Bank bail-outs

Financial regulation

How to fix finance

An influential group makes some provocative proposals for re-regulating global finance

WITH the fires still raging, scorching industry after industry, it might seem premature to ask what should rise from the ashes. But policymakers are understandably keen to start work on redesigning their financial systems. If 2008 was the year when the flaws in the old model became painfully clear, 2009 is likely to be the one when governments embrace re-regulation in an effort to fix it. A weighty report published on Thursday January 15th is sure to play a crucial role in shaping the agenda.

The Group of Thirty’s “Financial Reform: A Framework for Financial Stability” is important both because of the concreteness of its 18 recommendations and because of who was involved. The authors were led by Paul Volcker, a former head of the Federal Reserve who, as an economic adviser to Barack Obama, has the president-elect’s ear. Other members of the G30 include Tim Geithner, Mr Obama’s nominee for treasury secretary, Larry Summers, another economic adviser, and Jean-Claude Trichet, president of the European Central Bank. Although they recused themselves from direct participation, they are understood to support the bulk of the findings. “Everyone stands behind the report in spirit. No one disowned it,” says an insider.

And muscular stuff it is. Under the proposals, banks that are deemed systemically important would face restrictions—in the form of “strict” capital requirements—on high-risk proprietary activities, that is bets made using their own money. While this would not quite mean a return in America to the separation of commercial banking and investment banking that ended with the repeal of the Glass-Steagall act in 1999, it would strongly encourage the investment-banking arms of universal banks to focus on client businesses, such as merger advice, rather than trading. One reason for separating these functions is that they seem to be “unmanageable in financial conglomerates”, says Mr Volcker.

The report also calls for raising the level at which banks are considered to be well-capitalised. This should be expressed as a broad range, it says, with the expectation that banks will operate at the upper end when markets are frothy.

The recommendations concerning non-bank financial institutions—the so-called “shadow” banking system that has contributed so much of the pain—are no less radical. One proposal is sure to make the hair stand up on hedge-fund managers' necks: pools of private capital that live on borrowed money should have to register with a regulator and produce regular reports, disclosing things such as leverage and performance. The biggest of them would even be subject to capital and liquidity standards. The report even recommends bank-like regulation for money-market funds that give assurances about maintaining a stable net-asset value, as most presently do. And it calls for legislation in America to set up a mechanism for dealing with non-bank failures, the lack of which has caused no end of regulatory consternation. For banks and non-banks alike, the report calls for a more refined analysis of liquidity in stressed markets and more robust contingency-planning.

Central banks should have a stronger role in policing such things, the authors argue, and need to be especially vigilant in good times, when credit is expanding quickly. They should also be more involved in supervising bank safety and soundness—although, to safeguard central-bank integrity, the role of chief firefighter is best played by others once trouble ignites. Central bankers “need to be more concerned about financial stability, but less involved in crises,” says Tommaso Padoa-Schioppa, one of the G30.

Of the other areas covered by the report, three are particularly eye-catching. It advocates a formal system of regulation for over-the-counter derivatives, such as the type of credit swaps that sank American International Group, an insurer. It urges regulators to force banks to hold on to a significant portion of credit risk when they package loans into securities and sell them on, in order to curb reckless underwriting of mortgages and other debt. And it calls for a rethink of certain accounting principles that may exacerbate downturns through pro-cyclicality, including the practice of marking assets to the current market value; “more realistic guidelines” are needed for illiquid instruments and distressed markets. It also wants to see more flexibility in guidelines for loan-loss reserves. Some regulators take a dim view of banks that squirrel away extra reserves in good times, on the grounds that this constitutes earnings manipulation, even though it leaves them better prepared to ride out the bad times.

The other important message is that a global crisis requires a global fix. International co-ordination should go beyond rule-making to closer harmonisation, including enforcement, say the authors, and more needs to be done to curb the uneven application of international rules at national level—although they shed little light on how this could be achieved.

It is quite a package. At the press conference to unveil the document Mr Volcker was typically modest, insisting it was more an agenda for discussion than a hard-and-fast blueprint. But, given his closeness to Mr Obama, it is hardly far-fetched to imagine much of it becoming official policy. All that talk of the biggest overhaul of financial regulation since the 1930s just took a step towards reality.

Bank bail-outs

Bank bail-outs

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Bank of America and Citigroup report awful results, prompting yet more government intervention

“I’VE had all the fun I can stand in investment banking at the moment,” said Kenneth Lewis, the boss of Bank of America (BoA), in late 2007. Investment banking had other ideas. BoA’s fourth-quarter results, a $1.8 billion loss announced on Friday January 16th, mark the first time since 1991 that the bank has dipped into the red. The losses were driven primarily by write-downs in its capital-markets divisions, although the credit risks in its loan books are also increasingly obvious.

Yet the true horror lay elsewhere: a calamitous $15.3 billion quarterly loss at Merrill Lynch, whose acquisition was only finalised this month and whose results were reported separately. The usual culprits were to blame for the carnage at Merrill—leveraged loans, mortgage-backed securities, monoline insurers and the rest—but the scale of the damage is remarkable. Never mind the shattered hopes of John Thain, the man who sold Merrill to BoA, that he might eventually succeed Mr Lewis as boss of the combined entity. Mr Lewis’s own job prospects look considerably weaker.

At least his bank can still count on official support. As the scale of Merrill’s problems sank in, Mr Lewis reportedly tried to wriggle out of the deal at the last minute, only to be told by the government that the acquisition could not be allowed to fail. No surprise, then, that another burst of public money was made available on Friday, in the form of a $20 billion capital injection (to go with $25 billion received in October) and a state guarantee on $118 billion-worth of toxic assets, most of it housed in Merrill. Under the terms of the guarantee, BoA will take the hit on losses of up to $10 billion on the ringfenced assets; the government will stump up for 90% of any further losses.

The intervention is a virtual carbon copy of a similar rescue for Citigroup, another battered totem of American finance, which was stitched together in November. The parallel is not reassuring. Mr Lewis unveiled his results an hour before Vikram Pandit, Citi’s boss, came to the confessional and revealed that Citi had still managed to lose $8.3 billion in the fourth quarter. Over the course of 2008 as a whole, the bank lost $18.7 billion.

Mr Pandit also put flesh on the bones of widely trailed plans to split the bank into two parts. The old Citicorp name is being revived for the core entity, which includes Citi’s global retail and commercial franchises, a client-focused, advisory investment bank and its transaction-processing business. A business called Citi Holdings (executives somehow resisted the urge to name it Travelers) will house non-core assets that Citi hopes eventually to divest. These assets include Citi’s minority stake in Morgan Stanley Smith Barney, a brokerage joint venture with Morgan Stanley that was put together on Tuesday, as well as its consumer-finance businesses and, of course, the toxic assets that got Citi into this mess in the first place.

The renewed woes of Citi and BoA crystallise growing concerns among policymakers that much more needs to be done to right the banking system. Both banks have now been bailed out twice, and the prospects of them, and others, having to come back to the trough are real. A Citi of two parts is still on one hook for further losses until its unwanted assets can be sold (a tough job in these markets). Merrill may have further nasty surprises for its new owner. And even if the write-downs on banks’ toxic securities start to abate, old-fashioned losses on loans to consumers and corporates are spiking horribly.

An increasingly nasty choice looms for the incoming Obama administration. Does it keep propping up institutions with more money as they need it, allaying fears of bank collapses but risking a prolonged credit crunch. Or should the aim be to seek a more comprehensive solution based on cleansing bad assets from banks’ balance-sheets, which will cost even more public money and may entail wiping out shareholders. Fun indeed.