The financial crisis had many perpetrators but now this is about to change. In future there will be one that gets blamed. Since 2007 we have been trying to find out, with little success, who is guilty for the mess we are in. Is it bankers, regulators or politicians? The story was complex and complexity hides the truth. According to today’s FT the combined regulatory penalty that 12 global banks now face as a result of manipulating Libor is $22 billion. Why didn’t we see fines and sanctions of this scale earlier? It’s my bet that the collateral damage would have carried out more than bankers and as they say turkeys don’t vote for Christmas. But now it’s different. With Libor you can see what’s been going on and so far there’s no one else to blame but bankers. What used to be a game played out between the big boys has questioned their honesty and integrity. Make no mistake this is a systemic issue. Heaven help the banks if the regulators find evidence of a cartel. You also have to wonder whether market rigging went a lot further. Who knows? If this behaviour was mirrored elsewhere it could affect just about every financial index and market. One thing is for certain it’s "drains up" time for regulators. Who could blame them? As some dealers would appreciate when there’s nothing to lose and a lot to gain you do it in size. More bodies down there? I for one wouldn’t at all be surprised.

Barclays £59.5m fine rests on two aspects of Libor “fixing”: Profit. As Trader B explains: “I really need a very very low 3m fixing on Monday – preferably we get kicked out. We have about 80 yards fixing for the desk and each 0.1 lower in the fix is a huge help for us. So 4.90 or lower would be fantastic”. And Perception. “just set it where everyone else sets it, we do not want to be standing out”. What’s to blame? Apparently “Culture”. But maybe, just maybe, there is a little more to it than meets the eye. Knowing the difference between what is right and what is wrong and then applying it is critical. In this way nefarious behaviour by dealers, operations and management is less likely. How and why has this been forgotten? Furthermore segregation helps combat bad behaviour and fraud. Does it need re-enforcement? There’s a word for all this it’s “competence”. Perhaps it’s been overlooked. But that’s not all. Bad things will happen. In banking, money has changed personal behaviour – not always for the better.  It's time the personal risk/reward ratio was recalibrated. How quickly could that change culture? With the CEO out and the SFO in we may be about to find out.

The earlier reported loss of $2bn at JP Morgan has reignited the debate “What use VAR?” VAR you will recall is a statistical technique that tells banks how much they can lose for a given holding period for a given confidence interval. The confidence interval however never reaches 100%. Sometimes the loss is so much greater than the VAR that the whole methodology is brought into disrepute simply because financial markets don’t behave “normally”. Over a decade ago I asked traders what they thought of VAR and the results were uniform. They totally mistrusted it. Why? VAR was a “black box” where cause and effect were difficult to see; Deltas and a “feel” for the market could tell you when positions were large; Out of the money options traded with a “smile” because outlying events did happen; Basis risks were real and correlations weren’t stable. Despite these criticisms one number telling you all you need to know without getting too close to markets was an improvement. But like all tools VAR is merely a colour in a paint box. It adds to the picture. But would you paint in monochrome? Strangely enough it seems that is exactly what we did.  So what about stress testing? It’s not new but bringing it in as the central measure is. Is stress testing all it’s cracked up to be? Are we making the same mistake all over again? If I’d asked that question a decade ago the traders would have said. We tried it and our limits were far too large; We are still under pressure to deliver; Profitable hedging must be the answer. The real danger is that whilst some risks are being reduced bankers will find new (and old) ways to make money. This will involve taking risk. It drives the business. It may be a shock but just like VAR, stress testing largely ignores these risks. What does stress testing tell you? It just shows you that the risks you think you have are greater than you thought. This should be a warning. Stress testing just like VAR is flawed. Particularly when used as a panacea- it creates a false sense of wellbeing. More weight needs to be given to where the money comes from. Something traders know.

There are solutions for sovereign borrowers with excessive debt. More borrowing Repayment Paying back with money worth less (inflation) Default Option (1) is difficult when lenders run out of patience. Politicians now know that voters don't do austerity so option (2) doesn't seem likely either.  Inflation? Unlikely if you don't control the central bank. So option (4) is a favourite. Political preference is for order. But will that happen? Maybe not and it's leading some commentators to speculate that a return to the Euro legacy currencies is an alternative. Daft? Unthinkable? Catastrophy? Probably not. Why should it be worse than the current uncertainty that is paralysing markets? As an old colleague is fond of reminding me "what comes around goes around". Four things you may care to consider: Don't get caught borrowing in "hard" Euro areas to finance loans to "soft" debtors. Read contract small print  - what could you be redenominated into? Plan for EU currency trading. Prepare for a long weekend.

Earlier I mentioned that bail-in may leave unsecured depositors exposed to a higher loss given default. But it doesn’t stop there. There are at least four further potential knock-on effects: Collateralised bonds (covered bonds, MBS) become more attractive to investors. But encumbrance limits restrict the amount of funding that is available to issuers and reign in the ability of banks to leverage their balance sheet. Encumbrance makes other forms of funding a lot more expensive as unsecured depositors and senior bond holders recognise their now weakened position. Retail funding becomes increasingly more competitive (expensive) as banks try and hoover up alternative uncollateralised funding sources. The cost of borrowing from a bank will rise. This rebalancing favours savers. Is financial repression doomed?

In a regime of “too big to fail” the taxpayer bailed out banks. Whilst expedient at the time this led to the perception that the larger a bank was the safer it would be. Many large depositors pared back their counterparty list just to deal with 3 or 4 “prime” names. But large banks took this a lot further. 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.

There’s a lot of talk that the UK may lose its AAA debt rating. When this happened in the US government bond yields fell. So does it really matter? On the face of it no. 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.

This isn't going to be popular with NEDs. It's something I've mentioned and it meets stiff resistance. 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.

In 2012 you will see more pressure being brought to bear on explaining how you measure and price the risk in treasury and how that cost is apportioned to the business. It's part of a regulatory push that’s aimed at further scaling back mispriced risk; This is not a bad thing and it will create some big opportunities for those who have their house in order; The light at the end of the tunnel is not an oncoming train; In the next few years, mark my words, there is a lot up for grabs; For firms that can do this there will be big rewards. Not only will you be able to avoid some of the costly regulatory bear traps but you will be able to steal a march on the competition; This will be a world where business can be done at sensible prices because less nimble players aren't there. It's happened many times before and will happen again. The key is timing and that will come; In the meantime, if like me you believe your business is ongoing, you can tilt things in your favour ready for the "upwave"; Or as one of my past bosses told me just hire lucky traders!

Something to consider - is the FSA and the Bank of England run by a bright and talented group of people who have amazing foresight? Or are they subject to the same limitations as the rest of us, where collectively they operate around an average, often dragged down by politics, albeit with some PR? Surprise then when I read a speech made on 11th 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.

You don’t have to be Greek to understand that something very wrong has happened. Public and private sector over leverage has led to the certainty that it cannot continue in its current form. A problem that has been brought to the fore by markets who either won't lend more or want a much higher return for the perceived risks. 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.

Yesterday I was taking part in a webinar on liquidity stress testing. I had a check list of nine points they are here: 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.