They only lent to each via repo – a situation that now prevails. For small banks and building societies that don’t do this how safe is a deposit with a clearer? Can you still rely on being bailed out? Probably not………

In the new regulatory regime the FSA is requiring banks to put in place recovery and resolution plans. This is sensible. It means that there is an orderly demise and/or restructure of a failed bank. It protects those who need protection and reduces systemic risk. Importantly it protects the taxpayer. But what does the regulator say about unsecured debt?

Let’s look at consultation paper 06/11 published by the FSA in August last year:

“It must be possible for a firm to be resolved in such a way that ensures that shareholders and uninsured creditors bear appropriate losses as they would do in a normal insolvency, rather than benefitting from the immediate need to preserve financial stability or the continuation of essential services as they would do if the firm was bailed out”.

Assuming this proceeds (and there is no reason to think it won’t) large unsecured depositors and holders of bank issued senior debt in future can’t rely on being bailed out.

No wonder the big boys do repo.

More on this theme later.

In a world of increasing risk AA still looks attractive particularly if the market’s liquid. But if AA becomes a reality you have to ask yourself a few questions.

Will it stop there?

Can we draw a line in the sand or would the policy consequences of such action make the government unelectable?

Could the rating fall a notch further to A?

One key variable is economic growth. If the economy fires up things look much better. But putting this aside, what do the scenarios look like?

UK banks now hold substantial gilt liquidity buffers. If these ever need to be used as intended the resultant liquidation would run the risk of a disorderly gilt market. A risk that substantially increases as the UK credit rating deteriorates.

(Indeed I am not certain how Gilts qualify as buffer assets if the rating falls to single A).

Add to this the possibility that the Bank may need to reverse Quantitative Easing and the reality is that the policy decision will be stymied without much higher interest rates. This is a vicious circle as both public and private sectors end up with rising debt servicing costs.

If the UK gets downgraded be assured that much emphasis will be placed on playing down the importance of triple A. This entirely misses the point.

What you really need to consider is whether the line in the sand could be crossed. Will the government commit to a ratings floor? Unlikely. But if it doesn’t, market perception could be even more damaging than further credit migration.

The governance of banks and societies is heavily reliant on management information. This is normally produced monthly for the board meeting. The FSA has “suggested” that focus of this MI should shift from being backward looking to looking forward.

This is not an easy thing to do but it certainly has merits. However there is one glaringly weakness in the MI that NEDs get. It is monthly. It should be daily.

This is going to raise hackles. One I frequently encounter -”daily management is not my role that’s for the exec”.

Time is continuous. In a world where events unravel in hours knowing what’s what is part of governance. Daily access to a risk dashboard should be a prerequisite. It doesn’t have to take long but just show the main credit, market and liquidity positions. It also makes it a lot easier to follow trends. The technology is there and it’s secure so these’s no excuse.

After all you drive a car looking out of the windscreen not the rear view mirror.

Surprise then when I read a speech made on 11^th October 2011 by Andrew Bailey, Director of UK Banks & Building Societies at a APCIMS conference.

He was talking about the Prudential Regulation Authority (PRA) which will take up responsibility from the FSA on prudential supervision.

He asked a big question.

“…….do we understand sufficiently why we are undertaking this supervision?”

The answer was “no”.

This is a brave admission. Furthermore he went on to say.

“When I look at the Bank of England’s other public policy responsibility, monetary policy, I see a different state of affairs.  You can argue about whether you agree with the MPC’s decisions month by month, but what is undisputed is that the MPC has a very clear objective to achieve sustained low inflation and thereby contribute to stability of the economy……………………”

This was followed up by stating some objectives:

• A stable financial system
• Orderly failure of firms not a no failure regime
• Improved articulation of standards
• Counteracting the forward march of rule making
• Enhancing the role for audit and risk
• Improved confidence in solvency

What I don’t understand is, by this admission, since 1997 the FSA and now the PRA seems to have no clear remit about what it is supposed to be doing.

As the FSA is fond of reminding us this is surely a Board level responsibility. And it shows weaknesses in the way the regulator’s Board operates. There are clearly a lot of intelligent people in regulation. But the process just isn’t as efficient or as effective as it could be. How can you undertake your role of you don’t know what you are doing?

This reminded me of another piece I read entitled “Financial Regulation -Going Backwards” by Paul Killik (Killik & Co stockbrokers). He contends that the cost of regulation at over £5bn per annum is seven times more that the amount paid out in compensation. And asks, does regulation offer value?

After 13 years if the regulator can’t work out what it is supposed to be doing the answer is clearly no. Regulators and prudential authorities suffer the same difficulties as the rest of us, they make mistakes.

But unlike financial firms there seems to be no redress or sanction that applies to their senior management.

Things would be improved if this changed and yes it does matter because it costs you money.

But help is at hand there are three ways out:

1.  Orderly default. Lenders take a haircut. Borrowers get a level of debt that they can manage. The well known example is Latin America. It would take the banking system down again and recapitalization would be necessary. A forced transfer from taxpayers in surplus countries to those in deficit ones would ensue. It’s politically difficult.  But it works.

2. Inflation. Borrowers pay back with money that is worth less or should that be worthless? It misallocates resources, affects those on fixed incomes and easily gets out of hand. But it works

3. Repayment. Raising taxes and cutting government spending leads to surpluses. The cost is unemployment and social unrest. But it works.

So what are we doing?

In the UK the choice was made over two years ago. But you weren’t told.

Pledging to repay was intended to buy time. It’s what markets want to hear, it keeps borrowing rates low and is good for Gilts. But can we do it? The budget deficit continues to rise and discontent is manifest before the main cuts are made.

That’s why inflation is doing the heavy lifting. The 2% target has been continually missed by the Bank. Excuses have included:

• The wrong type of inflation because its imported. (Hasn’t accommodative monetary weakened the pound?)

• It’s the future inflation rate that matters, not the one today. (Incredible! Just how far forward are they looking?)

No wonder the government changes indexation from RPI to CPI. Do they know something you don’t?

So here’s the good news……

If you have on an interest only mortgage of £100,000 and inflation continues at 5%, then in real terms after 10 years you have just over £61,000 of debt.

the bad……

If the difference between after tax interest and inflation rates is 4% then £10,000 of savings will be worth little more than £6,700 after 10 years in real terms.

The value of your money is almost halved in value for a 7% difference. The chances are that with such extreme monetary policy being used bigger policy errors will creep in and will be very hard to contain.

and the ugly……..

If  Bank of England independence only lasted a short period of time the following statistics are salutary.

• RPI peaked in 1975 at 24.2%
• The low was in 2009 at -1.6%
• £1 in 1987 was only worth 43p in 2011
• From 1752 to 2001 the pound lost 99% of its purchasing power

Ronnie Reagan was right “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.”

Not that this bothers borrowers. The UK government just happens to be one of the largest.

1. Severe yet plausible: Can you justify the stresses being used? What are the core scenarios? How do they pan out and affect you?

2. Expect challenge: It’s easy to convince yourself but can you convince others?

3. Use hard data: Qualitative stresses work much better with quantitative support (and vice versa).

4. Going forwards: What does your buffer look like in the future? Are there any surprises?

5. Recalibrate regularly: After all markets don’t respect annual reviews.

6. Contingency funding: What are the scenarios and what can you do? (If possible quantify).

7.Where are the pinch points? Are there particular times in the year that create problems? Do concentration risks need dilution?

8. Stress costs money: Is it in your funds transfer pricing – does affect what you do?

9. Good news: Basel III – stress horizons, will 30 days replace 3 months?

One last thing.

Sense checking makes sense.

a. Deposit it all with Barclays?

b. Deposit it equally with Barclays, HSBC, Lloyds and RBS?

c. Deposit it in different amounts across ten counterparties?

d. None of the above?

This is a question I’ve been asked twice in the past week. So what’s the right answer?

That depends.

Do you believe in diversification? Diversification assumes that by spreading risk it is reduced. As a cornerstone in modern portfolio theory it sometimes works. But there is a problem when everything falls at once.

Do you believe in “too big to fail”? Many do. And that’s why counterparty lists have become smaller with large banks getting the lions share.

Do you believe in Warren Buffet? He has said that concentration reduces risk because you focus on looking at the investment more closely.

Do you believe in trust? Big banks don’t even trust each other. That’s why they are reluctant to place deposits without taking collateral. You may call this pawn broking – the technical term is repo.

Do you believe in ratings? A lot of people blame the agencies for failure but they still use the system to determine investment.

Do you believe in following the trend? Place it overnight at least (with luck) you get it back tomorrow.

Do you believe profit is the reward for risk? You are an outlier and probably not suited to banking in its current form.

In short there isn’t a right answer.

How profitable are you? How much capital do you have? How much risk do you want to take?

Place it all with Barclays and if you take a 50% haircut you will be finished. Try the big four, argue it’s safer and correlation will do the same thing. Try ten and there’s more risk of losing less. Try repo, that’s if you can get someone to play.

Perhaps you buy Gilts and nothing else. That’s one answer I got last week. Now here is the punch line.

A lot rides on chance and candidates in multiple choice tests can rely on Lady Luck. The only thing is that the adjudicator knows this too. It’s not so much the answer you give but the workings you show that get you marks.

Using your projections it to see what planned growth does to planned liquidity and capital is helpful. It shows up over extension before it happens and it may prevent failure. In this respect looking forward is a helpful way of reassessing the merits of your plans.

However if the best brains at the Bank of England can’t accurately predict the forward inflation rate what hope is there for mere mortals getting their projections right?

The increased level of economic uncertainty means that having faith in any plan beyond a one year horizon must be described as folly and it is here that the problem arises.

There is a danger that if all the forward indicators are green there’s no need to look any further. If they are red there’s the temptation to disregard them. After all, things are out of your control and surely it will all come back on track further down the road. Does this sound familiar?

The fact is looking forwards is helpful but its use tails off at an exponential rate as you go out in time.

It would be a pity if forward looking risk inadvertently makes us forget that managing a business requires that you have the ability to respond to changing events – many of which are completely unpredictable today let alone tomorrow – as they unfold.

It’s now time to ask whether the buffer restrictions in their current form are desirable. The widespread use of holding Gilts by banks may under certain scenarios destabilise the system.

If you recall the FSA uses three liquidity stresses – idiosyncratic, market wide and a combination. In a market wide stress where UK banks seek collectively to sell or repo their Gilt holdings isn’t a disorderly market the probable outcome?

If this in itself isn’t enough to review what’s held in bank buffers is not the intertwined nature of UK banking and the UK Government unhealthy?

Rapid liquidation of Gilts by UK banks could disrupt Gilt issuance. Failure to curb public debt could also increase yields leading in some cases to losses on buffer assets.

You will see I haven’t addressed the cost of holding the buffer but when you buy insurance you expect it to cover your risk not potentially add to it.

On balance the buffer requirements have hard wired additional instability into the system when it is under extreme stress. That obviously wasn’t the intention but now times have moved so should the rules. One problem remains, who would buy all those Gilts?