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from Breakingviews:

JPMorgan hits Washington’s reset button

By Daniel Indiviglio The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

JPMorgan’s whale is proving big enough to change the tide of regulatory reform in Washington. After nearly two years of haggling between lawmakers and the banking industry over details of the sprawling Dodd-Frank Act, a round of significant final alterations were finally ready to be implemented. But after U.S. senators ripped into regulators on Tuesday, it became evident that any clear rules look beached for now.

The loss of at least $2 billion from JPMorgan’s chief investment office temporarily silenced some critics of financial regulation. Those arguing the bank could manage its own risks without the government’s firm hand, including Chief Executive Jamie Dimon himself, are all devouring crow. Lobbyists are rewriting playbooks as any sympathy from politicians to go easier has quickly vanished. Less than six months from elections, members of Congress are unsurprisingly reluctant to look soft on Wall Street.

There are some strong, tangible signs that Washington’s reset button has been pushed. A meeting to put the finishing touches on revisions to new Dodd-Frank derivatives rules, which had at long last been coasting toward passage, was unceremoniously postponed by a House committee shortly after JPMorgan disclosed its blunder.

A previously scheduled Senate Banking Committee hearing about swap rules implementation on Tuesday went on as planned, but turned into a showcase for the new congressional tone. Democrats demanded to know how regulators could better prevent such disasters. Republicans pressed Commodity Futures Trading Commission Chairman Gary Gensler about why he learned about JPMorgan’s trading losses from the press instead of oversight.

The criticism and rhetoric on display at the meeting was only an opening act. More regulators are due to appear in early June. And then shortly thereafter Dimon will be hauled up to the Hill, so the government can try to figure out what exactly broke down in the regulatory and risk management processes. This time it only cost JPMorgan shareholders; no one wants taxpayers on the hook next time. Any fixes to new rules, no matter how well meaning, are now bound to get another look. And the delays to financial regulation today only mean it will probably be tougher tomorrow.

from Global Investing:

The “least worst” option?

Western governments saddled with mountainous debts will "repress" creditors and savers via banking regulation, capital controls, central bank bond buying and currency depreciation that effectively puts sovereign borrowers at the top of the credit queue while simultaneously wiping out real returns for their bond holders. So says HSBC chief economist Stephen King in his latest report this week called "From Depression to repression".

Building on the work of U.S. economist Carmen Reinhardt and others, King's focus on the history of heavily indebted governments applying "financial repression" to creditors arrives at several interesting conclusions. First, even though western governments appeared successful in using these tactics to reduce massive World War Two debts alongside brisk economic growth during the 1950s and 1960s, King argues that the debt was cut mainly by the impressive economic growth and tax revenues during that "Golden Age" - and this was mostly down to the once-in-a-century period of relative peace that involved unprecedented integration and cooperation among western governments also engaged in a Cold War with the Soviet Union. Compared to this boost, the financial repression was a "sideshow", he reckons.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           To show that, he applies

Instead, King says governments will adopt this repression tactic anyway just to stave off draconian austerity now and prevent a destabilising surge in economy-wide borrowing rates. This will effectively reduce the amount of credit to the rest of the private sector, or at least elevating its cost, while reducing the pressure on governments to cut the debt levels quickly. The net result, then will likely be "persistently lower growth", whatever your conclusion about the desirability of  state or the market allocation of resources.

And, in the absence of an obvious alternative, repression may also be the "least worst" option, King argues.

from Breakingviews:

JPM insider non-trading case puts banks on notice

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

No-one can accuse the Financial Services Authority of avoiding big targets. Indeed, the UK watchdog has trained its sights on one of the City of London’s most prominent dealmakers by fining Ian Hannam the best part of half a million pounds for passing on price-sensitive information about his client, Heritage Oil.

The penalty looks harsh given that the JPMorgan banker’s slip was accidental, and nobody traded on the tip. But even if Hannam - who has resigned in order to take the case to a tribunal - can get the ruling overturned, corporate advisers will have to re-think how they work.

Hannam is no stranger to controversy. As chairman of capital markets at JPMorgan he has been responsible for persuading a string of emerging markets mining and oil companies to list their shares in London. This has led to an inevitable clash between the business practices of oligarchs and the corporate governance standards expected by UK institutional investors.

This is not the first time that shares in Heritage Oil have attracted the FSA’s interest: two years ago, the regulator fined the chief executive of Genel Enerji, the Turkish oil company, almost 1 million pounds for trading on the basis of inside information about an oil discovery in Kurdistan. Nevertheless, the FSA’s case against Hannam looks sparse. It rests on two emails he sent in the autumn of 2008. The first alerted a potential bidder for Heritage - Hannam’s client - about a possible rival offer. The second signalled Heritage’s progress in finding oil. Hannam did not trade on this information, and there is no evidence that the emails’ recipients did either.

Without the trail supplied by the emails, there would be no case. The FSA maintains that simply passing on inside information constitutes a breach: it has successfully brought two similar “insider non-trading” cases in recent months. It also makes the point that somebody of Hannam’s seniority and experience should have known better.

from Breakingviews:

UK’s bubble-prickers seek iron grip on banks

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Britain’s bubble-prickers are aiming high. The Bank of England’s new Financial Policy Committee, which is charged with averting future crises, has asked the government for sweeping powers to rein in banks, insurers and fund managers. Even if it doesn’t get everything it wants, the FPC will clearly have muscle. The snag is that it has few ideas for solving the most pressing current problem: excessive risk aversion.

Most of the FPC’s wish list is pretty sensible. It wants to set and vary banks’ counter-cyclical capital buffers - the tool specifically designed to allow regulators to “lean against the wind” of excessive exuberance or caution. It also wants to control the size of banks’ balance sheets by setting the leverage ratio, which measures equity as a proportion of total assets. And it wants to be able to apply its powers to any regulated entity, including insurers and investment funds. That should allow it to quickly whack risk-taking that shifts from banks to other parts of the system.

More troublesome is the FPC’s desire to vary capital ratios for lending to different sectors. Such micro-management could undermine investors’ already-fragile confidence in the accuracy of banks’ ratios. It is also hard to reconcile with the European Commission’s efforts to ensure that new capital rules are applied consistently across the European Union.

True, the proposed tool would have allowed regulators to rein in banks’ property lending during the last bubble. However, the same aim could be achieved more easily by capping loans as a proportion of the value of a property, or a multiple of the borrower’s income. Sadly, the FPC appears to have concluded that demanding such powers is a political non-starter.

A more pressing problem, however, is that the FPC’s proposed powers are asymmetric: they are much better suited to tackling exaggerated optimism than in countering the undue caution currently gripping Britain’s economy. This tension is evident from the minutes of FPC’s latest meeting: it concluded that UK banks should raise capital to further strengthen their buffers, even as the government attempts to stimulate the flow of credit to small businesses and housebuyers. Even if the FPC gets the tools it wants, it could be years before they are used.

from The Great Debate:

The battle over money funds

Both Securities and Exchange Commission Chairman Mary Schapiro and Federal Reserve Chairman Ben Bernanke have warned in recent days that money market funds remain vulnerable to runs. That is unquestionably true, and if a run occurs, U.S. taxpayers will bear the costs of bailing them out. Should taxpayers continue to subsidize the money market mutual fund (MMMF) industry?

The run on U.S. MMMFs in September 2008 was a critical moment in the financial crisis. It underscored the extent to which these funds, an important part of the shadow banking system, created systemic risk that indirectly threatened the financing of even the healthiest U.S. firms. To end the run, the U.S. Government guaranteed MMMF liabilities, sustaining the funds’ promise to pay $1 for every share.

That guarantee stopped the run, but it also created enormous moral hazard. Were a similar threat to arise today, we can safely assume that taxpayers would remain on the hook to rescue the MMMFs. This uncompensated, rainy-day backstop constitutes a subsidy to the MMMF industry -- and to its investors and borrowers.

No wonder, then, that representatives of these groups loudly oppose regulatory efforts to counter the systemic threat that still emanates from the MMMF business model. The SEC (which is the industry’s regulator) reportedly is considering the introduction of capital requirements, constraints on fund convertibility and -- most important -- replacement of the $1-per-share valuation commitment with a floating net asset value (NAV).

From the point of view of taxpayers, policy action to address the systemic threat is long overdue. Aside from the government-sponsored enterprises, the most glaring omission in the Dodd-Frank financial reform was the failure to address critical short-term markets such as those for money funds and repurchase agreements.

There is no shortage of evidence for an enduring systemic threat. As recently as May 2011, according to Fitch, more than half the assets of the largest prime MMMFs were invested in European banks as the funds searched for yield to attract investors. When these funds (and their regulator) finally woke to the crisis in the euro area, it triggered a run. The scramble by the funds to exit put pressure on European banks to sell their dollar assets rapidly. A fire sale of dollar assets could have quickly undermined U.S. credit conditions. To avoid this outcome, the Federal Reserve reactivated its dollar-swap agreements with foreign central banks, allowing the European Central Bank to meet the dollar funding needs of euro-area banks from which MMMFs were running.

So why do we regulate MMMFs so differently from banks? To be sure, their assets are short term and of relatively high quality, making them less risky. Yet MMMFs are the prototypical “shadow” banks -- providing liquidity services that are virtually identical to those of banks, with the advantages of much less regulation and an uncompensated insurance policy from taxpayers. It is an extraordinary and enduring regulatory arbitrage for an industry that still holds $2.5 trillion in assets.

from Breakingviews:

De-globalisation of finance looks here to stay

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The global financial system is becoming more national. Three years after Western taxpayers were forced into a mass bailout of banks, Western lenders are in full retreat, encouraged by regulators and governments.

In the two decades leading up to the financial crisis, national borders became steadily less important in finance. The crisis made it clear that nationality does matter, because domestic taxpayers ended up supporting banks, including their far-flung operations. The crisis also showed that banks had too much leverage.

European banks are now leading a backwards charge. According to Barclays Capital, euro zone lenders had $1.2 trillion of assets in emerging markets in mid-2011 – double the amount just seven years earlier. A significant chunk of those assets are supported by the parent bank’s capital and funding. With capital scarce and funding costs high, retreat is the only option.

Europe’s banks are also pulling back on the business of lending in dollars, which were often borrowed from U.S. money market funds. After U.S. investors fled from Europe last year, that business looks too risky. Though the funds may be returning to the euro zone, banks are likely to remain wary.

Post-crisis regulation is contributing to de-globalisation. Capital-short banks in Europe and elsewhere have sold foreign businesses. And the UK government has accepted the recommendation of its Independent Commission on Banking to ringfence domestic retail banking operations, making foreign and investment banking units less appealing. The U.S. Federal Reserve’s latest stress tests effectively punished big U.S. lenders with extensive European operations by requiring them to be able to withstand a euro zone meltdown. And Canada and Japan fear the U.S. Volcker rule, which bans proprietary trading, will force lenders out of foreign sovereign debt markets.

from Financial Regulatory Forum:

Mitigating “Margin Call” risks

By Dave Ingram and Max Rudolph The opinions expressed are their own.

The financial thriller, “Margin Call,” which opened in movie theaters on Friday, tells the story of a firm in the mold of a Bear Stearns or Lehman Brothers at the height of the financial crisis. The firm in the film is akin to real-life firms that seemingly discover too late their reliance on a culture built on growth at any cost and tainted models at the expense of risk management.

Movies are great teachers, helping everyone better understand complex situations that can be confusing even to experts. “Margin Call” does just this, by putting a spotlight on the crucial role that proactive and skeptical risk management (or lack thereof) plays, particularly in financial services. Although the Occupy Wall Street movement is still in its infancy, it demonstrates how ordinary people feel the impact of the financial industry’s actions – and mistakes. Likewise, the movie demonstrates how great an impact one firm’s actions can have on the entire financial industry, underscoring the importance of risk management in such an interconnected system.

Based on our experience as actuaries, focusing on identifying and mitigating risks, we’ve outlined what we believe are the most important lessons of both the film and financial crisis. Hopefully those who see this movie, and those who lived through the crisis, will heed them.

1. All models are wrong – communicating the pros and cons of results is right

Models come in many shapes and sizes. Mental models can be simple, like rules of thumb, or they can be incredibly complex, like those used to calculate the expected payouts of structured securities. Models, however, rarely evolve to become simpler. In financial services, for example, some models will try to reflect second order interactions, like how often savers ask for their money when interest rates rise, or how many homeowners will default or prepay their mortgages given economic circumstances. As these models become more complex, they become harder for those who did not create them to monitor. The key is learning where the shortcomings are, and not being afraid to communicate the results to decision makers.

from Breakingviews:

Credible EU bank tests need a higher pass mark

By Peter Thal Larsen The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Europe’s banks may need to re-sit their summer exam. Regulators are looking for ways to inject more capital into the region’s troubled lenders. One potential quick fix is to use the same data as in July’s discredited stress tests, but impose haircuts on sovereign debt. But this wouldn't be enough. The authorities should also raise the minimum capital ratio that banks need to clear.

The flaw in July’s tests was that banks did not have to mark down the government bonds they currently hold at face value. As a result, only eight of the EU’s 90 largest lenders flunked the exam, with a capital shortfall of just 2.5 billion euros. Since then, worries about sovereign debt have spread from Greece and Portugal to Spain and Italy, threatening a systemic crisis.

Ideally, regulators would conduct another test. But that would take months, and Europe does not have the luxury of time. An alternative is to re-run the tests with the same data, while forcing the banks to mark all sovereign bonds to current market prices.

In that scenario, 18 banks would fail, with a capital hole of 40 billion euros, according to Breakingviews’ stress test calculator. But that would not be enough to restore confidence. The International Monetary Fund puts the capital shortfall of European banks at between 100 billion and 200 billion euros. Some analysts have come up with even higher numbers.

from Breakingviews:

Del Monte settlement quantifies cost of conflicts

By Jeffrey Goldfarb The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Wall Street just got a bill for its conflicts of interest problem -- and Barclays is picking up the tab. The UK bank will surrender a big slug of the fees it earned in the $5.3 billion buyout of Del Monte as part of a legal settlement with the food company's shareholders. M&A practitioners seem to have read the writing on the wall after a Delaware judge earlier condemned the practice of advising a seller while also financing the buyer. But when banks get spanked on the bottom line, the message resonates louder and clearer.

The Del Monte case stunned the dealmaking world earlier this year. Barclays hadn't even been named as an original defendant. That didn't deter a Delaware court from dragging it into the case and saying the bank "secretly and selfishly manipulated" the Del Monte auction to line its own pockets with additional fees. The accusations got the attention of bankers everywhere, who until then hadn't much seen the problem with so-called "staple financing," or lending money to a private equity firm so it could acquire a company the advisers were simultaneously helping to sell.

Banks won't necessarily concede any change of heart. But the evidence so far speaks for itself. While the volume of leveraged buyouts has shrunk considerably, it's nevertheless hard to find an example since February, when the judge first ruled, of any sizable deal where a bank has engaged in the practice. This week's $3.9 billion buyout of Pharmaceutical Product Development PPDI.O, for example, included four financing banks for Carlyle and Hellman & Friedman, none of which was a named adviser on the deal.

The now quantifiable cost of such conflicts of interest should help drive the point home. Barclays, though it isn't admitting any wrongdoing, will kick in nearly $24 million to the $89 million deal with Del Monte shareholders. And the Wall Street Journal is reporting that Del Monte will withhold another $21 million of fees from Barclays to help cover its portion of the settlement. It isn't easy to alter the methods of bankers. But removing the financial incentive works almost every time.

from Breakingviews:

UK bank commission sticks to its guns

By Peter Thal Larsen and George Hay  The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

Britain's Independent Commission on Banking has stuck to its guns. Despite concerted industry lobbying and growing political nervousness about the consequences of reform, its recommendations on how to fix Britain's banking system are resolutely tough. The ICB's only real concession is to delay to 2019 implementation of its proposals for ring-fencing crucial operations. Sorting out the details of the new rules could leave banks in limbo for years.

Largely as expected, the ICB's final report recommends putting vital banking operations inside a ring-fence. Its definition of what is vital is wide: the subsidiary must contain consumer and small business banking but the Commission's rules will also allow banks to include deposits from -- and loans to -- large corporations. The fence will also be high: the subsidiary must have its own board of directors, and will face strict controls on how it interacts with the non ring-fenced bits.

The ICB has been unflinching on capital. It thinks big UK lenders should hold equity equivalent to 10 percent of risk-weighted assets. That's 3 percent more than the Basel III standard adopted by international regulators. The commission also wants banks to hold total equity -- including bonds that can absorb losses in a crisis -- of up to 20 percent.

These reforms will impose sizeable costs. The ICB puts the hit to the industry's pre-tax profit at between 4 billion and 7 billion pounds. Most of this arises because businesses that are not ring-fenced will face higher funding costs. However, these costs also partly reflect the removal of the "too big to fail" subsidy currently provided by taxpayers. That was the ICB's explicit objective. Barclays and Royal Bank of Scotland, which have big investment banking arms, are likely to bear most of the burden.

Lloyds Banking Group, which has avoided the grim scenario of having to dispose of more of its huge UK market share to boost competition, has fared better. It could, however, still face a competition commission enquiry by 2015.

The ICB's main concession to its critics has been to push back the timetable for reform to 2019, similar to the deadline for Basel III capital rules. As with Basel, investors are likely to want it over and done with, and demand speedier implementation. Even so, there is plenty of scope for banks to argue with legislators and regulators. The ICB's own estimate of assets that will be inside the ring-fence ranges from 1.1 trillion to 2.3 trillion pounds. Investors hoping for clarity on UK bank reform have longer to wait.