Christopher Whalen

Bank of America has managed to step into the kimchee several times over the past couple of months, an achievement that only warms the hearts of crisis communications professionals. First came the abortive settlement of $10 billion or so in put-back claims by some large investors. The State of New York and anyone else paying attention intervened. Settlement is now mostly muerto in political terms, although the big investors are still paying the big lawyers to soldier on in hope of forcing a settlement on all parties.  Only in New York are such things possible.

Then came the decision by Bank America CEO Brian Moynihan to impose a $5 per month fee on ATM transactions, this in response to the Dodd-Frank law which cuts about half of the profits for big banks in the electronic payments market. Consumers reacted in rage to the announcement, which arguably helped to catalyze the Occupy Wall Street movement. Truth is that the big bank’s cartel control in payments is under assault by more than Congress. Think technology, Apple and Google, and stay tuned for a future post on the payments revolution. Steve Jobs does get the last laugh on the big banks.

Most recently Bank America drew attention to itself by disclosing that it had moved all of the derivatives footings from its Merrill Lynch subsidiary to the lead bank, Bank of America N.A. Bloomberg ran the first story, reporting “BofA Said to Split Regulators Over Moving Merrill Derivatives to Bank Unit.” This report led to comments and reports claiming that the Fed, by allowing this move, had somehow impaired the national patrimony and violated Section 23A of the Federal Reserve Act. Section 23A is among the more bizarre parts of the Fed’s enabling law and governs transactions between banks and affiliates.

Bill Black of University of Kansas City told me that the Bank America move was not merely an administrative exercise. “Here, B of A was not the counterparty,” says Black. “The 23A issue is moving an exposure [from Merrill Lynch] that is in trouble to the insured institution, apparently at book value, from an uninsured affiliate. That should be an easy call: ‘No.’ The Fed cares about BHCs and is institutionally primed to say yes to this kind of deal, while the FDIC is institutionally primed to protect the FDIC insurance fund.”

While I am sympathetic to concerns about potential losses to the FDIC bank insurance fund, the fact is that FDIC can reject any contract between any party and a failed bank. Truth to tell, however, such changes in the counterparty for OTC derivatives exposures are not that surprising for people who follow the securities industry. Goldman Sachs, Morgan Stanley, et al have moved their swaps business “in the bank” long ago. As Bloomberg notes, 99% of all of JPMorgan’s swap book flows through the lead bank. And yes, the Merrill business was particularly exotic, but keeping it in Merrill running through the smaller, FDIC insured Merrill depositories would probably be more of a risk to the Bank America group.

So the real question is why now? Susan Webber of Aurora Advisers, in her Yves Smith nom de plume on Naked Capitalism, commented on the motives behind and timing of the change:

You can argue that this is just normal business, the other big banks have their derivatives operations largely in the depositary. But BofA has owned Merrill for over a year and a half, and didn’t undertake this move until it was downgraded. Goldman and Morgan Stanley remaining big players in this business and don’t have a large depositary. If this was all normal business, BofA would have done this a while ago, and not in response to market pressure, and they would have gotten the FDIC on board. The way this was done says something is amiss.

Correct. To my earlier post regarding the need for a restructuring at BAC, “Housing, debt ceilings & zombie banks,” the move to put the derivatives exposures of Merrill Lynch under the lead bank could be preparatory to a Chapter 11 filing by the parent company. The move by Fannie Mae to take a large chunks of loans out of BAC, the efforts to integrate parts of Merrill Lynch into the bank units earlier this year, and now the wholesale shift of derivatives exposure all suggest a larger agenda.

I don’t have any access to inside skinny, but what I see suggests to this investment banker that a restructuring may impend at Bank of America. In the event, that is good news in a sense that this continuing distraction to the financial markets will be headed for a final resolution.

Global regulators are united in the belief that banks need more capital. The crisis of the past five years or so, regulators testify, requires more capital. Former FDIC Chairman Sheila Bair, upon hearing my heretical ideas on the US rejecting Basel III entirely, asked me whether I supported her and US regulators in seeking more capital in general.

My answer was no and here’s why: deflation, not capital, is the most urgent problem.

I’ve supported the views of JP Morgan CEO Jamie Dimon that Basel III is un-American and should be abandoned by the US. But both of us may be wrong on the provenance of the Basel framework. My friend Stephan Richter, publisher of The Globalist, believes that the US side actually created this entirely anti-American, authoritarian celebration of macroeconomc babble. We shall hear more on this when he completes his research on the fathers of Basel III. Comments are welcome.

But I think we can all agree that the statist, anti-democratic construction of Basel III is out of step with traditional ideas of American democracy and free enterprise. The world of Basel III is all about top down management of the economy, the sort of socialist claptrap that was introduced into the US political mainstream after the two world wars. Banks are, in fact, run like most other businesses, from the branch level up to the head office, but the deterministic world of Basel III is entirely European in outlook.

Whether you are GE Capital or Cullen/Frost Bankers, business opportunity and risk start from particular credit events. Regulations and capital requirements are all very fine when approached in a reasonable and transparent way. Yet the speculative, portfolio-level constructs of Basel III and the ridiculous mathematics behind it should be rejected when it comes to determining capital adequacy for any financial institution. But there is a larger reason why we need to drive a couple of wooden stakes in the chest of Basel III during this Halloween season.

Americans need to reject new era concepts such as market efficiency and fair value accounting, two of the key pillars of the Basel III world that encouraged the growth of opaque OTC markets in mortgage securities and derivatives. In good times, Basel III was an enabler for bad banking practices and excessive leverage. Now we are seeing the very same global bureaucrats who fomented the financial bubble rush around setting new, incomprehensible rules that we call “Basel III.”

The use of more direct measures of risk, such as leverage ratios and real-world estimates of specific obligor default probability, offer a far better route than Basel III and has in fact served the US banking system well for decades. But to the specific point raised in the discussion of Basel III, the fact is that most US banks do not need more capital. What banks need is less regulation of making good loans and clear, unambiguous rules for selling and servicing loans in the secondary markets.

If you look at the data from the FDIC as well as economic capital models created by my firm and others, the picture in the US banking industry is actually the under-employment of capital and a net run off of assets. Jamie Dimon is right to go on the attack when it comes to oppressive regulation and acts of collective delusion like Basel III because they hurt growth and job creation.

The real question which needs to be asked is why other members of the banking industry and the broader business community are not standing with Dimon and complaining about the monumental display of incompetence we see in Washington today in the form of Dodd-Frank. The reaction of the global political class to mounting debt deflation is to increase regulation and raise bank capital levels, thus worsening deflation and unemployment. Regulators encourage banks to cut counter-party credit lines with other banks to “limit risk.” This is precisely the type of bizarre thinking that drives the debt deflation affecting all of the industrialized nations.

Members of the chattering classes in the media should not be so quick to dismiss the warnings of Dimon and other less well-known bank executives when it comes to the negative effect of Basel III and Dodd-Frank on capital formation and job creation. Maybe in the teeth of this winter, when economic hardship and unemployment are the front-page news each and every day, the advocates of endless regulation and meaningless exercises such as Basel III and Dodd-Frank will reconsider their collective folly.

It’s beyond ironic — closer to moronic, really — that Jamie Dimon would give an interview to London’s very own Financial Times, complaining that international bank-regulation standards are “anti-American,” on the very day that the Vickers Report — Robert Peston calls it “the most radical reform of British banks in a generation, and possibly ever” — is released.

–Felix Salmon
Dimon vs Vickers
09/12/11

I have to disagree with Felix Salmon and agree with JP Morgan Chairman & CEO Jaime Dimon that Basel III is an anti-American nightmare and needs to go. There are many reasons why Basel III is irrelevant to the management and regulation of banks in the United States. In general, Basel is a poor risk management scheme for measuring bank capital adequacy.

First and foremost, the Basel III risk weighting standards are nonsense, with securitized and government guaranteed exposures given superior treatment (and lower risk weights) than comparable loans. Under Basel III as with the previous iterations of the Basel framework, lending is seen as bad, while complex structured securities, illiquid fiat currencies and OTC derivatives are still somehow seen as superior risks – even with the experience of the past decade of subprime residential mortgage backed securities (RMBS).

This entire framework is incredible, especially if you look at the use of quantitative models and statistics to generate default probabilities at the portfolio level to feed into the Basel III capital models. Basel III is a celebration of efficient market theory and economist guesswork, something that most reputable analysts and researchers have long ago rejected as pure garbage when it comes to risk analytics. Yet the Basel regulators continue to embrace this discredited approach. Why? Because, very frankly, the macro economists who dominate the Euro-American bank supervisory community have nothing else available to replace it.

Second and more important, the Basel III guidelines are rarely relevant to the managers of American banks. Because US banks still live with the more severe and arbitrary discipline of a leverage ratio, basically assets vs. capital measured without the benefit of ersatz risk weightings, managers of American depositories rarely run out of risk weighted capital as per Basel III, but leverage is a constant constraint. Whether a bank has too little or too much risk weighted capital is largely relevant only to regulators and lawyers.

Because agencies such as the FDIC under former Chairman Sheila Bair insisted on the retention of the leverage ratio for US banks, lenders such as JP Morgan have twice the capital to total assets of their EU counterparts, part of the reason for the lack of confidence in EU banks. Say what we may about Bank of America and other troubled lenders, but US banks still have substantially more capital than do banks around the world and especially in the Eurozone. To Felix’s point about Basel III being obviously good for American interests, I strongly disagree. Our rejection of the fantasy world of Basel III risk-weights saved American banks from looking like the insolvent shells of the EU today. From a practical as well as nationalist American perspective, who needs Basel III?

Third and more importantly, Basel III is extremely bad for the US housing sector at a very bad time. Reflecting the Euro bias of the Basel III apparatchiks at the Bank for International Settlements, the new framework demonizes mortgage assets, especially servicing rights. Nobody at the Fed, OCC or FDIC had the wit to object to this proposal, but this alone is reason enough for the US Senate to demand that President Obama withdraw from Basel III. Unless this ridiculous rule is changed, many US banks will essentially be forced to exit the residential loan servicing and warehouse lending businesses.

At a time when the US needs to be creating new capacity to support credit and leverage, adopting the Basel III rule is a bad idea. While some observers like Felix Salmon pay lip service to the illusion of international coordination of bank supervision, a more realistic view is that national treatment and rules remain the practical reality. When you look at the ridiculous pretense of EU banks referring to “risk weighted” capital ratios instead of simple leverage in their public disclosure, the bankruptcy of the Basel III process is visible for all to see.

Making US banks operate under rules that are acceptable to regulators in the EU, where most of the banks are insolvent or nationalized, seems like a particularly bad idea at present. Since the adoption of the first Basel accord three decades ago, the asset quality and solvency of EU banks have steadily deteriorated and American institutions have drifted into progressively riskier and opaque derivatives. Why should we follow this failed example for another moment longer? Dimon is right: America should withdraw from Basel III and embrace traditional American standards like the leverage ratio as the road to sanity and solvency in terms of prudential regulation for banks.