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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?”

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?

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.

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.

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.