s Prime Minister last April, is likely to have little impact.

Yes, it will attract the usual ceremonies and displays of goodwill, but it comes at a time of disillusionment with the BRICS, and suspicion about Mr. Modi’s real political objectives. So it is not likely to change much of anything.

For the past 15 years, the BRICS have been seen as the world’s best hope for sustainable growth. These five countries, representing 40 per cent of the world’s population and 25 per cent of its GDP in 2013, recorded growth rates 4 to 5 times greater than those of the US, Europe and Japan, and threatened to displace them as the world’s most important economic powers in another 20 years or so.

Today, this seems much less likely – China is struggling to achieve a 7 per cent growth rate this year and avoid a banking crisis caused by excessively easy credit.

India’s growth has fallen to less than half the rate of its best years.

Russia, struggling with the crisis in Ukraine and President Vladimir Putin’s approach to foreign investment, will be lucky to report any growth at all.

And a humbled Brazil expects a growth rate of only 0.9 per cent at best, while South Africa’s is even worse.

Weathering economic shocks

True believers in “emerging markets” maintain that new growth has to come from internal economic reforms that permit market forces to set prices and allocate capital and labor.

It is the expectation of market-driven development in these countries that attracts the capital, which in turn underwrites higher rates of growth. The BRICS, the largest countries in the “developing” world, all set out to follow this template, even though some (Russia and China) were starting out on the journey well behind the others.

Even ardent supporters of the BRICS understand that there are obstacles to face along the way, primarily economic shocks (like the financial crisis of 2008) and domestic politics.

Over time, these obstacles slow growth performance, but the power of the internal reforms and the sheer size of the future markets for goods and services at “normal” per-capita consumption rates still made a good case for the BRICS.

India re-energized

Mr. Modi is thought by many in India to be just the sort of bold, charismatic leader needed to re-energize India’s effort to free up market forces.

The Rupee is up 3 per cent against the dollar, and the Indian stock market has gone up 14 per cent in value in the last year.

He may well be just such a person, but India’s recent political paralysis and economic slump that helped elect Mr. Modi, only confirms the skeptic’s view that the country’s burdensome political, bureaucratic and legal systems are just too much for any leader to shift long enough to transform the country into a market-driven economy to complement its democratic political structure.

These concerns now include Modi’s surprise decision in July to block an important WTO trade facilitation agreement because it lacked provisions to enhance government food subsidies.

While in the US, Mr. Modi will have many opportunities to discuss US-Indian trade, investment and bilateral cooperation. Mr. Obama will surely look for India's support for US policies in Asia, especially regarding relations with China and Pakistan; Mr. Modi - a newcomer to such issues - is likely to be cautious and non-committal.

Still, the meeting between the US and Indian heads of state is important. It helps clarify what each expects of the other, and what the costs and benefits of helping each other might be.

More importantly, however, is what Mr. Modi does back in India to advance the case for becoming a viable market economy. Progress in this direction can have an enormous payoff in terms on increasing India’s power and influence, including its influence in Washington.

Mr. Modi has political capital to spend in India, and he ought to use some of it to winnow government subsidies, reduce protection of certain economic sectors, and to do all he can to increase basic competition in goods and services.

Infrastructure and education are important too, but these take a long time to improve. The most immediate need is to get the growth rate back to a 9-10 per cent level.

Keeping doors open

The success of the BRICS has taught us that the prospect of change from low growth to high growth triggers all kinds of private sector energies seeking to engage in the opportunity the shift presents.

Vast amounts of inward foreign direct investment can be attracted, along with technology and managerial skills.

These resources are premised on the willingness of such countries to keep doors open and to treat investment capital fairly. Equally, however, they can be reversed if these conditions change.

Mr. Modi has to convince the world’s investors that he means to restart India’s efforts at becoming an emerged marketplace, despite inevitable setbacks.

If he achieves this, his next visit to Washington will be very different.

Vladimir Putin, Sanctions and the Ukraine

Roy C. Smith and Ingo Walter
 

Vladimir Putin, a martial arts enthusiast, must be an admirer of Muhammad Ali, master of the famed “rope-a-dope” strategy in boxing. Putin’s antics are a mirror image of Ali’s in-and-out style, but in a different arena. Annexation of territory, soldiers losing their way on somebody else’s property, cross-border artillery barrages, anti-aircraft missiles that aren’t there but leave 297 passengers blown out of the sky, solemn agreements unremembered after lunch.

Many observers think Putin’s strategy is working. The Obama Administration’s reliance on sanctions and world opinion seem too weak to derail Putin’s aggression - which suggests a tougher, military alternative that would fall largely on the US. But supplying and supporting the Ukrainians militarily in Russia’s back yard could easily lead to escalation.

Reliance on military involvement may well be unnecessary. In the long run, Putin’s actions are self-destructive on several important economic fronts that are likely to be powerful enough to moderate them sooner rather than later. Each relies on the disciplining force of economics and markets.

Despite Putin’s periodic interventions, Russia’s economy has become highly linked to the global economic and financial system - to the great benefit of the Russian people. Exports (mainly oil and gas) account for 43% of its GDP and more than 50 percent of its fiscal revenues. Rising oil prices and increasing global involvement enabled Russia to achieve an average annual GDP growth rate of 7.1% from 2004 to 2008 and attain prominence as an emerging market economy - something that was unthinkable a couple of decades ago. While Russia’s growth rate declined after the global financial crisis, like most other countries, it was still able to attract $94 billion in foreign direct investment in 2013. At the beginning of 2014, Russia even broke into Bloomberg’s list of the top 50 countries for doing business.

Putin’s bellicose initiatives have resulted in modest sanctions which, limited and recent as they are, have already had a significant effect on markets. Russian GDP growth in 2013 dropped to 1.3%, down from 4.8% in 2012, and is expected to be zero or less for 2014. The ruble and stock prices are down around 15% for the year, the 10-year Russian government bond, reflecting an increase in inflation to 7.5%, now yields 9.7%. Capital outflows exceeded $100 billion in the last year. Access to foreign financial markets, from which Russian banks have obtained the majority of their funding, has been denied and inward investment has effectively been brought to a halt. Oligarchs are getting their money out as best they can while Russian banks and industrial groups are repatriating theirs to avoid future sanctions.

New sanctions now being considered by the EU at America’s urging could limit non-contractual oil and gas sales and the use of the dollar and euro payments systems, as well as blocking access to funds held externally by Russians. In combination, these would substantially constrict the Russian economy and most likely drive it into recession.

Today’s financial reporting requirements and payments tracking technology make it very difficult to evade sanctions, and their enforcement by determined regulators is relatively simple - as was demonstrated in the recent $9 billion BNP Paribas settlement with the US government. Sanctions take time, but they can work.

Putin’s actions have frightened Russia’s most important customers. Already the EU is accelerating efforts to find alternative suppliers and sources of energy – Europeans may restart nuclear reactors, invest more in conservation or in fracturing, recommit to wind or solar sources, or import LNG from the US. Technology has increased their choice of practical alternatives, certainly over the longer term, and Putin has provided an excellent reason to move ahead with greater urgency.

Russia’s European customer base formed a steady, safe, lucrative and growing market for its energy exports. Now it will increasingly have to replace these customers with less dependable and less profitable markets elsewhere. Russia’s recent 30-year ($400 billion) deal with China is an example, but it will take years before shipments flow and much can change in the relationship between Russia and China over the life of the contract.

The Ukraine conflict began a year ago with a domestically popular effort by Kiev to link more closely to the EU in order to expand economic opportunity. It was halted by Ukrainian President Viktor Yanukovych apparently at the behest of Vladimir Putin, who did not want to “lose” the Ukraine to the West. Demonstrations on Maidan Square ended with Yanukovych’s forced departure and the formation of a new, much more westward leaning government that was soon opposed by Russian-backed separatists in the East.

When forced to choose between the kind of prosperity common in Poland and other Eastern European countries and reverting to political and economic subservience to Russia, it is not surprising that the majority of the Ukrainians selected Europe. Their willingness to endure hardship and violence to move in that direction may be surprising, but their actions did not go unnoticed by others in the Russian Federation, or within Russia itself.

Putin’s rope-a-dope tactics aimed at preserving the Russian sphere of influence appear to be popular in Russia, where national pride and honor have been revived. Russians have long suffered economic hardship in the past, but, having tasted prosperity, will they tolerate losing it? Could the next Ukrainian-style demonstrations happen in Red Square?

Over time, Putin’s actions threatens to isolate Russia from the world free-market economy, which operates on the basis of maximizing growth and opportunity. A retreat into a Soviet-style shell will have consequences he may not be able to endure for long. He needs a political solution that creates an effective “reset.”

Mr. Obama’s job is to keep his eye on the long-term prize – turning things around with Putin to get him back on-message in the global economy. Global economic pressures -- workable new tools of the 21^st Century that are preferable to Cold War saber rattling -- can be very powerful in helping to shape national behavior.

Blueprint Needed to Rebuild Structured Finance

By Roy C. Smith

While the corporate side of global finance is recovering well, another side that suffered in the crisis is still ailing so badly it is a drag on the US economic recovery as a whole. Mortgage-backed securities may have got a bad name in 2007-2008, but some way to revive the structured finance market must be devised to get the housing market out of the doldrums.

Corporations around the world issued $2.1 trillion dollars of new bonds in the first half of this year, according to Dealogic, setting a record.  The issues included corporate investment grade, high yield and financial industry bonds. Corporate new issues of stock (including a big increase in IPOs) also increased over the first half of 2013, to $489 billion, a 20% improvement.  So global capital markets are on track to provide about $5 trillion of corporate finance in 2014.

Banks also provide global syndicated loan facilities (including bridge and other leveraged loans, and refinancing) to corporate clients. For the first half, the volume of all such loans was $1.7 trillion, up 8% on 2013 and the highest since 2007. 

The main difference in capital market activity since the crisis, however, has been the plunge in global “structured finance” (securitised debt). In 2006, $2.8 trillion of global structured finance issues were sold.  By 2013, volume had dropped 70% from its peak, to $790 billion, and at a pace of $356 billion in the first half of 2014, it appears to be drifting even lower. Most of the decline in structured finance has been in mortgage-backed securities, especially those issued without US federal agency guarantees.

In the US, banks make mortgage loans based on credit scores, then sell the loans to federal housing finance agencies (the Federal National Mortgage Association, Fannie Mae, or the  or Federal Home Loan Mortgage Corporation, Freddie Mac) that guarantee the loans and package them into mortgage-backed securities to be sold to the market.  The banks recover their investment and repeat the process, providing a continuous, relatively low-cost flow-through mortgage finance system that greatly aids the real estate industry.

A Serious Structural Problem

The collapse of the mortgage finance system has left a serious structural problem. The system is now being squeezed at all its vital points.

The federal mortgage agencies are not playing the flow-through role they were. Before the crisis they were aggressive, overleveraged and devoted to expanding home ownership by lending to weaker credits. But  since being taken into federal “conservatorship” in 2008, they have deleveraged, become more cautious and been made to run a tight ship.

Under conservatorship (which lasts indefinitely) the agencies have had to rebuild their balance sheets, repay the government the $187 billion of bailout funds they received, and distribute all free cash flow to the government, not to investors. In the process, the agencies have cut back their purchases and securitisation of mortgages from pre-crisis levels; in 2013 these were 13% less than the year before,  and down a little more in the first half of 2014.

Non-agency credit sources have disappeared; the agencies now guarantee nine of ten US residential mortgages.

Banks, addressing their own balance sheet problems, have pulled back on loans to borrowers with lower credit scores. But the pace of the pull-back has accelerated. In the first half of 2014, total mortgage lending declined by 53% from 2013 levels, according to Inside Mortgage Finance, and non-bank mortgage lenders among the top 30 originators accounted for 23% of the market, up from 11% in 2012.

Partly this decline is because the largest US mortgage lending banks (Wells Fargo, Bank of America, JP Morgan and Citigroup) are wary of doing business with the federal agencies. The banks have complained of the massive government lawsuits over technical breaches and failures that occurred long after the loans were made, but felt they had to settle rather than face the risk of losing at trial. 

Fed chair Janet Yellen said in June that this concern by the banks has substantially dampened the recovery of the US housing market. Sales of existing homes in July  were 4% below the 5.4 million-unit level of July 2013 and sales to first-time buyers remain historically low, according the National Association of Realtors. House sales are still about 25% below what they were in 2006.

Restoring housing activity is a key, but still missing, component of the broad economic recovery that the government says it is seeking.  A drying up of mortgage credit has continued to be a drag on the housing market.  It may get worse before it gets better.

In August, John Stumpf and Jamie Dimon, chief executives of Wells Fargo and JP Morgan, respectively, warned (separately) that unless the government offered a “safe harbour” from such litigation, based on clearly defined rules for handling the business, they would hold back from making new loans to the millions of people with lesser credit scores that are looking for mortgages.

Resuscitate the private sector

The Treasury tried to get out in front of the housing finance problem in February 2011 when it announced a plan to wind down the housing finance agencies over time to be replaced by private capital that would be appropriately disciplined by Dodd-Frank’s enhanced regulatory umbrella.

The Treasury has done little since then to support the plan or to explain how it might happen. A bi-partisan effort in the Senate was made this year to bring a bill to restructure the housing agencies. This much anticipated bill, which endeavored to get rid of the federal agencies but preserve the government guarantee of mortgage loans and a commitment to “affordable housing” ,disappointed just about everyone when it was revealed in March, and is now permanently stalled in committee.  

The best hope for restoring mortgage finance activity is to rethink ways to get the private, non-government guaranteed portion of structured finance market restarted. Surely a new set of more conservative and transparent mortgage backed securities that would appeal to institutional investors (especially in this low interest rate environment) can be created, but it will take a combined effort of the banking industry, credit rating firms and public regulators to make it work. They will have to cooperate to establish a new set of standards for what goes into the securities, how they are to be analysed and rated, and how regulatory safe harbour rules will work to enable the issues to be underwritten.

This is really a job for old-fashioned investment bankers to take on, one that requires a lengthy series of patient negotiations with the various parties involved to produce a workable prototype for a whole new market to develop. Sigmund Warburg and his partners created the first Eurobond through such a process in 1963.

A similar effort is now essential to redesign the global structured finance market.

From Financial News, 8 Sept., 2014

Can Black Political Empowerment Help Save Ferguson?

 

Can Black Political Empowerment Help Save Ferguson?

Ingo Walter

Looking ahead at the future of Ferguson, Missouri after the events of recent weeks, it seems certain that the overwhelming African-American majority will press for empowerment in municipal affairs. This transition needs to come with a parallel effort to strengthen the municipal economy, drawing on any and all local and external resources to prevent a “politics of scarcity” that can end badly for the town and its residents.

Drive a short distance west of “ground zero” in Ferguson toward Lambert St. Louis International Airport, and you will find the overgrown lots, blocked streets and crumbling building foundations of Kinloch, once an all-black town of about 10,000 residents – one of nine such cities in the US back in the 1960s.  Kinloch at the time was a politically autonomous black community, created in 1948 by residents of an unincorporated area of St. Louis County – then a blank space on the map of mainly middle-class white towns that had incorporated in the region over the years.

Some residents had migrated to Kinloch from the South in the 19^th and early 20^th Centuries. Others settled as returning soldiers after World War I, and some moved from Illinois after East St Louis race riots in 1917. After World War II, new residents often sought refuge from poor living and housing conditions facing African-Americans in the City of St. Louis, particularly in the “projects.”

By incorporating, Kinloch residents were fully empowered at the municipal level, and were free to plan and conduct their own affairs by whatever means they chose to try improving their conditions of life. Indeed, the town was established on the premise that, through a substantial measure of self-determination, African-Americans could gain for themselves what they were denied in superordinate white-dominated political structures. The town formed a circumscribed and identifiable political unit, and its well-marked borders formed social as well as political boundaries. For advocates of separatist-style Black Power in those years, Kinloch might have provided an ideal beta-test for the independent development of black-led institutions and separatism.

But in a social and economic study of Kinloch at a time of serious US racial tensions in the late 1960s, John E. Kramer – then a sociologist at the University of Missouri - St. Louis – and I concluded that the overall effect of political autonomy on Kinloch’s economy was primarily adverse. For all of its political autonomy, Kinloch appeared to be a strikingly depressed and stagnant zone of economic deprivation even at its peak, in the midst of a rapidly growing region during the prosperous years of the 1960s. The social and physical contrasts between it and its immediate neighbors like Ferguson were remarkable and obvious.  

Making sustainable economic progress proved to be a tough slog for Kinloch. There were new street lights at street corners, a new fire engine and some other gains, but such progress may well have materialized anyway if the community had remained an unincorporated area of St. Louis County. A large 1965 federal grant for sewer con­struction might not have been forthcoming had Kinloch remained unincorporated, but the grant seemed less a consequence of political autonomy and the develop­ment of strong indigenous political institutions than the result of one individual's personal initiative. Most importantly, the Kinloch schools remained a hopeless exercise in economic hardship, even as social ties centered on the town’s churches were impressive and serious leaders emerged from time to time to try and make a difference.

Meantime local taxes were much higher than they would have been if the municipality had not been formed. The tax base was just too small. So Kinloch residents had lower disposable incomes under home rule and public revenue was woefully deficient. The sadly inferior schools the town was able to maintain had an evident and predictably deleterious effect on the academic and vocational skill levels of its work force at a time of plentiful jobs in the St. Louis region. Perhaps the most discouraging single image during our research was a large pile of books, donated by other St. Louis County school districts, piled in the library basement under a foot or two of water.

In the end, we concluded that the residents of Kinloch had gained little in a material sense from political independence, and may have lost a good deal more – we could find no identifiable connection between political autonomy and improvement of economic welfare. The economic “air supply” was absent, and there was nothing on the horizon back fifty years ago that might have given give substance to hope - the critical sequencing of economic development and political empowerment suggested in Jason Riley’s new book Please Stop Helping Us (2014) in the case of Kinloch was in effect reversed.

There is also the irony of attempting a separate-but-equal approach to civil and political organization even though that same approach had been ruled unconstitutional and inherently unequal in the educational sphere more than a decade earlier.

In the 1980s much of Kinloch’s land was taken over in an Airport noise abatement project and the most recent data (2010 Census) records a mere 299 residents. So it’s not possible to assess how Kinloch would have fared during the late 20^th and early 21^st centuries.
 

In today’s coverage of Ferguson, few media reports mention neighboring Kinloch, and when they do it’s about unruly kids crossing the town line and vandalizing local homes. Going forward, developments in Ferguson are uncertain. However, in Kinloch we have a valuable, nearby warning that empowerment, desirable as it may be, is limited in its ability to foster development. In the end, people want to improve their lives. Period. And that involves going back to the basics of creating marketable labor skills, attracting capital investment and providing well-funded public services. If the new Ferguson wants to succeed, an object lesson is right next door. Political empowerment by itself won’t cut it.

A “Safe-Harbor” for Ethical Conduct at Banks

By Roy C. Smith

The NY Fed said recently it would hold a “workshop on bank ethics and culture” in the fall. It is stepping up pressure on banks to exercise better leadership to prevent abusive conduct that still seems prevalent in some institutions long after the lessons of 2008 were absorbed. How it should do so is still in doubt.

Alleged rigging of LIBOR and foreign exchange markets, efforts to aid clients in evading US taxes, and conflicts of interest and inadequate disclosure related to dark pools operated by banks have been at the core of recent events that have upset regulators.

Most of these allegations have involved foreign banks operating in the US, but recent settlements of federal charges related to the sale of mortgage-backed securities by JP Morgan and Citigroup (and prospectively Bank of America) have kept US banks in the arena.

The Fed is suggesting that part of its annual stress test evaluations of big banks will include queries into their ethical and cultural fitness.  If the threat of additional multi-billion dollar lawsuits hasn’t been enough to get the attention of bank CEOs, then possibly failing a stress test should be. The combined power of the Justice Department and the Federal Reserve to punish discretionary findings of a qualitative nature is certainly an important game changer for the US banking industry.  But is a new reality.

The banks might argue that they have been unfairly required to shoulder most of the blame and financial responsibility for the economic effects of the financial crisis. Much (though not all) of what they did was to seek innovative but untested approaches to creating new products or client accommodations for which there was considerable demand by knowledgeable financial institutions.

The banking industry is global and very competitive, and individual banks must be innovative and accommodative to survive. They are also corporate entities seeking to maximize profits in accordance with the law and ethical norms. In times of market ebullience and technical changes such as CDOs and high frequency trading, what the law and ethical norms may be can be quite unclear.

The Fed probably takes the view that much of what actually happened was the result of the banks loosing control over the actions of their employees who were aggressively taking as much advantage of the bubble as they could to boost the banks’ profits and their own compensation. The ethical and cultural tone of a bank needs to be set at the top, the Fed has been telling executives, according to The Financial Times, which all of the bank CEOs, of course, say they do.

What the ethical and cultural workshops will accomplish is unclear. Such events have a history of being of little value, but, with some effort by the Fed, the forthcoming ones could be quite useful.

The Fed could begin by defining the standards it wants banks to meet. These should begin with the requirement that all banks strive to achieve a culture that values high ethical conduct and insists on treating all customers and clients fairly. The effort to do this is auditable to a reasonable degree.

The Fed could say that it will provide a “safe harbor” for banks (i.e., it will hold them harmless) if they can demonstrate that they have adopted and enforce policies that make unit heads and mid level management responsible for the integrity of products and marketing and sales procedures. Those that involve potentially injurious conflicts of interest, or rely on loopholes or technicalities to make it to market, need to be nipped in the bud. Violators must be stopped at the point of origination, and dealt with appropriately. Compensation policies also must be modified to allow generous bonuses for problem averting activities, but, as with all bonuses, with meaningful clawback provisions.

The safe harbor idea could be adopted by the ECB as well. It has a similar need to upgrade ethical standards.

Making mid level managers responsible for playing defense and well as offense may be a change that will require additional training over time, but will produce better senior managers. There are thousands of these people in every large bank, so a lot of management development work will be necessary to reprogram them.  Today banks are hiring thousands of new compliance officials to manage the new regulations they must accept, but these people are not the core future management of the bank, the mid level people are. Hiring more compliance people should not be in lieu of empowering mid level operating people.

The mid level guys are also the ones the banks depend on the to make adjustments to products and services so as to adapt to the new regulatory and market environment and to position their banks for the future.  Perhaps they need a way to discuss new product ideas confidentially with the Fed, either just before or after a new approach is introduced.  If the Fed challenges the new idea, the bank should be allowed to withdraw it with impunity.

For banks to be active and competitive they need also to be healthy and economically viable. Investing in greater defensive empowerment of the mid level could be economically very advantageous if it means banks can avoid the massive legal costs of the past few years in the future, and if the effort enables the banks to regain the reputational value that has been lost.

The largest capital market banks have been struggling for years to regain economic viability and to restore their reputations. They could benefit from some helpful understanding from the Fed, which, particularly in view of its enhanced discretionary powers, should advocate roll-back of restrictive regulations put on in the heat and darkness of Dodd Frank but not really necessary to maintaining banks’ fitness and properness in the future.

All this is good stuff to discuss at a workshop, but finding common ground for a workable safe harbor is the real objective.

From Financial News, 11 August, 2014

 

Understanding the Russian Sanctions

By Roy C. Smith and Ingo Walter

The latest tightening of the US and EU sanctions on Russian business and finance will provide an interesting lesson in international political, economic and military affairs. Here are some key issues to think about:

These Financial Sanctions Can Be Very Potent

They deny Russian access to capital markets in the US and Europe, which is to say global capital markets. Asian markets are not included but they are not significant enough to matter much.  This is the most important sanction imposed on Russia so far, since Russian banks and businesses have been obtaining about half of their total funding requirements from these markets over the past three years, according to the FT. 

Between them, Russian non-financial state-controlled companies ($41 billion), state banks ($33 billion), private banks ($20 billion) and non-financial private companies ($67 billion) will have $161 billion of foreign debt maturing in the next 12 months. The sanctions prohibit these borrowers from rolling-over this debt.

Where’s the Re-funding Money Going to Come From?

The Russian borrowers will have to obtain funds from sources other than the capital markets to avoid default.  The logical main source of refinancing is the Russian central bank, which can draw upon the country’s $500 billion or so of foreign currency reserves.  Russia has the means to absorb the effects of the sanctions for a few years, at least, but the effects on economic performance will certainly be meaningful. It could have the effect of shutting down Russia’s internal credit generating capacity.

If Russia fails to refinance its maturing debt, the borrowers will have to default – and since many of the borrowers are state-controlled, this will turn into a “sovereign” default. Default makes all outstanding foreign debt become immediately due and payable.

This will trigger all sorts of additional denials of credit to Russian banks and businesses, which would deepen the isolation of the Russian economy, reduce the value of its currency, increase interest rates and inflation and curtail domestic growth, which is now forecasted at about 0% for 2104. 

Adding to the pressure is the recent ruling of the international Court of Arbitration in The Hague that the Russian state misappropriated assets of Yukos several years ago and must return $50 billion to shareholders of the company. Russia does not want to pay this claim, but it is an obligation of the government and surely will involve default litigation if not paid.

Default most likely would trigger a rush by foreign creditors to impound Russian assets abroad (think of Lukoil’s gas stations and Aeroflot aircraft “arrested” at JFK Airport), plus certain foreign currency receipts - including (possibly) those related to sales of oil and gas and other commodities.

Some may not believe a default would have that much of an impact. Russia says it can become more self-reliant. But just ask Argentina about its economic track record since 2001, when it undertook the world’s largest default, compared to how the country would have done otherwise. Now that Argentina in on tenterhooks again after 13 years in default, stay tuned. Russia tried a debt “moratorium” in 1998, and learned to regret it. The key to avoiding default is the ability and willingness to service foreign debt. Russia may be able but unwilling.

The Other Announced Sanctions are Meaningful - But Longer-Term

They also include prohibitions on the access to oil and gas industry technology that is crucial to Russia’s ability to develop its energy reserves in the future, and limit transactions in the armaments industry. The effects of these sanctions are much more structural and will only be felt over the years, but they are important nonetheless.

The Sanctions Are Enforceable.

As we saw in recent US litigation of major European banks engaged in sanctions-busting, violations of the rules related to the enforcement of sanctions can involve very meaningful penalties. These rules are now not just American rules, but have been adopted and will be enforced in Europe also.

Economic Sanctions Can Replace Military or Diplomatic Moves

The Russian sanctions are the first set of US and European economic  “blockades” that have been applied to a major country with serious military capability. They may have a chance because of the increased globalization of the Russian economy which brought with it growth and increased prosperity for its people. Sanctions can result in a serious drop in Russia’s domestic economic welfare and possibly cause pressure on the government to change its behavior in Ukraine in order to avert domestic discontent.

But don’t bet on it. Russia is far from democratic. Russians are nationalistic and Putin at least temporarily is at the top of his game. He thinks Russians are stoic and suffer well – invoking World War II and decades of stagnation under Communist rule. His oligarchs and cronies are certain to squeal under the sanctions, but he can pick them off one at a time. And he can point to the spotty record of sanctions imposed on countries like North Korea, Cuba Iraq, Sudan and Iran in changing offending policies.

But whatever he says, these sanctions are going to be painful and reduce growth and economic opportunity for all the Russians. It will be an interesting time. Fasten your seat belts.