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Bankers are again voicing their concerns over the cost of regulation and its potential to drive business elsewhere. Anecdotally they are correct. But their ability to come up with hard numbers to prove their point has been lacking. At the same time politicians have set the tone for regulation. This has been framed by one of the most severe economic contractions since the 1930s which has stretched budgets and pushed monetary policy to the limit. In real terms people have suffered and there is general disbelief in the way bankers have escaped criminal prosecution and continue to get paid (at a senior level) very well indeed. Leverage, dominant competitive positions, expensive products and a government guarantees all made the big banks handsome profits.  But now the genie is out of the bottle a return to the halcyon days is not about to happen. Instead of complaining about regulation Chairmen of the biggest banks should perhaps consider how it may work in their favour. Large banks are still at the heart of the financial system. This puts them in an enviable and protected place. To remain there compliance is currently a necessity. Whilst the increased cost will undoubtedly chip away at return on capital it is not unique to any one bank. All banks suffer. But some suffer more than others. How you comply and keep the cost under control is now a matter of judgement for Boards. In this respect it is another business problem to solve albeit one that is relatively new and subject to change. In this world the “too big to fail” bank can spread its costs much more widely and it also has a much deeper pocket to hire the well-connected to smooth the path. Smaller firms can’t compete. The moat just got bigger.

Carry trades are frequently used to beat markets. They involve buying an asset that has a higher return than the cost of finance. Profits accrue when markets go up or sideways. Losses only arise when markets fall. Winning two times out of three is clearly very attractive. But it has its risks. You may have noticed that in November 2012 the Bank of England handed some £11bn to the Treasury because the Gilts held by the Bank had an income that exceeded their funding cost. This sounds very much like the results of a carry trade. Of course the Old Lady isn’t alone in undertaking creative monetary policy. Indeed some central banks seem to want to go much further and purchase all sorts of assets in order to get economies moving. Are central banks moving into sovereign wealth fund territory? Perhaps if we asked a simple question it could throw some light onto an area of markets that seems to be far from transparent. How important is it to the central bank that it reports a profit on its operations? As any trader will tell you that once you start to engage in any sort of profitable series of transactions the process quickly becomes addictive. In the world of commercial banking this is tempered by limits on (market) risk. However in Central Banking these seem never to be discussed. Am I alone in thinking this is odd? Maybe for some reason they just aren’t relevant but I have my doubts. If you buy a pile of £375bn Gilts with say a duration of 7 years that gives you a £26 bn loss for ever 1% increase in interest rates. And I’m pretty sure there isn’t a matching swap position that offsets this. You may think it doesn’t matter after all the Bank could just sit on the Gilts until maturity. Provided its funding rates remain low any mark-to-market loss isn’t realised. This is true. But what happens if rates rise? You get a loss and it doesn’t matter whether you use accrual or MTM. Is it not time to ask more questions about how things work?

A few years ago a bank explained that it would make a market for $5m with a two point bid offer spread for a CDO should the client so wish. This was sold to the client as a demonstration of commitment and liquidity. Liquidity is important for a number of reasons. It reduces transaction costs, provides continuity and minimises the possibility of discontinuous market pricing. The effects of which can be unpredictable. What constitutes a liquid market is hard to define. But from my experience it requires infrastructure, traders, customers, brokers and confidence. When this is working well a large number of parties collectively buy and sell. Both large and small amounts can be shifted without significant price movements. It’s helpful to everyone. Recent market reforms correctly clamp down on market abuse. But whether infrastructure reform is entirely necessary remains to be seen. Clearing may lead to the mother of all risks if it fails. Likewise any reform that alters the ecosystem of players may well lead to some unintended consequences that we only find out about in the years to come. In this respect reduced trading inventories must surely increase risk. As the CDO investor found out when fear overcame greed prices fell 20%. Being able to sell $5m was not remotely beneficial particularly when the entire position was ten times larger. Liquidity never has been a guarantee of safety.

When will interest rates rise? That’s a big question that faces markets and has the potential to upset asset prices. Past experience suggests when the economy gets hot rates rise. Leading or lagging depends on the balance between short term growth and longer term inflation. Previously this has been a political decision and the inflationary consequences in the UK economy are well known. Has this changed? At the time of writing base rate remains at 0.5%. This 300 year low has dragged down all rates along the curve. Consumption and asset price inflation boost the economy. But have things been so bad that a “temporary” 0.5% needs to last years? Perhaps the answer is in who owns the leverage. Whilst the banks and to a lesser extent consumers have adjusted their balance sheets the government deficit has ballooned, likewise that of the Bank of England’s balance sheet. For any borrower low servicing costs are a good thing ditto bond investors. Therein lies a problem. There are vested and very influential interests that benefit from continued low rates. They are the Treasury, the Bank of England and a Government running into an election period. This conflict of interest can only be over ridden by a truly independent rate setting process. About which there are serious doubts. The pressure of “group think” must be overwhelming so the policy bias is towards keeping rates lower for longer than is appropriate. Markets will dictate how long this can last.

I recently carried out a straw poll using a somewhat loaded question. “Do you think that Rogue trading is more or less likely in the future?” The response? A significant number felt that banks were better placed to stop rogues. The overriding belief was that regulation and compliance was now significantly more robust and as a consequence it was much harder to commit fraud. This opinion appears to be based on the assumption that things will be different in the future and I think that’s too great a leap of faith. Checks and controls are more intense, that’s true, but the motivation is still there. What creates rogues? Sometimes it’s greed but in many cases it’s the inability to admit to losses combined with a belief that one more roll of the dice will put things right. A game of double or quits ensues with losses being covered up with false trades. This isn’t new. In other walks of life it’s called gambling and the unfortunate few find it addictive. This addiction is the danger. Checks and controls catch mistakes but against the motivated and determined it’s a different situation. Many rogues show an uncanny aptitude to understand complex processes and systems and use this to their benefit. If there is a bad apple in the barrel it’s very likely contamination will occur. Are we being lulled into a false sense of security? I think so. After all it’s been some time since a high profile case. At the moment there’s a lot going on so our guard is naturally down. My respondents at one level could be right. Detection is probably better than it used to be. But one thing is for sure it’s only a matter of time before the next “Big One”. Semper vigilantes.

In last weekend’s FT Terry Smith wrote about a $1.9bn error he had noticed in IBM’s 2009 cash flow statement. This got me thinking. How frequently is board and shareholder information inaccurate? Probably a lot more than many businesses would like to admit. This is of course anecdotal but I’ve seen plenty of reports that purport to show risk that aren’t right. This largely arises from two sources. First the sheer volume of data now being collected, reported, copied and transposed leaves room for fat fingers, aka human error. Second some risks aren’t picked up leaving the recipient unaware of the real exposures being run. Is this significant? It depends on whether we need accuracy or approximation. A model error can cost millions. Other things are more subjective like the volatility estimate in a VAR model or the parameters used in stress testing. Notwithstanding it’s helpful (where possible) to have your own estimate and to cross reference reported risk in order to validate it and understand how it is behaving. This needs time and experience. What’s interesting in Smith’s article is that IBM confirmed the error and no one else had been in touch. Was this because no one asked the question or was it because financial reports aren’t looked at? That is surely the real question. Are we getting lazy when dealing with numbers?

As readers of this blog will know I am not an advocate of complex regulation. It leads to problems. Bonuses are no exception. In a move to stem short term risk taking, regulators now prefer vesting share based compensation with claw backs. This is opaque. Each bank has a relatively few individuals who run things and like it or not they get well paid. Look at any remuneration committee report and try and figure out how it works. Share based remuneration is often highly dilutive and is wealth damaging to shareholders. As for claw back, it won’t happen. No wonder that many successful investors shun banks. It’s hardly a recipe for a successful government exit. As a supporter of the free market I find myself surprisingly in agreement with EU law restricting bonuses to 100% (or 200% with shareholder approval) of salary. Even if salaries are increased it’s transparent and makes expensive staff liable to be culled particularly if they don’t produce, (something that can get lost in share based vesting comp. which to some almost seems like free money). EU caps are a blunt instrument but bankers have been lucky. Other state supported enterprises with the notable exception of farming have been let go when their markets or businesses failed. The only reason why this time it didn’t happen was because at its core banking is a utility. Bankers explain success in terms of their expertise. This is partially true. But make no mistake the main reason why many banks make money is not employee expertise per se. It’s a combination of things in which barriers to entry, access to central banks and shareholder capital play important roles. Indeed these factors are so crucial that bankers resist ring fencing and on the whole prefer not to set up shop on their own. What’s the answer? The faster ring fencing takes place the better. Bankers can then choose. Do you want to be in a safe, regulated utility business with a fixed salary or do you fancy a flutter at the casino with all the personal risk that involves and yes bonuses if you are good (or lucky). Until then tax payers' interests are better served resisting payouts. After all some banks fall at the first hurdle. They don’t even make a profit. What happens when all the hard done to dealmakers shuffle off to Goldman to get paid more? We should be reminded of similar threats in 2008 about leaving the UK. They were idle too. In footballing terms do second division players join Manchester City?

Now all eyes are focusing on tapering you could be forgiven for thinking that rates will bound up just as fast as they went down. As central banks now seem to target employment rather than use it as an indicator this is unlikely. The only spanner in the works being a collapse in confidence and hot money (out) flows - this has happened before and it causes rates to rise fast. (Watch out for bond and stock holders running to the exit all at once). On a more mundane issue some central bankers have been trying to convince us that QE is wealth neutral. This of course depends on how you are invested. Their argument is that falling returns on cash are offset by capital gains on longer duration assets. Not bad for a well balanced portfolio. This is however only part of the story. When rates eventually rise (as surely they will) equilibrium is restored. But the cash investor has experienced a permanent loss of interest. With rates being low for so long it would take very high real rates to reverse this situation. Something that I point out above is unlikely to happen unless sentiment changes in a big way. Regardless of what central banks may tell you the policy that’s been adopted is a direct transfer of wealth from those holding variable rate assets to those with variable rate liabilities. This has social consequences that need to be considered but are conveniently sidestepped by policy makers. Furthermore it means the normal process of liquidating inefficient businesses is temporarily suspended. The longer it remains the less economic sense it makes.

In 2013 I never expected that I would be writing this but there seem to be those employed in banking from the top to the bottom that lack some of the basic understanding of how things work. And it’s getting worse. Why is this? The crisis has taken its toll. Redundancy and retirement cuts costs but depletes know-how. Replacements do what they do. But do they know why they do it? Contribution needs to be more than an aspiration. How does general experience furnish the NED with the right skills to deal with banking? When regulators go on fishing expeditions (to banks) they must learn how to tie the fly! In the UK the Coop sends us a message. (Hopefully not an extensive report on the shortfalls and the promise that it won’t happen again). Businesses that involve complexity (banking does - in spades) need those involved to have the right skills. It’s fashionable to blame the ills on “culture” but the enforcement regime of compliance and regulation that surrounds this will fail if those involved don’t have the prerequisite knowledge to understand straight forward issues let alone form independent judgements. As a fall back regulators are increasing fines.

In the run up to 2008 banks remodelled their business to take advantage of complex financing transactions and new products. This produced growing profitable businesses. Getting to the bottom of what was going on was not only devilishly difficult but it just didn’t suit everyone involved. Since then we’ve experienced the worst financial crisis since the 1930s. We’ve changed the way things work and we have added a lot of rules. But does the same inability to challenge the dominant pattern of thought still prevail? I think it does. This is why. Here are some facts: Base rate remains at 0.50% whilst the central bank balance sheet has ballooned with £375 bn of asset purchases. Base rate is now governed by a 7% unemployment rate (with triggers). The refined Sterling monetary framework makes liquidity more readily available to the banking system against a wider range of collateral for a lower cost. The Bank’s Funding for Lending Scheme has provided funding directly to banks at rates lower than the market price. The CPI inflation target of 2% has been consistently breached for 47 months in a row. The Bank’s new Governor recently floated the idea that “By 2050, UK banks’ assets could exceed 9 times GDP….” What we have seen is a great experiment in monetary policy with more to come. And because economics is not an exact science the outcomes remain unknown. The speed at which this has taken place means that it is highly likely that some of these policy decisions will prove unsound. Furthermore these policies are far from zero cost. They lead to substantial wealth transfers from savers to borrowers, support unsustainable businesses, create (housing) market bubbles, encourage devaluation, increase inflation rates, reduce real income and spending and potentially reduce wealth creation by dragging down future growth rates. But what really is of concern is the lack of challenge that the Bank of England faces. Indeed with so many groups being adversely affected you would expect some noise but there is little. Why? I suspect it boils down to complexity, lack of transparency and self-interest. Very few people, this includes many working in finance, understand the policy, processes and governance of the Bank of England and how it interacts with the Treasury and government. There are parallels here with the 2008 debacle. Perfectly sound arguments that refute the current received wisdom aren’t being heard. It’s as if central banking has gained its own “escape velocity” where it is largely immune from challenge. This is less worrying when policy is “accommodative” but a totally different story when it becomes “creative”. We have got these things wrong in the past. Is history about to repeat itself?

It’s now over three years since the FSA asked banks to implement funds transfer pricing. It was difficult to fault the regulator on its stance. After all why shouldn’t product pricing reflect the risks incurred? However regulation is straight forward in theory but the difficulties start when it’s put into practise. In the case of transfer pricing this was rightly or wrongly compounded by the perception that FTP was predominantly a quantitative issue. For something with a lot of moving parts this can’t be true. (All good risk pricing embeds subjectivity into models – just ask an options trader). Proportionality also came into question. How sophisticated were simple firms expected to be? Could complex businesses get away with a basic approach? The results were a bit piecemeal, that’s history and we moved on. And it’s made me think. Why did FTP become last year’s problem? Probably because of QE. In a world of cheap money FTP is the last thing you want to hear about (or do). The “carry trade” is on and pays very well. Just ask any punter. However if you feel, like me, that all good things come to an end then it’s a sound idea ask yourself how you make money. Is it through mispricing risk? Now we have seen the first signs of tapering it’s hardly surprising that regulators are starting to ask the same question. And where better to start than a re-assessment of the FTP? In a simple way it helps answer their question “do you know what you are doing?”

With overnight rates being 0.50% or lower how do you manage excess liquidity? A question many treasuries now face and one that’s unlikely to diminish. There is no easy answer. Small firms are particularly vulnerable, this is why. The temptation is to seek assets with more yield - usually bonds. The additional return is the reward for liquidity, market and credit exposures. Recent focus has been on the first two. But history tells us credit risk is where real losses occur. It’s therefore worth considering the process of credit approval. How does this work in treasury? In the interest of “segregation” credit analysis and approval is normally outside treasury. This is however deceptive and provides false comfort. A major problem is “skin in the game”. Credit analysts often act in an advisory capacity. They don’t experience the P&L implications of their decisions. In a bank the credit department was asked, for a fee, to underwrite the risk on treasury assets. No surprise that previously acceptable investments became prohibitively expensive to insure. In other words “I will put your money to work in the casino but not my own”. If we acknowledge this inherent weakness in the way credit is approved where do we go from here? Surely we need to ask why there is excess liquidity burning a hole in our pockets. Is there something we can do in the core business that can alleviate the problem? Short run solutions through treasury “investments” are fraught with difficulty. After all most dealers are unlikely claim “credit” as a skill so it’s remarkable that we expect them to identify what is rich and cheap in the credit sphere. By definition credit spread risk requires skills and the capacity to absorb losses. It’s the domain of large banks. Even then things can go badly wrong.