Broken Business Models (1)

Several recent reports and discussions have shed some interesting light on parts of the dilemma facing the banking industry.   The IBM report "Fit, focused and ready to fight" released in December 2009 is kind of humorous if you compare the title of the report to the content.  Ostensibly about what it will take for banks to get competitive, a careful read would lead one to the conclusion that, as currently structured, the banks are toast.  The core concept, represented as "Too Complex to Thrive", or "TCTT" has evoked positive responses from some of my colleagues in the industry, as capturing the heart of the matter in a spiffy new acronym.  The following chart seems to summarize the issue:

(You'll probably have to click on the chart to be able to read it, depending on your browser settings.)

Summarizing, this is trying to say that, in order to get back to the level of profitability that the banks have become used to in the last 5-10 years, they have to cut costs by roughly 40%.

Oops...

Initial Reactions to the new Basel Committee Recommendations

I'm hearing some of the first reactions to the new rules posted by the Basel Committee last week. These basically tell bankers what the rules are, and specifically how much capital they have to hold in reserve against losses in their lending and trading activities. Quite a few folks have made the argument that the last set of rules, which assumed that bankers were rational and responsible, didn't work. Don't think there's much question about that.

Here's some interesting posts and news articles I've come across so far:

Sent in by a London colleague -- a blog report by the BBC's business editor with some comments from readers across the pond ...

A story in Friday's Financial Times had a couple of interesting quotes:

Joachim Müller, banking analyst at Cheuvreux, part of Crédit Agricole, said: “They are very harsh on the definition side but they are more moderate on the implementation side because they allow for phasing in. It is a good balance between strict reg-ulation and allowing for growth.”

The Nomura banking analysts also took heart from the schedule, writing: “We feel that the Basel committee has a proposed set of rules that are very stringent in the first reading but the caveats on timeline and grandfathering means that the final proposals are likely to be watered down.”

Really gotta love the way in which certain language translations allow things to come through in ways that a native speaker might think twice about ... In Hong Kong in 2008 I heard a senior official at an Exchange talking about how they viewed one part of their business as a "cash cow to be milked". Had also heard the term used by another non-english speaker use the term "cash cow" in front of his customers the prior year in the States.

The full Basel Committee draft is here.

More on this later, after we've had a chance to dig into the details a bit ...

Tell us how you really feel, Mr. Volker

Paul Volker really laid it out there at the recent Wall Street Journal Future of Finance Initiative in the UK. A couple of the choicer quotes:

Every day I hear financial leaders saying that they are necessary and desirable, they are wonderful and they are God's work. Has there been one financial leader to stand out and say that maybe this is excessive and that maybe we should get together privately to think about some restraint? I hear about these wonderful innovations in the financial markets and they sure as hell need a lot of innovation. I can tell you of two - Credit Default Swaps and CDOs - which took us right to the brink of disaster: were they wonderful innovations that we want to create more of? You want boards of directors to be informed about all of these innovative new products and to understand them but I do not know what boards of directors you are talking about. I have been on boards of directors and the chances that they are going to understand these products that you are dishing out or that you are going to want to explain it to them, quite frankly, is nil. I mean wake up, gentlemen - I can only say that your response is inadequate.

Emphasis added, of course ... full quote is here.  Very fun reading. But further on he gets specific about where the core of the problem is -- a total lack of innovation in things that matter.

Accounting (1)

The past week has brought a plethora of news stories related to accounting rules.  FASB announced last week that it was thinking that regulators should “decouple” their analysis, especially when it comes to capital accounting, from the reporting provided to investors.  The CFA Institute, for one, isn’t mincing words about how they feel –

“The purpose of financial reporting is to convey the results of the company,” said Sandra Peters, the director of financial reporting for the CFA Institute, an investor advocacy group. “It is not to assure the company stays around.” 

It’s nice to know that someone has a clear picture of what they expect from financial reporting.  But it’s become increasingly clear over the past year that the name of the game for financial reporting is just that – a game.  Exhibit A would be the SPV’s that were classified as “bankruptcy remote” – there’s a non-operative term if we’ve ever heard one.  (A “no-op” for the computer geeks out there). 
In addition to SPVs and related nonsense, some of the discussion refers to that perennial favorite, “Mark to Market” vs. “Fair Value”.  There are so many problems with this whole issue that one almost doesn’t know where to start.  The two that leap to the front, however, are:

• “Fair value” accounting means that the market isn’t correctly valuing the asset.  That may be the case, but if it is, please don’t claim to be a believer in efficient markets with the one exception being the assets on your balance sheet.

• “Mark to Market” for thinly traded securities has always been as much of an art as a science, but the proliferation of securitized instruments based on heterogeneous pools of underlying assets has happened too fast for those practicing the art (or the business processes) to do much more than scramble behind, trying to keep up.

A recent NY Times article lightly touches on the biggest issue – capital arbitrage – which is behind what I consider to be the true Naked Emperor here.  Capital arbitrage is the term used to describe the manipulation of a bank’s balance sheet through securities issuance and the creation of various off-balance sheet entities so as to enable a bank to evade specific regulatory capital requirements.  There are echoes here of the “principles-based” vs. “rules-based” regulatory debate that’s gone on between the US and European cognoscenti for the past couple of decades, but to my mind the evidence points pretty strongly to this discussion being irrelevant in practice.

Great Cartoon

In today's Washington Post -- Op Ed.

Ratings Schmatings

I was at legal conference this week to hear the lawyers’ view of the current state of financial legislation before Congress, legislation attempting to address the origins of the credit crisis. As a member of the industry now – and a non-practicing lawyer – it was interesting to hear the lawyers’ view of things. But what took my thoughts back from musing about the cocktail reception post-event was the last question of the evening (after a very lengthy Powerpoint overview presentation of the bills before Congress and their expected impact and implications for banks). The question came from a lawyer who wanted to get a better handle on what impact the legislation around the credit agencies would have on his clients.

But, honestly, there isn’t much legislation being considered seriously that would do anything to change the way the rating agencies do their business today. (And the answer from the front of the room was “wait and see.”) Nonetheless, the lawyers worry about proposed provisions for increased transparency and publication of their due diligence (though the lawyers can’t really be worrying – it only means more work and more dollars in their pockets). (See Evaluating Risk If Congress Fails to Act on Ratings Agency Reform, by Carol E. Curtis, Securities Industry News, 12/7/09)

The SEC has oversight over the agencies through the Credit Rating Agency Reform Act of 2006, but the Commission’s oversight is in the same vein that it oversees broker-dealers, public companies and investment companies. They require disclosure and policies and procedures to enforce the securities laws. But that doesn’t fix what is broken.

It’s been pretty well documented that throughout the mortgage boom that became a bust that the securitized mortgage products were being rated by agencies well into the pockets of the investment banks that paid them to rate the securities. Due diligence was non-existent – it’s not even clear that the rating agency personnel understood the nature of the products they were rating.

I think the first Naked Emperor here is the whole ratings agency process. The independent third party assessment that these companies are supposedly providing to the investment public is a sham. It’s not worth much, anyway, as we know now. But it’s a requirement by every exchange and regulator and parties to a security issuance. It’s time to rethink this process from the ground up.

Further, the current system provides monopoly status to three firms that have no incentives whatsoever to bite the hands that feed them. It sets up a whole set of principal-agency conflicts in the securities markets that we are just now identifying and beginning to discuss.

The second Naked Emperor exposed here is the apparent inability of the legislative and regulatory bodies to even address the situation – it’s completely broken, everyone knows it – and, apparently, we’re not going to do anything about it.

Does Anyone Else See This As A Problem?

Nomi Prins has gone through the SEC filings of three major banks, Bank of America, Citigroup and Wells Fargo. (The Daily Beast, "Worse Than Enron?" by Nomi Prins, 12/1/09) She’s been looking to see how much of the banks’ revenues are derived from trading (taking a risk) vs. other businesses. She’s found it difficult to get an answer, or at least she’s not finding what she thinks she should be finding. She accuses the banks of striving for opaqueness, rather than being transparent about how they are making money. She suspects that they are moving money around their balance sheets to make it appear like they are making a profit. She invokes the Enron scandal, where people didn’t understand how the company was making money. And in fact, it wasn’t.

“With taxpayers now on the hook, we need an objective, consistent evaluation of bank balance sheets complete with probing questions about trading and speculative revenues, allowing for comparisons across the banking industry. This lack of transparency leaves room to misrepresent risk and trading revenue.”

She may be right. (Not holding my breath here, waiting for companies to embrace transparency). However, the companies are (probably) faithfully following updated accounting rules, which the post-Enron changes were meant to address. She hits on something that I think is more revealing, however. She looks through the BOA/ML merged filings and is unable to find a breakout of trading account profits, which jumped from a $6 billion loss in 2008 to an almost $14 billion gain in 2009. Value at Risk (VaR) doubled between 2008 and 2009. “If I was CEO, I’d want to see this critical comparison on my own merged company filing.” She questions whether management has any idea of what is going on in their company.