Well, Ol' Ben got up in front of the Congress today and beat the hell out of them. Confident, tough and obviously smarter, he broached no insult and put on a command performance. The road forward will not be easy, however. The Republicans don't like him more for his easy money positions than for his role in the financial mess of last year. Apparently, they don't seem to realize that the man waiting in the wings would probably end any semblance of independence at the central bank which as loyal readers know I feel has already been seriously compromised. But credit where credit is due: he did a hell of a job.
I said I would talk about regulation today. What I have chosen to do is to give you a peek at a letter I wrote to a friend, a VERY senior official at one of our regulatory agencies. It's now over four months out of date and very long but in re-reading it I said to myself, "Self, you're pretty good." The names have been changed to protect the guilty. Enjoy.
February 5, 2009
Dear xxxxx ,
You asked that I send you my views on what I perceive to be the state of supervision in today's financial sector. While I am delighted to comply, I must first apologize for being unable to approach this topic from the standpoint of purity of purpose as I do not believe that the role of supervision stands alone from the overall state of the financial system but that it is intimately related to the history and present state of the same. A further apology: I am not without bias. I have for some time held the view that the supervisiory role is far more placebo-like in it's existence than worthwhile in its effect and that the present state of the financial system makes it even more placebo-like today.
Way back in the last century I can remember the visits to the xxxxxxxx xxxxx Co. of your colleague, Tom McQueeny, still accurately (and fondly, I might add) referred to by my former colleague M.B Kelly as, “a tough Irish Cop” (I guess a Kelly should know). Tom was good at his job and could smell a rat like any good cop, but there were few occasions when he actually caught the rat; even in those days there were simply too many rat holes. Banking even then was a complex business; today it is a mind-bending complexity of products, markets, personalities, nationalities and political pressures far beyond the ability of a small group of people charged with the responsibility of oversight of the far-flung operations of today's financial supermarkets. Indeed, I would argue that the size and breath of today's institutions makes them not only impossible to supervise but almost impossible to manage except in the fantasy of some egomaniac's mind (a few come to mind who shall remain nameless) but who have been exposed by recent events.
Mores have changed as well. In my time there was of course an awareness that we and the supervisor were on different sides but there was civility about it: it calls to mind a conversation with a friend, a very senior member of the Metropolitan Police in London. Ray said that in the old days, if you caught a villain in the act it was, “Right, fair nick, Gov,” and you took him off to the local jail. Today, says Ray, be prepared for a fight, a knife or a gun.
Different times in our business as well and although I hate to say it, my old shop was at the cutting edge in the growth of the lack of civility which, existing today, makes the supervision task even more impossible. It's a war out there with a very clear view within the industry as to who are the bad guys.
Consider as well the change in the nature of the business, in the players and in the nature of the competition. In my time, bankers took deposits and made loans. Investment banks, on the other hand, did other things. Today, there is no distinction between the two; indeed, the latter no longer exists in any meaningful way. The melding of the two cultures (and the cultures were VERY different) has created problems unforeseen at the time of deregulation. Before, institutions competed among themselves: today, institutions compete within themselves—the “commercial” bankers vs. the “investment” bankers, brought together in the unholy alliance of many of the mergers we have seen with the prize being amounts of remuneration never before envisioned.
There is an incredible drive to “innovate” simply to keep one's self ahead of one's competition-
whether internal or external-which has resulted in the creation of an vast number of complex and opaque financial instruments all designed to enable what is often financial results which are later proven to be unnecessary or untested or unreal. Unintelligent people were not employed in this exercise: indeed, the “Valley of the Quants” existed in many institutions—extraordinarily bright, highly educated individuals—but not individuals brought up in the mores of the past where the client generally came first and, as the words above the old Stock Exchange in London stated, “My word is my bond.”
They were not short on hubris either. Indeed, their confidence in their products was overwhelming. The only problem was that understanding the product...and by extension the risk related thereto was far beyond the capacity of ordinary men. As I have told you, I once expressed the “Average Intelligent Man” theory of risk; if an average intelligent man couldn't understand it, it was to much. I was nearly fired for my efforts. But that did not stop internal risk managers from expressing their understanding of the risks being taken (they do not lack hubris either) and elaborate and highly sophisticated profiles being drawn up at every major institution in the world and being followed to the letter in the internal monitoring of risk. Thus was born structured products and there is where it went all wrong.
Into this comes bravely the representatives of the oversight bodies of the world who are expected to monitor the nature of, and the extent of the risk being taken by the institutions to which they are assigned. Few, I suspect, have on their c.v. a Ph.D in mathematics from M.I.T. It is an impossible task so what they do is to approach the creators of the products and are told that they have proven the variation in result is no more than two standard deviations from the norm and therefor, the risk is quantified at x. They are happy. Mind you, in a global institution, risk is being taken in every major (and minor) financial center in the world. Unquantifiable risk in certain instances such as credit default swaps (which are among the simplest). I sit here in the fly-over zone viewing this and have become convinced that I should have retired to Bedlam. There is more sanity there than for the regulatory authorities around the world to believe that they knew the state of their financial institutions.
But there was always the chance that the quants were completely correct. What truly amazes me is that there was ample evidence to the contrary. Ten years ago LTCM was wrecked by the very same kind of reasoning and there it was proven that within a very short period of time the foundation of every risk theory in existence—the existence of a functioning market—could disappear. I am hardly in a position to know for certain but it appears to me that the only difference in ten years is the velocity at which catastrophe can occur. If there is no historical perspective in the monitoring of financial institutions, there is no point to the exercise. A further case in point: the financial state of Eastern Europe and the causes thereof is NO DIFFERENT that the sovereign meltdowns that we have witnessed in our business lifetimes. Remarkable.
To this point, supervision has always been more of an exercise in locking the barn door rather than the preservation of the herd. The situation is even more dire today. I suspect that unlike the past when an examiner could look for loan performance, concentration and total exposure, WHAT to look for today is basically unknown. You do not possess enough examiners of sufficient background, training and education to possible carry out the oversight tasks assigned to you. As to a solution, allow me to digress for a moment.
The tragedy of the past year is that we have witnessed another example of unintended consequences. For years banks have made loans and syndicated substantial portions thereof, but for many of those years it was somewhat of an unwritten rule that the originating bank maintain a portion of the loan in its own portfolio for servicing purposes and in order to give comfort to smaller institutions who were participants. For a variety of reasons, that practice, which had many benefits, disappeared and with the explosion of securitization and the expansion of a vast number of different institutions playing the role of investors, the practice of maintaining “some skin in the game” has all but disappeared. We now have pure originators and pure purchasers. In addition, the change in accounting requiring a “mark to market” treatment of practically all assets has made it imperative that all assets created be distributed as quickly as possible. I shall not discuss the abject stupidity in my view of requiring a asset with a conceived life of 30 years to be marked to a market that may disappear overnight, but it is important to understand that faced with the knowledge that you are not going to own it at the end of the day human nature will undoubtably suggest to an originator that getting the deal done is somewhat more important than getting it done RIGHT. After all, as the risk of owning it is only two standard deviations (or some such calculation) so who cares. Makes sense does it? It short, in an attempt to create “transparency” a stake was driven in to the weakly beating heart of credit culture.
But of course we have the rating agencies. They have, throughout this exercise been given a total pass and in my view that is outrageous. But that is not the subject of this paper and I shall return from this digression with the simple thought that a public execution, in the words of Rousseau often is useful, “Pour l'encouragement des autres.”
At the risk of understatement, the future is dismal. From conversations I have had the state of supervision has not progressed much further than the time when I was active, not because of a lack of dedication but because of a lack of trained people in adequate numbers to deal with an industry of far greater complexity in both instruments and business lines. Further, it is my understanding that the cooperation between various agencies charged with the same or overlapping responsibilities has not improved; it remains poor. Unfortunately, from my standpoint, government involvement is bound to be far more intrusive and this will only make things worse as throughout these past few months politics has shown to be at it's most dangerous when aligned with ignorance.
One thing that can happen, however, with government help is the creation of about the only thing that I can see as being useful and that is a financial Executive Service Corporation. Unless you are inside a financial corporation you simply do not know what is really occurring and no number of examiners can be parachuted in to fulfill an oversight mission. For many years, the Bank of England placed a senior retired from on of the Clearers into every new bank in London to monitor best practices. It was a different time of course but it was useful. I believe we need this type of oversight today and I suggest two (out of I am sure many other) thoughts:
1.1.A form of Executive Board of oversight with whom management would be directed to consult on the nature, form and extent of risk. The Board would be appointed by the appropriate oversight institution and report to the same.
1.2.A “Bank of England” executive, or executive, but not a retired banker but a banker seconded from a competitor for a period of time to oversee credit activities deemed at risk by the overseer. The individual or individuals would continue to be paid by the 'lending” institution but would have no contact with their employer and would report to the oversight insight institution in a manner to be agreed.
I rather like #2 as it is deliciously nasty but if one stops to think it might well be the most effective method available given the amount or resources at your disposal. It also, to a degree, leaves the oversight within the system and places a very high degree of cooperation between not only yourselves and you “clients” but insures that the oversight is performed by people who know what they are doing and who for what they should be looking. Hope this helps in some small way. Sorry for the “vent” but it felt good.
Charlie
Nothing proposed over the past few weeks has changed my view as of the state of play to any great degree. The issues have been politicized and beaurocracy has triumphed over reason and motion has once again been confused with progress. Weekend reading. Send me your thoughts. See you on Monday.
No comments:
Post a Comment