Posts Tagged ‘Banking’
Thursday, July 21st, 2011
Smeal’s John Liechty testified before the U.S. House Committee on Financial Services, Subcommittee on Oversight and Investigations, last week regarding the newly formed federal Office of Financial Research (OFR). The OFR, which was formed last year with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, is charged with collecting data on the financial system to allow another government entity, the Financial Services Oversight Council, to effectively monitor its stability and ward off potential threats. The agency is the brainchild of Liechty, who spent 18 months gathering industry support and meeting with members of Congress to push its establishment.
According to The Hill‘s On the Money blog, the banking subcommittee wanted to learn “how the new Office of Financial Research plans to keep mounds of financial data safe from hackers. … With hackers always looming over the horizon, Republicans want to know what the office—which they charge lacks proper congressional oversight—is doing to keep that information in the right hands.”
In his prepared testimony, Liechty explained the origins of the OFR and why he believes its a necessary component to the country’s financial security. He opened with an outline of his three main points:
Financial stability requires transparency – The ability for regulators to both see through the counterparty network and the ability to see through asset backed, financial products to the underlying assets is an important fundamental component that is needed in order to be able to monitor the stability of the financial system. Transparency will require universally accepted identifiers and reporting standards—in essence it will require banks to get their back-offices in order. The investments required to improve transparency will not only result in improved macro-prudential regulation; they will result in improved risk management and substantial operational savings for the industry.
We face a significant scientific task – Not only do we not have the data in place, we have not done the science needed to understand system-wide risks to the financial system. In many ways, financial regulators are like the weather services, before the National Oceanic and Atmospheric Administration (NOAA) was established. NOAA was given the mandate to i) collect new data, ii) develop new models for identifying extreme events and improving weather forecasts, and iii) conduct the science necessary to understand the weather systems and build these next generation models. The Financial Services Oversight Council (FSOC) and the Office of Financial Research face similar challenges and have been given a similar mandate.
We cannot afford to fail – We live in a leveraged economy where the resilience and growth potential of the economy depends on having both an innovative and stable financial system. Innovation often leads to instability, unless the appropriate infrastructure is in place to provide stability. The FSOC and OFR offer a way forward to build this infrastructure. The risk that we live with, if we fail to have the proper oversight to provide a stable system, is not just the devastating economic impact that would come from another financial crisis of the magnitude of the 2008 crisis, but more importantly the political reality that will follow. If we can’t get this right and there is another crisis, then there is a very real risk that the political response may result in a response that adversly affects the finanical market’s ability to innovate.
You can view the entire hearing on the House banking committee’s website. For more on the Office of Financial Research and Liechty’s role in its creation, check out this Smeal Report feature from late last year.
Wednesday, March 2nd, 2011
In today’s Philadelphia Inquirer, Smeal’s J. Edward Ketz and Anthony H. Catanach Jr. of Villanova argue that there are too many banks in the United States offering indistinguishable products to their customers. These banks, they say, are under enormous pressure to raise their margins, which eventually leads many of them down the road of questionable loan activities. Their solution:
First, reduce the number of financial institutions: 15,000 institutions simply cannot all make money by making loans funded by deposits to customers who tolerate them simply because they need check and processing services. Is a bank on every corner really necessary? As these regulated institutions struggle to meet performance targets in a talent-poor, over-banked industry, is it any wonder that they often turn to questionable, high-yield investments fueled by volatile, unstable funding sources? A banking glut forces institutions to compete aggressively for a fixed pool of high-quality investments, loans, and talent, meaning some banks will be forced to accept lower quality assets and personnel to operate.
Banking regulators can initiate this industry contraction by denying new charters for federally-insured financial institutions. Next, they should set a ceiling on the number of financial institutions significantly below current levels. This target should be aggressively pursued by closing and/or merging institutions that have historically been marginal performers. Finally, imposing a federal income tax on credit unions also will eliminate many poorly performing institutions that exist only because of their federally subsidized cost advantage.
Second, those who monitor financial institutions (accountants, auditors, and regulators) must reaffirm their responsibility to the investing public. Financial watchdogs must think more strategically and recognize that an over-banked industry leads to poor banking decisions and greater risks.
Monday, January 24th, 2011
Almost 2.9 million properties received foreclosure filings in the United States in 2010, despite federal programs like the Making Home Affordable Program, which allows some borrowers to modify or refinance their mortgages. According to Smeal’s Brent Ambrose, these programs are failing to stem the foreclosure crisis because they focus strictly on borrower payment-to-income ratios, and, as a result, do not remove the incentive to default for long.
“The programs rolled out by U.S. regulatory authorities will not significantly reduce defaults unless house prices rapidly stabilize or go up,” Ambrose says. “The only way to truly reduce the default probability is to either reset the mortgage balance to a loan-to-value ratio that is lower than 100 percent, probably around 80 percent, or have frequent, predictable balance resets.”
Yes, balance resets. Ambrose and his colleague Richard Buttimer, a professor in the Belk College of Business at the University of North Carolina at Charlotte, have proposed a new type of mortgage contract that automatically resets the balance and the monthly payment based on the mortgaged home’s market value. They call the new mortgage contract the “adjustable balance mortgage” and contend that it reduces the economic incentive to default while costing about the same as a typical fixed-rate mortgage. Under real-world conditions, including the presence of unrecoverable default transaction costs to the lender, this new mortgage contract is better for both lenders and borrowers.
It works like this: At origination, the adjustable balance mortgage resembles a fixed-rate mortgage—it has a fixed contract rate and is fully amortizing. From that point on, at fixed, preset intervals, the value of the house would be determined based on changes to a local house price index. If the house value is found to be lower than the originally scheduled balance for that date, the loan balance is set equal to the house value, and the monthly payment is recalculated based on this new value. If the house retains its initial value or increases in value, then the loan balance and payments remain unchanged, just as in a standard fixed-rate mortgage.
For example, if a homeowner was found to owe more than the current market value of her home at one of the predetermined quarterly adjustment dates, then her balance would reset to the current market value and her monthly payment would be lowered as a result. At the next reset interval, if the market had recovered and the house was now worth more than what the homeowner owes, the mortgage balance reverts back to the originally scheduled balance, resulting in a higher monthly payment but one that does not exceed the payment specified at origination.
Read more about this new mortgage contract in Ambrose and Buttimer’s paper, “The Adjustable Balance Mortgage: Reducing the Value of the Put,” scheduled for publication in a forthcoming issue of Real Estate Economics.
Friday, May 14th, 2010
“The Senate approved a provision that would thrust the government into the process of determining who rates complex bond deals, in a move to end alleged conflicts of interest blamed by some for worsening the financial crisis,” The Wall Street Journal reports. “The amendment aims to resolve what’s considered one of the thorniest problems in financial markets: Bond issuers choose ratings agencies and pay for ratings, meaning raters’ revenues depend on the very firms whose bonds they are asked to judge. Under the new provision, the Securities and Exchange Commission would instead establish and oversee a powerful credit-rating board that would act as a middleman between issuers seeking ratings and the rating agencies.”
Years ago, Smeal’s J. Edward Ketz proposed a much simpler way to remedy this conflict of interest in a manner that doesn’t establish an entirely new regulatory scheme. From a 2008 Ketz column on SmartPros.com:
The fundamental problem with credit ratings is the conflict of interest caused by the issuer’s paying the rating agency. Because such a conflict of interest exists, various potential problems surface since employees—in particular managers and analysts—know how they are compensated. Even if the credit rating agency is smart enough to avoid direct linkages between compensation and ratings, there nevertheless is an association. All employees know that their continued employment, their salaries, and their promotions depend upon their contributions to the real business of the organization.
… The real solution is simple and existed prior to 1970. Require the credit rating agencies to charge the users of its information instead of charging those they investigate. The conflict of interest is completely removed. Not only that, but you reinstate a market mechanism: If the users really want the information, they will pay for it. And if the market has sufficient competition, the price will be the value of the information.
Tuesday, February 2nd, 2010
“President Obama’s proposals to tax and curb the activities of Wall Street have thrown an unpredictable element into the debate over financial regulatory reform,” The New York Times reports. “They also have touched off an intensive new round of lobbying and raised questions in Congress over whether his plan will add urgency or merely bog things down.”
Before we have “sensible, comprehensive financial reform” of the business community, I think a better place to begin is with Washington. Reform is vacuous unless it includes a reform of the reformers. It is clear that various senators and representatives were and are shills for Fannie Mae and Freddie Mac and other financial institutions. I don’t know how we reduce the money-and-power linkage between Wall Street and Constitution Avenue, but the folks on Constitution Avenue are hypocrites to regulate Wall Street on the one hand and accept donations and other perquisites with the other.
Also important is the misuse of the budget and financial reporting by Congress. Anybody who does not have the will power to balance a budget has no business in Washington. In today’s world, taxation with representation is no better than yesteryear’s taxation without representation, especially since so much of it is negotiated behind closed doors.
One suggestion—how about an audited set of consolidated financial statements for the U.S. government, including the reporting of all off-balance sheet liabilities? If this was done, I think the general public would be shocked to see the tens of trillions of dollars by which this country is indebted. And for which Congress is responsible—which is why this likely will never be done.
Wednesday, January 20th, 2010
President Obama last week unveiled his plan to recoup federal bailout funds with a new tax on the nation’s biggest banks. According to Smeal’s Brian Davis, the tax is little more than an acknowledgement of the populist anger directed toward big banks:
When looking at President Obama’s bank tax, it’s important to consider the following four statistics:
1) Unemployment Rate: 10%. (Bureau of Labor Statistics)
2) Lending and Credit: As of Dec. 23, the latest date for which data are available from the Federal Reserve, bank lending, at nearly $6.7 trillion, was down $100 billion from the month before. In the past year, the volume of loans outstanding by banks in the United States has fallen by more than $500 billion. (Time.com)
3) Wall Street Bonus Pay: The top 38 U.S. banks and securities firms are on pace to pay their people a record total sum of $145 billion for 2009. (The Wall Street Journal)
4) Obama Approval Rate: 50% vs. 62% in the prior year. (CBS News)
Clearly, the tension has been building. “I did not run for office to be helping out a bunch of fat-cat bankers,” President Obama assured Main Street voters again and again in speeches defending the Troubled Asset Relief Program (TARP). Repeatedly, administration officials warned bankers about exorbitant compensation packages and anemic lending volume. Jaw-boning was clearly not working.
The new fee applies to institution with assets of more than $50 billion. Each will pay 0.15 percent of its eligible liabilities, measured as total assets minus capital and deposits. Investment banks with few deposits, such as Goldman Sachs and Morgan Stanley, will be hit much harder than commercial banks, so the fee is being sold as a tax on the riskier asset positions of the trading and hedging activities of larger investment banks. (These are also the institutions paying out the largest compensation packages.)
The fee will last a minimum of ten years—longer if it is necessary to recoup the full cost of TARP. The Treasury expects the fee to raise $90 billion over that period; however, conservative estimates peg TARP losses at $120 billion—perhaps pushing the application of the fee past 2013.
In examining the effects of this new tax, it seems little more than a populist “tip of the cap” to Main Street voters seething over Wall Street bailouts. First, relative to total bank earnings, the fee is minuscule. Upon the fee announcement, bank stocks did not react, as investors seemingly shrugged off the effect of such a tax on bank earnings. Second, it is fairly certain that banks will be able to recoup any negative tax incidence by passing higher fees onto consumers—resulting in unintended consequences. Third, if the intention of the fee is to force banks to internalize the costs of risk-taking behavior, again, other bank regulation initiatives involving the Federal Reserve and the FDIC seem more effective and appropriate.
Friday, November 20th, 2009
“The attorney general of Ohio sued the country’s largest credit rating agencies on Friday, alleging that they had cost state retirement funds some $457 million by approving high-risk Wall Street securities that went bust in the financial collapse,” The New York Times reports. The paper quotes Ohio Attorney General Richard Cordray as saying: “We believe that the credit rating agencies, in exchange for fees, departed from their objective, neutral role as arbiters. At minimum, they were aiding and abetting misconduct by issuers.”
Moody’s and the other agencies make money by charging the business entities who are issuing debt. It doesn’t take a genius to see the conflict of interest. The credit agencies lean on the issuer for more money or they risk receiving a poor rating. Payment not only entitles one to a good rating, but also it gives one the privilege of not receiving a downgrade unless bad news becomes public.
… Policy-makers can reduce the problems by reducing the very real conflict of interests that perniciously raises its ugly head from time to time. The solution is to prohibit credit rating agencies to receive any funds from the issuers. If the ratings have any merit, then investors will be willing to pay for them.
Wednesday, October 21st, 2009
The New York Times reports today that former Fed Chair Paul Volcker’s call to forbid commercial banks from mixing with investment banks is falling on deaf ears within the Obama administration. Volcker, head of the president’s Economic Recovery Advisory Board, believes keeping banks from owning and trading securities will keep them out of the trouble they have experienced in the current recession.
According to Smeal’s Jean Helwege, Volcker’s plan would likely make future economic crises less costly than this most recent one, however, it won’t keep the Fed from spending taxpayer dollars to bail out poorly run banks in the future.
More from Helwege:
Paul Volcker, former Federal Reserve chairman and adviser to President Obama, recommends that we go back to the good old days when commercial banks and investment banks were kept separate. The logic now, as it was in the 1930s when Glass-Steagall was enacted, is that investment banking is too risky a business to mix with consumer deposits. In a speech earlier this fall Volcker stated, “I do not think it reasonable that public money—taxpayer money—be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial banking organization.” Volcker recognizes that his views are hardly “progressive,” noting that “people say I’m old-fashioned and banks can no longer be separated from nonbank activity.” But he points out, “That argument brought us to where we are today.”
The $64,000 question is whether we would be where we are today had we pursued different regulatory policies leading up to this recession. Whatever the policies regarding mergers of banks and investment houses, we would have experienced a housing bubble and it would still have popped, bringing massive losses to homeowners across the nation and a retrenchment in homebuilding that would last years. Fannie Mae and Freddie Mac would still be in conservatorship, having overleveraged themselves to peddle the American dream of home ownership. Investors would still have lost money on mortgage-backed securities built on subprime mortgages. Those losses would still have led to concerns that safer mortgages might default, expanding the breadth of losses in the MBS market. We would be in a deep recession as a result of the housing downturn regardless of whether banking activities are segregated.
However, Volcker’s arguments are more geared toward preventing the next near-Great Depression and redefining the policy responses to such crises. If we still had Glass-Steagall, we would not have seen the merger of JPMorgan Chase (a bank) with Bear Stearns (an investment bank) in 2008, which might have prevented people from expecting a similar deal with Lehman and some other commercial bank and thus the fallout when Lehman was dropped like a stone from the list of firms “too big to fail.” If we still had Glass-Steagall, Goldman would never have decided to convert to a bank holding company and potentially would not have received the largesse it did. Nor would Bank of America have had its arm twisted into acquiring Merrill Lynch. Bringing back Glass-Steagall might bring us back to the days of more narrowly defined policy responses by the Federal Reserve. And it might mean that the next crisis will not be worse than today’s now that the investment banks are so strongly encased in the regulatory womb of the Federal Reserve.
Reinstating Glass-Steagall is a simple response to a complex issue. While simple may be all we can swallow, it remains the case that the Federal Reserve has not been successful in striking a balance between helping out the economy and condoning bad behavior by financial firms. The Fed identified AIG as strong enough to get a loan (i.e., the Fed was sure it would get paid back) and Lehman as incapable of repaying new funds. It deemed CIT too unimportant to deserve aid but was willing to help out the entire money market mutual fund industry. The Fed’s willingness to extend its hand to all manner of poorly run firms is a concern and Volcker’s efforts to rein in this independent agency may help, but unfortunately it’s more likely that the Fed will find another way to expand its role as lender of last resort regardless of whether we revert to Glass-Steagall.
Friday, September 18th, 2009
Speaking on Wall Street this week, President Obama renewed his call for a Consumer Financial Protection Agency to “make certain that consumers get information that is clear and concise, and to prevent the worst kinds of abuses” by financial institutions. Smeal’s Edward Ketz, in a forthcoming column, says this proposed new regulatory agency amounts to little more than politics:
What Obama is really trying to do is give American voters the impression that he is in charge, that he cares about them, and that he is improving matters so that the chances of another financial meltdown is infinitesimal. It is political legerdemain.
As long as managers have perverse incentives to cheat investors and as long as the SEC goes after only the little guys and ignores managers at Enron, WorldCom, Madoff Investments Securities, and GE, nothing is going to change. If the Congress and if the president want to improve matters—and I have no idea if they really do—then they must change the set of incentives and disincentives. To effect real change, the system must punish managers and directors who lie and steal and cover it up with scandalous financial reporting.
More regulation might make society feel better, but that is just an indication that most Americans have little understanding of economics. They will continue to lose in the stock markets until they insist elected officials do something substantive.
My fear is that Democrats will rally around Obama while Republicans vilify him, similar to the previous administration when Republicans rallied around Bush and Democrats denigrated him. There is too much partisanship in this country and not enough rational analysis. Americans need to understand that both presidents have failed us by supporting new legislation and by crippling better enforcement. (For whatever it is worth, this is one of the reasons I am an Independent.)
Tuesday, September 1st, 2009
Rep. Ron Paul told The Wall Street Journal that Rep. Barney Frank, chairman of the House Financial Services Committee, backs Paul’s legislation that would give Congress new authority to audit the monetary policy operations of the Federal Reserve.
Smeal’s Jean Helwege argues that the monetary policy work of the Fed should be independent from second-guessing by Congress, however, she says that Fed Chairman Ben Bernanke needs to maintain the Fed’s impartiality and put an end to its picking and choosing winners and losers in the capital markets:
Rep. Ron Paul has been pushing to rein in the Federal Reserve and has proposed a bill to give the General Accounting Office (GAO) powers to audit it. The Fed is already subject to audit by the GAO when it comes to consumer protection laws and banking regulation, but not with regard to monetary policy. This bill would change that situation, although not so dramatically that the Fed would lose its independence (it’s not clear what the penalty is for any agency failing to live up to a GAO audit, but the Fed would surely get away with even more than the typical government group). Recently, Rep. Barney Frank, who surely is as far along the spectrum away from Ron Paul as any politician can get, voiced support for expanding the GAO’s powers to more thoroughly audit the Fed.
The Fed has pumped billions into financially distressed firms in the last year as part of its effort to revive the economy. These actions clearly fall under the category of monetary policy, not banking regulation, even though most of the money went to banks. Because the Fed traditionally sends more than 95 percent of its revenues to the U.S. government (i.e., it is a source of revenue on the U.S. Treasury budget), any money lost on firms like AIG is truly money spent by the U.S. taxpayer. For that reason, Ron Paul would like to see less of it spent in ways that seem wasteful and bad for the economy in the long run. I suspect that Barney Frank is on board with the plan because he wants some reassurance that the money going to AIG is not being paid out in the form of bonuses to the higher-ups there.
In contrast, Fed Chair Ben Bernanke would argue that, as part of monetary policy, the Fed, through the FOMC, should be allowed to pursue whatever policies are most helpful toward maintaining price stability and economic growth. He undoubtedly would argue that whatever waste and distaste is associated with AIG, the payoff to society is worth the relatively minor cost. Bernanke believes Americans should trust the Fed chairman to do what is best for the U.S. economy, even if some of it seems illogical or annoys those who want to punish the people who got us into this mess.
Bernanke is right to fight for Fed independence on monetary policy. Determining where the economy is at and how best to maintain low price inflation is a difficult job that is not made any easier by having the public or Congress second-guess the decisions that are ultimately made by the Fed. However, Bernanke’s form of monetary policy involves a tremendous amount of policy that essentially picks winners and losers in the capital markets. By choosing to bail out AIG and not bail out Lehman; by choosing to drag its feet with regard to GM and CIT but to propel Bear Stearns at lightning speed into the arms of JP Morgan Chase; and by choosing to slowly offer assistance at the discount window to insurers but to immediately open it up to investment banks are all decisions that most Americans would rather not leave to Ben Bernanke or any other Fed chairman. These decisions seem capricious and poorly justified in terms of monetary policy and this perception is not at all helped by the e-mails regarding the merger of Bank of America and Merrill Lynch. Either the Fed strictly maintains its independence and avoids bailing out specific institutions or it should expect the people ultimately footing the bill to take notice when several hundred billion dollars are showered on what appear to be worthless ventures.