naked capitalism

By Richard Smith, a London-based capital markets IT consultant

In my last post, “Tracking the Rabbit through the Anaconda” , I mocked Geithner a bit and promised you all a spot of moaning about what’s missing from the financial reform bill.

Well, the anaconda has now had the time it needed to produce its offering. As an outsider considering the 20 hour orgy of bill consolidation and last-minute horsetrading that rounded off the whole process, I must say I find the US legislative process combines frivolity, pomp and ineptitude in a way that – reminds me of dear old England. Perhaps you are all very proud.

Shadow banking reform is the subject this post, since it is terribly important, much more compact than the rest of the reform, and the outcome is very very depressing. That leaves consumer finance, derivatives, and consumer finance for later. And let us see what FASB deliver in accounting changes, if anything.

This is how it all looked to me four weeks ago:

“The shadow banking stuff now looks appropriately targeted, by and large. They have sort of got it. Doubtless there will be nits to pick, down in the detail…

…To be honest, at this level of description the proposals don’t look quite as horrific as they might have done (after TARP et al, one’s expectations were modest indeed). So should one hold out for more, or quite a lot more? Is perhaps this – all holes and no cheese – still the right take on what will emerge?”

With respect to shadow banking, it seems, alas, that I was still far too optimistic; the short answer to the last question above is a resounding YES, and here is why.

Thoughtful NC regular RueTheDay has returned to blogging, and saved me some re-exposition with this crisp recap on the shadow banking system and its role in the Great Financial Crisis. To add: US shadow banking assets at the peak were $8-10Trn. That depends on what you include; the NYFRB’s relatively inclusive figure for market-based credit puts the figure at $16Trn (see Fig 1 here ), comfortably larger than the traditional deposit-based banking sector’s $10Trn.

Whatever the bonus-enhancing attractions of near-infinite ROC, you really wouldn’t want a run on that little set-up, and naturally, in September ’08, we got one. Trouble was, there wasn’t much equity in those shadow banks, and no liquidity buffers at all. Shadow banking “equity” – the capital that is there to absorb losses and promote investor confidence in the bad times – is something of a nebulous concept. Instead of ordinary equity you have various kinds of guarantee, for instance:

for SIVs: ‘liquidity puts’ (vide CitiGroup SIVs)

for money market funds: informal guarantees that the buck will not be broken, extended by the fund’s parent, but not credible in a crisis (vide Reserve Fund Sept ’08 and the ensuing shadow banking seize up)

for repo: haircuts for repo collateral, that increase dramatically in a crisis, and thus, precipitate runs

for in house hedge funds: you sometimes have an honour system, whereby the parent informally undertakes to indemnify hedge fund investors against losses (following through on that promise killed Bear Stearns)

for financial insurers: you might have a huge well-capitalized parent (though AIG and the monolines turned out to be not quite well capitalized enough)

Roughly speaking, it would be safe to say that the amount of equity in shadow banks turned out to be negligible.

Now suppose you decided: “Well, shadow banking is just a form of banking. Let’s just ignore the liquidity issue for the moment, and ignore the variety of business models of the various kinds of shadow bank, and require the shadow banks to put up a not very demanding 5% capital cushion and regulate to that, somehow.” Assume, for simplicity, that we want to keep all that lovely shadow banking activity going and that shadow banks’ assets are identical in size to their liabilities; that 5% capital cushion would then be 5% of $8-16Trn. That’s between $400Bn and $800Bn of capital to raise.

Or, perhaps more likely, our shadow banks take 50% losses on 15% of their loans that they never never want to do again (the CDO bonanza, etc), and then need 5% equity on the rest. That way our shadow banks would need $925-$1,850 billion in equity. Which is impressive, but fair enough: the traditional banking system has about $1.3Trn of equity, and we know the shadow banking system is the same size, or somewhat bigger, and more prone to runs. Why, pray, should it not at least be capitalized to the same level, either by new capital, or by shrinkage?

So – do you want a big capital raise, or a massive credit contraction (that would in turn impact OTC derivatives activity), or another crash? Not an enticing choice, and perhaps unsurprisingly Geithner’s 6th May marketing statement doesn’t have anything to say about capital and liquidity in shadow banks. So I suppose “another crash” is the preferred option, by default.

Though actually, when you do delve into the bill, you find, with one exception (the Collins amendment, which is a departure from Treasury’s script) that there isn’t much nitpickable detail at all. It just doesn’t have much to say about shadow banking. In May the US Treasury Secretary identified four shadow-banking related reforms. Here they are, with summaries of their form. Since there is no more detail now than there was in the May puff piece, I quote from it again; what detail there is ain’t encouraging.

Comprehensive Constraints on Risk Taking

“Chairman Ben S. Bernanke will have a seat on a newly created Financial Stability Oversight Council. That board will deputize the Fed to set tougher standards for disclosure, capital and liquidity. The rules will apply to banks as well as non-bank financial companies, such as insurers, that pose risks to the financial system.”

Repo Markets

“These reforms [FSOC, above]will give the Federal Reserve the authority to build a more stable funding system, take action to address the unstable aspects of the short-term repo markets, and ensure that these markets are used much more conservatively in the future. ” Well I hope this infrastructure paper isn’t the sneak preview – the paper itself acknowledges, in a strangled kind of way (p 4, para 2), that infrastructure isn’t the key issue.

Higher Standards for Money Market Mutual Funds

“The President’s Working Group on Financial Markets is preparing a report setting forth options to reduce the susceptibility of money funds to runs.”

Ratings Agencies:

Bloomberg have an update , needed because Geithner’s proposals have (did you guess?) been watered down: “The overhaul legislation requires the SEC to conduct a two-year study on whether to create a board to decide who rates asset-backed securities. That curbed a Senate proposal to establish the board with SEC oversight. After the study, the board would be established only if regulators can’t come up with a better alternative.

Congress also softened a proposed liability provision, making it harder for investors to sue ratings agencies than it would have been under language approved by the House in December.”

Or perhaps you would prefer the short version:

Comprehensive Constraints on Risk Taking:

TBC, by a committee called the Financial Stability Oversight Council.

Repo Markets:

TBC, by FSOC.

Higher Standards for Money Market Mutual Funds:

Options for standards are TBC, by a committee called The President’s Working Group on Financial Markets. The actual standards will then be selected – by yet another committee perhaps, or maybe the same one.

(I can’t find anything in the sneak preview that addresses csissoko’s more fundamental gripes here and here )

Ratings Agencies:

TBC. First a two year study by an SEC committee on whether a) to create a committee to approve ratings agencies (perhaps they should pick a resonant name for it first), or b) do something else. After that, do whatever the SEC decides to do, assuming they reach a conclusion; otherwise, create a committee to approve ratings agencies…

It seems to have been drafted by the Monty Python crew when you put it like that, but I don’t think it’s a terribly unfair caricature. Not to downplay the importance of other reforms, but a page or to create the committees to save the world, some Fed initiatives that were already in hand before the legislative process started, and then 1,495 pages of other stuff? It seems out of balance.

Still, there is the Collins amendment. It is pretty sensible: bank holding companies will have to be capitalized to the same level as their subsidiaries. You’d think that will force more capital behind some shadow banking activities at least: repo for instance? With due deference to the creativity of accountants, perhaps it will put pressure on some kinds of OBS vehicle too? Here’s hoping…

Collins does have a smart move on capital quality, specifically TruPS, which no longer count as capital. Though not just yet – if you are a big bank, you have 5 years to replace TruPS with proper capital; if you are a small bank, up to 20 years. TruPS were a feature of the crisis, especially once repackaged into (you guessed it) CDOs . The whole idea that holdings in other banks’ debt should count as bank capital is batshit insane, and not even in hindsight; cross holdings have been known to be major contagion vectors since the investment trust fiasco of 1929 (see JK Galbraith “The Great Crash”; UK readers may also remember the Split Capital Investment Trust disaster of 2002, our very pale British imitation of the Wall Street Crash). And in something between 5 and 20 years, that TruPS coupling will be gone, perhaps after another crash. The pace of reform is not dizzying.

The Treasury Secretary’s angle on the very reasonable Collins amendment makes me unsure whether these avowals about shadow banking reform were totally sincere:

The lesson of this crisis, and of the parallel financial system, is that we cannot make the economy safe by taking functions central to the business of banking, functions necessary to help raise capital for businesses and help businesses hedge risk, and move them outside banks, and outside the reach of strong regulation.

But compare Geithner’s ringing words with Geithner joining hands with the banks versus the Collins amendment. The attempt to unpick the Collins amendment looks suspiciously like the familiar “divide and conquer” approach to banking regulation, but led, it seems, by the US Treasury. The steps would be: try to dilute the US regs now, then, in due course, dilute the Basel III provisions on leverage (presumably Geithner is actually the US official said to be opposing the Basel III tightening of capital rules), then, exploit the international dimension to excuse porous regulations. And then you are back to business as usual.

Still, Collins’ amendment has survived; that is a little victory for Collins, or more accurately, I suspect, Sheila Bair and FDIC – see more here (though you should take the stuff about Eurobank leverage with a grain of salt).

So where does that leave us with our shadow banking reforms? Well, we have a modest tweak to bank capital requirements, of unknown efficacy (Collins) and a bunch of new committees, mostly in the Fed. The mountain has laboured, and brought forth a mouse.

Or you might prefer to pursue the anaconda/rabbit imagery to a physiologically realistic conclusion.