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“Basel III – the OK, the Unfinished and the Ugly”

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By Richard Smith, who works for the London consultancy Cubematch, which specialises in risk, collateral and change management

The OK

The BIS analysis of the 2007-09 banking crisis floats my boat. Here is their headline list of causes: excessive on- and off-balance sheet leverage, diminutive and low quality capital bases, insufficient liquidity buffers at banks. That gave us a banking system unable to absorb the systemic trading and credit losses, and unable to cope with the reintermediation of large off-balance sheet exposures from the imploding shadow banking system. The crisis was intensified by panic deleveraging and by the interconnectedness of systemic institutions via OTC transactions. “During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions.”

In the tradition of a certain kind of official document, it gets more punchy as you get away from the executive summary; additional factors are either spelt out in the detail of the reforms, or implicit: OTC securities markets were mostly a bad idea; there was a complete failure to manage counterparty risk; opacity of accounting facilitated the gaming of capital rules, which concealed massive leverage; there were “basic lapses” in liquidity risk management; there was excessive reliance on ratings, which led to outsourcing of risk management functions properly kept in-house; initial margins were too low, and shot up during the crisis, intensifying the liquidity squeeze; there was “Measurement Error”; “model risk” was underestimated. It turned out that banks tested their credit risk models very badly indeed, and they were impressively defective. This last applies particularly to credit risk models: for instance, counterparties defaulted just when volatility was at its peak and exposure at its highest (think AIG, monolines); which appears to have come as a surprise. The Basel committee rejects more colourful coinages (“chocolate teapot risk”), and calls this “wrong way” risk.

That all sounds about right. It contrasts nicely with this year’s US regulatory reform programme, and it’s quite a refreshing change after a year listening to people trying to blame it all on the CRA, feckless homeowners, Fannie and Freddie, regulators and yada yada yada.

Anyhow, multiple market failures propagated across the globe at unprecedented speeds. There was a fierce contraction in global liquidity, in cross border credit availability and in international trade. The public sector had to step in, and taxpayers are on the hook for many years to come.

That apart, the talent earned its bonuses.

Finally (and perhaps I am putting a little more emphasis on this point than the Basel Committee do), the procyclicality of the existing regulations further amplified the procyclicality of in-crisis deleveraging; and there was regulatory arbitrage. Putting it another way, Basel I (1988) simply wasn’t relevant any more, and thoroughly gamed; Basel II (2004) didn’t help much either, and probably made things worse.

The Basel Committee reasonably concludes that “it is critical that all countries raise the resilience of their banking sectors to both internal and external shocks”, and that, since greater resilience at the individual bank level reduces the risk of system wide shocks, the needed reforms must have a dual focus: microprudential and macroprudential.

So the Basel Committee want to strengthen global capital and liquidity regulations. Excellent. Their auxiliary aims: improve banks’ risk management and governance; strengthen banks’ transparency and disclosures; strengthen the resolution of systemically significant cross-border banks. Quite some shopping list, on which they haven’t made uniform progress.

The capital rules first, which seem to be relatively cut and dried, and mostly not too bad, and more or less finished, plus or minus feedback and impact assessments.

First, with restated purposes, the Tiers are getting simpler, and a whole host of accounting dodges, sub-tiers and other wheezes are getting obliterated. Tier 1 is there to help a bank stay a going concern; it is to be common equity, or at least some kind of capital that absorbs losses in exactly the same way as common equity. Tier 2 is there to absorb losses once the firm is broke. Regulatory capital adjustments “must be harmonized internationally”; we’ll see how that works out. There are new disclosure requirements which might actually make the capital levels of different banks comparable, at least until the accountants figure out how to obfuscate the new disclosures. Tier 3 is swept away, along with concessions for goodwill, unrealised gains on investments, goodwill, deferred tax assets, investments in own shares, various cross holdings (other bank equities, not bonds as far as I can see, might be an important omission there), other investment stakes, pension fund assets, changes in the bank’s own credit risk. That list is not exhaustive, but you can see that a slew of favourite dodges appear to be doomed. “Yee-hah” is not classic Basel Committee language, but if this part of the document had a watermark, that would be it.

Second, the Committee is jacking up the capital requirements for counterparty credit risk exposures arising from derivatives, repos, and securities financing activities. This is meant to cope with “wrong-way” risk and mark-to market hits from highly correlated assets all heading south at the same time in heavily coupled markets. This bit isn’t all good and I’ll come back to it.

Third, they want to supplement the risk-based capital requirement with a leverage ratio. What’s not to like about that? It should “help contain the build up of excessive leverage in the banking system, introduce additional safeguards against attempts to game the risk based requirements, and help address model risk”. Reading between the lines, only a little bit, the Committee thinks its new Basel III measures may be just as porous as the old Basel II ones, and is slapping this on as ‘belt and braces’. Highlights: no netting for repos, no allowance for purchased CDS protection, written CDS included at notional value. This is where off-balance-sheet items get their comeuppance, too, though again, there are accountants in the mix, so who knows how heavy a blow will actually land on VIEs? The implementation of FAS167 in January will be a straw in the wind: my gloomy bet is that rather less than expected will actually revert to bank balance sheets. But that’s not the regulators’ responsibility, yet.

Next up, the global liquidity standards. The intention here is not so much to prevent fiascos like Northern Rock or HBOS, (both of which would have been lossmaking, rather than hopelessly illiquid, if they had had sane funding models), but rather, to enable the authorities to get warning of an approaching liquidity problem, or at the very least, to give them a known timeframe in which to sort out the problem once it’s hit. So there are three prongs: first, a 30-day liquidity coverage ratio requirement, so that the authorities have that long to sort out new capital from somewhere, even in the face of a bit of a run. Despite the BoE’s legendary slow response to Northern Rock, 30 days really ought to be long enough to sort out new capital for an institution of that size. For the likes of JPM or Citi, probably still enough, though there might be pressure from a more severe run than the base scenario in the document. Second, there is a longer-term structural liquidity ratio to which banks must adhere; common sense, really. Third is a common set of monitoring metrics to assist supervisors in identifying and analysing liquidity risk trends at both the bank and system wide level; also common sense.

The Unfinished

Impact assessments…rather a lot of impact assessments. One would really love to see how those changed capital and leverage requirements affect European and US banks. Will it be sharp intakes of breath, stunned silence, and perhaps some shouting (good sign), or ritual whingeing and (in private) big shrugs all round (bad sign)? Wait and see.

Then there’s the consultation, a.k.a. watering down process.

And they really need to put a whole lot more meat on the “reducing procyclicality” idea, which is a rag bag of ideas to mitigate the massive positive feedback loop in asset prices in a crisis (for which mark-to-market accounting get some of the blame). The Basel Committee are in a bind with mark-to-market. They kind of knew that mark-to-market was procyclical, but crossed their fingers and went ahead. That didn’t work out so well; now it’s back to the drawing board.

The next idea is to mandate countercyclical capital buffers that can be drawn upon in periods of stress. As opposed to paid out in bonuses, for instance. Me, I think the UK’s interim 50% tax on bonuses is a great stopgap. In the spirit of offering predictions to suit all tastes, I suggest you look for that tax to vanish mysteriously in the next few weeks, last until the next election, or persist until Basel III is adopted by the UK regulators; and maybe get copied by Spain.

The next aspiration, not really even an idea yet, is to address systemic risk and interconnectedness. The Basel Committee are looking at charging extra for systemically interconnected banks. If I remember correctly, those are the ones with the really powerful lobbies. We’ll see how it goes.

And lastly, the timetable:

“A comprehensive impact assessment of the proposed capital and liquidity standards, to be carried out in the first half of 2010”. So the final regs will depend a lot on where the lines are drawn in this impact assessment. Which banks are to be deemed representative? The “average” ones?

“Review the regulatory minimum level of capital in the second half of 2010, taking into account the reforms proposed in this document to arrive at an appropriately calibrated total level and quality of capital.” Groovy!

“A fully calibrated set of standards by the end of 2010 to be phased in as financial conditions improve and the economic recovery is assured.” Whenever that is. It makes you wonder how the banking lobbyists will argue the case a) that we’ve recovered and b) we haven’t recovered enough for the new rules to be phased in. I’m sure they can thread that needle just fine.

Aiming at implementation by end-2012; with “appropriate transition and grandfathering arrangements”. So: (with thanks to the Basel Committee for their economic forecast) a bit of work for the IBs, nicely spread out, as banks rejig their capital. It’s an ill wind…

The Ugly

An intended side effect of the increased counterparty capital requirements is to increase incentives to move OTC derivative exposures to central counterparties and exchanges, which, it is hoped, will reduce coupling. This sounds fine for the more vanilla end of the market – interest rate swaps and the like, where genuine hedges of various kinds exist. It’s less convincing with Credit Default Swaps, which essentially start out as a mechanism for pretending that you can short corporate bonds, when you can’t, and spiral off into full-blown psychosis from there. To point to the anti case, I’ll just recycle my link from my recent post about the FSA and Basel III. Net effect: FSA has parted company from the Basel Committee on this point already. It looks as if there will be a shot at getting CDS traded via a central counterparty anyway, so we’ll get a chance to see who was right, eventually.

Rating agencies reform isn’t pretty. They are as firmly embedded in the new Basel rules as they were in the old. Once again the Committee is in a cleft stick. They rightly mistrust banks’ internal ratings as an alternative, but are reluctant to admit the possibility that the rating agencies aren’t really all that independent from banks. Perhaps they are just being polite to the US.

As mentioned, banks are given a general whack on the muzzle for not testing their credit risk models properly, and are given a whole slew of new specifications of what their models should be like. We are now to have stressed EPE (an attempt to tackle wrong-way risk), stressed VaR (actually this was specified back in July), extra back testing requirements, extra stress-testing requirements, extra model validation requirements. This will be a geeks’ bonanza.

The jury is out on how well one can expect to manage wrong-way risk. I can’t see how any numerology can possibly do it, since it doesn’t have any insight into the deteriorating fundamentals that drive a company’s creditworthiness.

But at least there’s another chance to take a kick at the corpse of VaR, now tricked out as Stressed VaR, but just as dead as it was before the makeover. I am indebted to David Murphy of the blog Deus Ex Macchiato for some nice references, quotes and data points here. Stressed VaR has had a wee bit of testing (in here, section 5). On average, using stressed VaR increased market risk capital requirements by 280%. Not on average, it increased market risk capital requirements by anything from 7% to 700%, depending on the bank, a level of variability in the results that makes the average pretty meaningless.

Not as meaningless, however, as Stressed VaR itself. From Murphy: “One need only compare JPMorgan’s capital allocation for market risk — $9.5B at Y/E 2007 — with its VAR — $107M — to see the problem with trading book capital based on VAR alone.”

OK, now multiply that $107M by 700%. I think JPM still won’t believe their VaR numbers….

In another twist, the Committee promotes the use of CDS to hedge against credit valuation adjustments (CVA – this is where the value of a position is adjusted by changes in the counterparty’s creditworthiness – it led to huge mark-to-market losses in the Crisis). So the wrong-way risk engine had better be a good one, otherwise the CVA hedges will blow. Not sure that the new world is much different from the old, here. Anyone (apart from banks, that is) want to be long credit risk on a group of banks in a crisis?

The End

That’s about it. Wait for the impact assessments and the final rules. Don’t hold your breath.

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31 comments

  1. BigBadBank

    Yeah baby, yeah! Great post – my only quibble is that the UK 50% bonus tax is a one-off for this year only, so it’s not much of a predo to say it will soon vanish.

  2. fresno dan

    “Here is their headline list of causes: excessive on- and off-balance sheet leverage, diminutive and low quality capital bases, insufficient liquidity buffers at banks.”

    Being in the gubermint, I enjoy byzantine language as much as the next guy. But large language destroys sharp thoughts.

    I don’t think the rules and accounting caused the problem – I think the problem was caused by human emotion – whether it be people who thought they could double their money bying a house, or mortgage brokers thinking the same thing, or bankers etcetera.

    New rules will result in new ways to wiggle out of them. None of it will work unless there is someone with the power of “No!” and clear, simple rules without a hundred billion exceptions and caveats.

    Now, it used to be heads of businesses perfomed this task – nothing like bankruptcy & penury to concentrate the mind. But when there is no consequence to being an idiot (or venal) you get a lot of idiocy and venality. Look at Chuck Prince – a man who admits he didn’t know what he was doing – why isn’t that man poor??? (I mean selling apples on the street corner poor).

    1. Richard Smith

      Well you are right, fresno dan, what can I say.

      But regulators can’t get at that bit; it’s down to legislators and governments and peer pressure and good upbringing and interest rates a smidge higher than they are now, and some smashing fraud trials, and so on, to keep us all on the straight and narrow.

      Nevertheless, cleaning up the capital rules and dropping in some liquidity requirements is some sort of start in making it harder to game the regs and take goofy risks. The Committee really have made it harder to work the exceptions to advantage by the simple expedient of getting rid of them. The gamers will have to start again, and of course, they will.

      When you look at what the Committee have chucked out, it is pretty striking what ridiculous exceptions made their way in in the first place. I doubt if that point has been lost on the regulators, but time will tell.

      It is pretty natural to expect some sort of pushback from the banks now; we will see if the Basel Committee is ready for it.

    2. LeeAnne

      You just happened to hit on a pet peeve of mine: Chuck Prince had the decency to apologize; although hardly enough for anyone connected to the fraudsters, he IMHO took the fall publicly for the real culprit, Sanford I. Weill who, after a string of acquisitions, and stopped by his failure to acquire the prized Merrill, Lynch lead the way to Wall Street’s purchase of the US Government for his acquisition of merger of Travelers Insurance with Citi, giving him the competitive advantage over all finance acquisitions. And, for that, he, Robert Rubin and ex President Ford are traitors to the American way of life and its government by the people, for the people.

      “In 2002 the company was hit by the wave of Wall Street managerial restructuring that followed the stock market downturn of 2002. Chuck Prince replaced Mr. Weill as the CEO of Citigroup on October 1, 2003.” Wikipedia

      The “$76 billion merger between Travelers and Citicorp, and the merger was completed on October 8, 1998. The possibility remained that the merger would run into problems connected with federal law. Ever since the Glass-Steagall Act, banking and insurance businesses had been kept separate. Weill and John S. Reed bet that Congress would soon pass legislation overturning those regulations, which Weill, Reed and a number of businesspeople considered not in their interest. To speed up the process, they recruited ex-President Gerald Ford (Republican) to the Board of Directors and Robert Rubin (Secretary of Treasury during Democratic Clinton Administration) whom Weill was close to. With both Democrats and Republican on their side, the law was taken down in less than 2 years. (Many European countries, for instance, had already torn down the firewall between banking and insurance.) During a two-to-five-year grace period allowed by law, Citigroup could conduct business in its merged form; should that period have elapsed without a change in the law, Citigroup would have had to spin off its insurance businesses.” Wikipedia

      And, furthermore, not entirely off subject, in today’s WSJ: “According to the report … Two thirds of the [New York City] job loss in the six months following the September 2008 financial meltdown were outside the finance sector.”

      Clusterstock

      The casual observer can see all over New York City, small retail businesses and restaurants disappeared and replaced pathetic franchise businesses and cell phone storess, enhanced Duane Reades, and massive with empty floor space Chase (JP Morgan) Bank branch for corner signage that skirts highway outdoor signage laws and furthers the squeezing out of private businesses.

      Yes Virginia, JP Morgan Chase is a government-supported business -hardly private, hardly free market, barely capitalistic, hardly self-supporting, and hardly legitimate since it has destroyed the US legal system protecting finance consumers and taxpayers, and squandered taxpayer money on gambling and broads -sorry, I meant multi-million dollar vacation homes, cars and boats.

  3. bb

    for me the biggest problem that Basel III does not address either is the pricing of wholesale inventory at retail price levels. banks have huge balance sheets that could be likened to truckloads of fruits which they sell to retail buyers (hedge funds, mutual funds, private equity shops etc.) at retail prices. at the same time, their whole inventory is marked to market at those retail levels. this is simply wrong, because the natural turnover of their assets is very low and they cannot be liquidated even within a year at those prices without leaving the bank with a significant amount of rotten fruit.

  4. Richard Smith

    You scamp, you made me panic about some hideous typo (“What could I have possibly mangled into “Jaime Caruana” in a trudge through Basel III?”).

    1. Uncle Billy Cunctator

      Terribly sorry. Just that we don’t have many people over here that know anything about (publicly) the folks at BIS, or the inner workings of the various Basels (some have seen Fawlty Towers on pbs, however).

      This post will be picked through by some veteran commenters at the Baseline Scenario blog, to be sure. One, an ex-IMF director, will want to know exactly what the new capital requirements are, and if/how american ratings are considered in the new Basel conception of risk, or something like that. Any thoughts?

      Also, any idea why I’m inundated by ads for whisky and kilts when I look up Cubematch management? Do you folks do work for any of the Central Banks, BIS, World Bank, IMF, or the like? Do you recruit IT folk for them?

  5. Richard Smith

    Whiskey and kilts huh? Not major CubeMatch themes AFAIK. Whiskey a bit perhaps. CubeMatch do indeed do recruitment, don’t see that bit so not sure how much for BoE and the like.

    Wondered about “Basel Faulty” but inevitably it’s been done, lots.

    CubeMatch’s clients are mostly big banks, but (distancing self hurriedly) it’s more the worthy operational stuff from the days when banks mostly did things like manage collateral or look after client assets or fret about credit risk. Plenty of that still goes on, in fact, and it gets more and more complicated.

    American ratings (S&P, Moody, Fitch) are still a big piece of the picture in Basel III. They’ve added a due diligence requirement (H/T Brick for the nudge above) but studiedly avoided the delicate issue of who pays for the ratings – reforming those agencies is a job for the US. The basic dilemma is that if you leave it to the agencies you get one kind of ratings cockup; if you leave it to the banks you get another (or a very similar one, really). So they’ve gone for both. Wonder what the result will be.

    There is a code of conduct for ratings agencies http://tinyurl.com/ygm28af that the Committee will add to the regulatory framework. To calibrate your expectations of its effectiveness, note the publication date. Maybe a revision is coming.

  6. JKH

    Very informative post.

    “One need only compare JPMorgan’s capital allocation for market risk — $9.5B at Y/E 2007 — with its VAR — $107M — to see the problem with trading book capital based on VAR alone.”

    important

  7. i on the ball patriot

    It is heart warming to see that such a whistle free of corruption and truly democratically instituted organization such as the Basel Committee (that has not been tainted with even the slightest whiff of co-option or hijacking by the wealthy ruling elite in any way), finally providing some very simple, crystal clear, and concise remedial measures to the global system of gross usury and counterfeiting currency.

    Your article might better have been titled;

    “New Rules for Gang Rape”

    Deception is the strongest political force on the planet.

  8. jdmckay

    Good article, but… seems to me most of folks having payed attention along the way know most of this, no?

    Sic…

    (…) a banking system unable to absorb the systemic trading and credit losses, and unable to cope with the reintermediation of large off-balance sheet exposures from the imploding shadow banking system.

    Translation: junk derivatives backed up to irresponsible issuers (banks/mortgage lenders) who’s high commissions trumped due dilligence… actually, any dilligence, magnified by WS’s 45:1 “leveraging”, marketed to the world, etc etc.

    The crisis was intensified by panic deleveraging and by the interconnectedness of systemic institutions via OTC transactions.

    translation: the Dons of finance cannibalized each other over remaining breadcrumbs on the way down, grabbing unprotected cash out of any unsecured vault (taxpayers) on the way down.

    “During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions.”

    Translation: US financial gurus, aided and abetted by bribed FED/Treasury/K-Street politicos stole and raped US’ collective wealth.

    We’re over a year from time all this fully metasticized. Corrections, fixes, recalibrations… any meaningful corrective measures implemented, much less planned?

    Nope.

    A nation living and planning in the rear view mirror leads to self evident, predictable results… the collective unconsciousness of living as such notwithstanding.

    The US citizenry is getting exactly what it collectively deserves for running w/all this… eg: nothing.

  9. Dan Duncan

    That’s a great post, Richard. Fantastic explanation. You made a difficult summary come to life and you made it look easy. Thank you.

  10. TimOfEngland

    “That apart, the talent earned its bonuses.”

    :) we concur.

    In other type of businesses, bonuses are claimed back from the recipients (Sales agents) if the deal ends up going bad, sometimes many months after sale was made. This should apply to banks and investment broker/agents etc. This is what the UK government is trying to force at the moment. Some backup for our guys (the Chancellor et. al.) would be appreciated.

  11. Dave Raithel

    Even I could follow most of this. Any chance of a post explaining the relation between Basel and FASB? As I understand it, Basel is “advisory” – there are no treaties binding the nations who send delegates. But FASB is “regulatory” since the SEC uses that code?

    This is part of what makes regulatory arbitrage possible?

    1. Richard Smith

      There is a whole tendentious back story to tell about that. I was originally going to write it up but thought it would be too long and dull and it was going to take more research.

      Pending which, and oversimplifying a bit no doubt, the framework is that Basel is a standards body and the national regulators refer to it when setting their local standards. That “refer to it” is where some of the niggly reg. arb. stuff comes from – local regulators can come under pressure to be just that bit more indulgent, and there is room for interpretation. Then also there is the legacy of local securities legislation and business practice, which can be more or less accommodating. For instance, in the big European financial centres, there’s never been a Glass-Steagall equivalent as far as I know, though other separations of business role have been enforced at times. Another example: in the UK we don’t have anything like the US’s Securities Exchanges Act 1934, which was a handy little loophole for Lehman (et al) right up until their bankruptcy clobbered a whole bunch of hedgies who weren’t too savvy about the difference in client asset protection between UK and US, and found their assets swept up into the bankruptcy. That episode has really hurt our hedge fund industry and is one example of how tighter regs suddenly become a selling point after a screw-up. Maybe the same will apply to our bonus tax eventually.

      Then there is the inertia from changing tatty old computer systems, or adding new ones, and from changing business practices and documentation.

      And a spot of politics. And then the whole overlay of FASB (US accounting, with which the regulation must be compatible) vs IASB (everywhere else, supposedly, and another constraint on how the regs are framed). I haven’t had to go there ever, so I am not terribly solid on the differences. But for sure, one of the long term horrors leading up to this crisis has been the steady erosion in accounting standards, which the Basel people seem to have suddenly tired of now.

      All this means that the Basel standards get adopted at different paces depending on the national jurisdiction etc etc. Basel II mark 1 was published in 2004, and went through annual tweaks until adopted in Europe in 2008; in the US (for big banks) it came in on 1st April 2008, which is a nice touch. It is now part of the US reg standards (it’s the Fed that mandates its adoption). But out in the big wide world there are countries, OK maybe not leading edge finance centres, that won’t have it in place until 2015.

      Even in US/UK, and even if you assume that BIII only takes 2 years to get thrashed out and 4 years to get adopted, there’s time for a whole new boom-bust cycle before BIII is in place…

      Ponderous…you can see why people say it’s a waste of time and the banks will always be a step ahead.

      In practice concerned locals may step in a bit quicker this time.

      Not been terribly convinced by the US reg reforms so far; nothing much in the UK yet apart from throat clearing and ambiguous gestures, occasional squibs from FSA and BoE as they get on with their polite turf war. UK proposals will start to come out in the New Year I think, and also you guys will get a chance to find out what the Senate will do to your various Bills.

      Bloody hell, I seem to have written the post already. Not fact checked at all mind you, roughly right I hope. Well, I’m not going to chuck it away. Here you are, a first draft, with caveats.

  12. mannfm11

    Maybe I am stupid here, but why would they talk about capital then leverage. Aren’t they the inverse of each other? Being the big rollovers were the international banks, I can see this getting about 3 blocks down the street. He mentions talent getting the bonuses? If this is talent, I don’t want them near the horse track with my money.

    1. Richard Smith

      mannfm1,

      You are right. The Committee are tackling the methods the banks used to increase their leverage.

      The first is just to use funding techniques that are highly leveraged.

      The second is to apply very relaxed definitions of capital, so that you end up employing much less genuine, expensive capital in your business. Trouble is that without genuine capital you can’t absorb the losses when they come (which they will).

      Those two techniques multiply up, and you end up with a much higher return on capital (= bigger bonus), but a much riskier one. You pay yourself a bigger bonus until it all falls apart…and here we are.

      Capital rules close the second loophole; leverage rules make it harder to exploit the first one. You have to cut off both routes to leverage if you want to stabilize banks and the “system”.

      That’s the hope & intention, anyway.

  13. CrocodileChuck

    Richard

    Great post, thank you v much. I hope that you post here more often in 2010 on EuroBanking (have a sneaking suspicion there are more dominoes to fall in the EU)

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