Felix Salmon

Edward Wyatt makes a very good point today — why is the SEC doing big favors for big banks, every time it slaps a fine on them?

If a bank settles a fraud case, it automatically loses certain privileges, like the ability to issue debt securities opportunistically, without going through laborious SEC filings, and the ability to shelter forward-looking statements against lawsuits from investors.

It’s worth noting here that no company has any kind of right to these privileges. If a company tells lies to investors, those investors should be able to sue it. And if a company wants to issue securities to the public, it’s the SEC’s job to examine the proposed offering first.

But somehow, along the way, a handful of very big companies — especially banks — managed to persuade the SEC that they were trustworthy corporate citizens, and that they didn’t need to be bound by those rules.

That’s a little bit suspicious just for starters. But it gets much worse. The SEC, quite naturally, put in place a policy which said that if any of those companies ended up being fined by the SEC for violation of securities laws, then it would lose its special privileges.

And then the SEC proceeded to ignore that policy.

An analysis by The New York Times of S.E.C. investigations over the last decade found nearly 350 instances where the agency has given big Wall Street institutions and other financial companies a pass on those or other sanctions. Those instances also include waivers permitting firms to underwrite certain stock and bond sales and manage mutual fund portfolios.

JPMorganChase, for example, has settled six fraud cases in the last 13 years, including one with a $228 million settlement last summer, but it has obtained at least 22 waivers, in part by arguing that it has “a strong record of compliance with securities laws.” Bank of America and Merrill Lynch, which merged in 2009, have settled 15 fraud cases and received at least 39 waivers.

Wherefore these waivers? Former SEC chairman David Ruder says that were it not for their privileges, these poor banks might have difficulty staying in business. Which, it seems to me, is a very good reason to remove those privileges. Too-big-to-fail banks should be rock-solid, with fortress balance sheets, able to withstand big and unexpected shocks. If their ability to operate as a going concern would be threatened by forcing them to comply with standard SEC regulations, then there’s something very wrong with them indeed, and they don’t deserve special waivers at all. Instead, they require extra-close scrutiny.

But in fact losing the privileges is not the end of the world for a bank. Look at Citigroup, which lost its privileges for three years in October 2010, and is certainly in poorer financial shape than, say, JP Morgan. It’s still chugging along quite happily, making a net profit of well over a billion dollars per quarter.

The SEC does seem to be far too cozy with America’s biggest banks, going soft on them when they commit fraud just because it fears for their livelihood if it gets tough. That’s wrong. America can live without big banks; what’s truly dangerous is a world where too-big-to-fail banks have de facto impunity and can do what they like. Right now, the fines banks pay to the SEC are like protection money: they pay a few million bucks here and there every so often, and in return get to continue doing whatever they like. It’s time the SEC put a stop to this. But I’m not holding my breath.

Jesse Eisinger and Chris Arnold have a really good story about Freddie Mac today, a company which is preventing mortgage refis at the same time as it’s making enormous prop bets that homeowners are going to continue to find it hard to refinance.

Back in September I noted that mortgage bonds are trading well above par just because investors are well aware that refis are hard to come by for many homeowners, and said that those investors were “taking unfair advantage of the fact that homeowners are locked into above-market mortgage rates”. What I never dreamed of was that the investors and the rule-setters were the same people — in this case, Freddie Mac.

But here’s what Freddie is doing. In the past two years, it’s bought $3.4 billion of hugely-risky “inverse-floater” notes — essentially bets that homeowners with above-market mortgage rates won’t be able to refinance to market rates. And then it turns around and implements rules which prevent homeowners like Jay and Bonnie Silverstein from refinancing. The Silversteins have made all their mortgage payments on their current home in full and on time, despite the fact that they’re paying an interest rate of 6.875%. They’d love to refinance to get that rate lowered, but Freddie Mac won’t let them — because of the way they sold their previous home.

The Freddie Mac rule certainly maximizes Freddie Mac’s income, but it’s dreadful and unfair public policy. At the same time, it’s also policy which is very much in line with the FHFA’s stance on principal reduction, or anything else which might help homeowners. Given the choice between extracting short-term cashflows from homeowners, on the one hand, and improving the all-over health of the housing market, on the other, the FHFA will always choose the former.

Check out the long-awaited letter from FHFA director Ed DeMarco, for instance, justifying the fact that he won’t allow Frannie or Freddie to do principal reductions. It’s basically a long list of tables with precious little annotation or explanation, but at heart it seems to be based on two ideas. The first is that if you reduce principal to 115% of the value of the home, that doesn’t help very much. Well, duh. The whole point of principal reduction is to give homeowners back some equity in their home, and if they’re still underwater, you’re not doing that. And the second reason is just that Frannie’s computer systems aren’t really set up for principal reductions:

Neither Enterprise can accommodate the new accounting and tracking of principal reduction without operationally challenging changes to the existing IT systems, which are outdated and inflexible. The team did not require the GSEs to provide FHFA with cost projections, but experience implementing the HAMP program suggests that each Enterprise would need substantial funds and would rely upon scarce personnel resources to make the necessary IT modifications.

This is pretty desperate stuff — “we don’t know what the IT costs might be, and we didn’t bother to try to find out, but trust us, they’d be substantial”. In the wake of ProPublica’s story today, I don’t trust the FHFA at all. It signed off on all of Freddie’s trades, and its actions are entirely consistent with a regulator perfectly happy with Frannie taking on massive bets at the expense of homeowners, just to try to make some extra money. Oh, and the chap at Freddie in charge of buying these inverse floaters is paid $2.5 million a year.

It’s all quite a disgusting spectacle, really. Matt Levine attempts some kind of defense of Freddie’s actions, based on the idea that the inverse floaters are just what’s left after Freddie sells off everything it can easily sell — but that’s not what actually happened. In fact, Freddie went out and bought these instruments, on the open market. It almost looks like inside trading: they’ll pay off handsomely, just so long as Freddie continues to make it hard for homeowners to refinance. Which means that refinancings in general, and principal reductions in particular, are still going to be rare to nonexistent going forwards. Which is bad for homeowners, bad for the housing market, and bad for the economy as a whole. Even if it’s good for Freddie’s prop book.

Noam Scheiber is raving about Dylan Ratigan’s new book, giving it his highest praise: he calls it “sensible”. Which is maybe not obvious from the title, Greedy Bastards: How We Can Stop Corporate Communists, Banksters, and Other Vampires from Sucking America Dry.

He’s wrong. It isn’t sensible at all. Scheiber says that “one of the more intriguing ideas” in the book comes from Dick Grasso, of all people, who wants to classify a large part of the CDS market as “online gaming” and therefore “null and void”. Which sounds like one of those ideas which sounds great in the middle of your third bottle of wine.

But giving Scheiber (and Grasso, I guess) the benefit of the doubt, I had a look at the page of the book in question. Here it is, page 54, in full:

We must require not only that banks retain more capital but also that when they place bad bets, they pay the price for their losing bets themselves. Otherwise we are stuck with the worst of two economic systems: like a capitalist country, we have private banks that keep their profits. But like a communist country, we have a system where banking losses are charged to the government. Only when we end this corporate communism will we realign the interests of the banks with the investors they serve. The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well. By definition, if you can print it, you can cancel it.

As we have already seen, a swap can either be an insurance policy that helps to lower long-term costs for a business or a bet by an outsider on whether a given company or country will succeed or fail. Putting swaps on a public exchange would create the visibility for all to see the difference between commodity insurance that is critical to the economy and speculative bets that are not much different from gambling. In fact, Richard Grasso, former chairman of the New York Stock Exchange, suggested to me in a personal interview that the speculative bets that fueled the financial crisis could be reclassified legally as online gaming — and then cancelled. His technical explanation: “I believe regulators should require the product to be registered with a central clearing agent (like an exchange) and thus able to be monitored globally to prevent contracts being written in excess of the debt obligations they are designed to insure (corporate or sovereign). This is easily accomplished by [regulators] and Treasury issuing a cross-markets rule adopted by non-US counterparts. Any contracts written outside these requirements would be deemed null and void by regulators as simply online gaming.”

This is exactly the kind of thing we need much less of, at least in book form. It’s fine if you’re just shooting the breeze with a bunch of financially-illiterate friends, but it really doesn’t belong in a volume which aspires to present “smart policy” prescriptions.

I mean, we start off OK, with a standard-issue broadside about privatized profits and socialized losses. Got that. But what on earth is this supposed to mean?

The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well. By definition, if you can print it, you can cancel it.

I’ve spent the best part of a day trying to work out what on earth Ratigan might be driving at here, and I’ve come to the conclusion that he was probably just high. Never mind the fact that he doesn’t bother to identify which debt he wants reduced or canceled; just admire the elegant way that he proves that debt cancellation is somehow the equal and opposite action to printing money. (In reality, of course, printing money is a way of canceling debts, by inflating them away.)

Even more admirable, in a sense, is the way that Ratigan throws in his “let’s just delete some zeros” idea and then jumps straight to something completely unrelated — the idea of putting all derivatives on exchanges. I mean, it’s not as though deleting zeros willy-nilly would destroy the fundamental nature of capitalism as we know it, and might therefore be worthy of, oh, another sentence or two. We’ve got Grasso to get to!

Of course, we’re not going to get into any nitty-gritty here about the difference between exchanges and clearinghouses, despite the fact that Ratigan’s talking about the former, Grasso’s talking about the latter, and the two are not at all the same thing. And we’ll not spend much time either on the silly idea that anything interesting or systemically important happens at the point at which the notional value of derivatives contracts exceeds the amount of the underlying. (It doesn’t.)

Because even putting those points aside, what Grasso is suggesting here doesn’t stand up to the scrutiny of sober thought. (Especially if debt obligations — the underlying bonds being insured — can simply be reduced or canceled by deleting zeros.)

The way that markets and exchanges work, there’s no way that a clearinghouse would ever be able to know whether the counterparties to a derivatives contract had some kind of insurable interest in the underlying. Grasso’s proposal wouldn’t put an end to what Scheiber calls “naked bets”, it would just allow speculators to crowd out genuine hedgers, to the point at which people who did have an insurable interest wouldn’t be able to do any hedging, because the speculators would have got there first and written contracts up to the maximum allowable limit.

Ratigan has a bully pulpit on the television, and his heart is pretty much in the right place. I can see why he’d want to publish a book where he can tease out his policy ideas in detail, while keeping them accessible to his television audience. But it’s irresponsible to boil complex issues down into a simplistic world of good and evil, complete with simplistic solutions (cancel debt! outlaw speculative gambling!). If anything, it plays right into the rhetoric of the Tea Party, which Ratigan hates.

There are big and hugely important issues to be addressed in the global economy; the least we can do is take them seriously. And stop pretending that being harsh on a coterie of banksters would be both necessary and sufficient to solve all our problems.

Vikram Pandit has a clever idea:

It is not enough to require financial institutions to disclose capital ratios. Without knowing what that institution’s underlying assets are (only insiders and select regulators know that), outsiders, including most investors, cannot properly assess how that institution calibrates risk.

What is needed is a way to compare apples with apples. Regulators should create a “benchmark” portfolio and require all financial institutions, not just banks, to measure risk against that. The benchmark portfolio would not actually exist on the balance sheet of any one institution. Rather, it would be a collection of real investments that stand in for the kinds of assets that most financial institutions actually hold at the time. What is more, its contents would be 100 per cent public.

Institutions would be required to produce, on a quarterly basis for that benchmark portfolio, a hypothetical loan/loss reserve level, value at risk, stress-test results and risk-weighted assets. Right now these measures are run only against an institution’s actual portfolio and only a limited number of the results are disclosed. Worse, those results have no common frame of reference. The benchmark portfolio would supply that needed frame of reference.

As Lisa Pollack and Kate Mackenzie say, the problem here is that investors have to be able to trust that banks are modeling the benchmark portfolio in exactly the same way, using exactly the same tools, as they use for their own real assets. And this I think is where this whole idea falls down.

In the real world, banks know when they’re doing something risky, and then they create structures which make that risk invisible. They might, for instance, classify assets as “Level 3″ in an attempt to stop having to mark them to an inconvenient market. Or they might do what Pandit’s employer, Citigroup, did, and create all manner of off-balance-sheet vehicles which don’t report to shareholders or investors at all. Or they might do something else entirely which we won’t discover until after the next crisis.

That said, there’s the germ of something useful in Pandit’s proposal. So here’s how I’d improve it. Rather than having just one benchmark portfolio, or even four, as Mark Carney has suggested, give banks a kind of pop quiz every so often. One day, at about 10am, all the big banks in America would suddenly get given a surprise portfolio as selected by the New York Fed, and told “reserve against this”. With results due at, say, 3pm that afternoon. The New York Fed would then publish every bank’s answers, along with the amount of time that bank took to generate them.

By all means keep Pandit’s benchmark, too. But don’t allow the banks to game the benchmark just because they know exactly what it contains: it’s important to see how banks’ risk-management systems treat a portfolio which they haven’t been tweaked to expect.

What I’m thinking about, here, is the series of statements coming from John Thain, when he was the CEO of Merrill Lynch, saying that this latest write-down was the last ever write-down he would ever need to make against the bank’s mortgage-related assets. In that kind of atmosphere, the New York Fed could easily have published a portfolio of mortgage bonds, and asked every big bank to mark it to market and say how risky they thought it was. And that, in turn, would give a pretty good idea of just how conservative someone like Thain was really being.

And more generally, just being able to see the range of results, for any given portfolio, will be a healthy reminder that banks measure risk in very different ways. Pandit’s proposal wouldn’t just show which banks were particularly conservative; it would also show how much variation there is in the banking system as a whole. Which is in many ways even more important.

So let’s keep this concept alive, and try to make it as good as we can. As Mark Carney says, it can’t hurt. And it might just do some good.

Amar Bhidé has responded to my piece about his proposal to guarantee all bank deposits.

First, he says that the real stupidity in Ireland wasn’t the blanket guarantee of bank deposits; after all, he says, “virtually all Western governments implicitly or explicitly guaranteed all bank deposits (and other forms of short term cash, such as money market funds) in 2008″. Instead, it was Ireland’s guarantee of bank bonds. “this was dumb”, says Bhidé, “but it has nothing to do with whether or not deposits should be guaranteed”.

I think the two are in fact intimately connnected. Deposits are a funding source for banks, as are bonds. If you take in more of the former, you’ll issue less of the latter; cheap deposits will quickly chase out expensive bonds. If investors start flocking into 1-year and 3-year certificates of deposit on the grounds that they’re federally guaranteed, it’s hard to see how investors would find 5-year or 10-year uninsured bonds particularly attractive, unless they yielded a lot more than the CDs. And it’s equally hard to see why the bank would feel the need to pay through the nose to issue expensive 10-year debt, when it had unlimited access to much cheaper short-term funding instead.

Bhidé says that capital requirements would force banks to issue bonds — but I don’t see it. If there’s one thing we learned during the financial crisis, it’s that no one really considers subordinated debt to be useful capital: no bank has ever defaulted on its bonds and survived. In other words the kind of capital you get by issuing bonds is the kind of capital no one particularly wants. Instead, investors and regulators are increasingly looking at pure equity, in the form of metrics like TCE. I would hope that we’ve moved away from the paradigm that when a bank wants to improve its capital ratios, it issues a bunch of new liabilities which mean certain death if they’re ever defaulted on. That doesn’t strengthen a bank at all, and everybody knows it.

Bhidé’s proposal wouldn’t just destroy price discovery in the bank-debt market. It would also have the effect of raising interest rates more broadly, and increase the US government’s cost of borrowing. After all, bank CDs are always going to yield more than Treasury notes. If they carry exactly the same government guarantee, then there will be a significant move out of Treasuries and into bank deposits. I can’t see why the government would want that.

And yes, a lot of governments did implicitly or explicitly guarantee all bank deposits during the crisis. But here’s the thing: implicit guarantees are better than explicit guarantees, and temporary guarantees are better than permanent guarantees. Bhidé wants a permanent explicit guarantee, which is the worst of all.

An explicit and permanent guarantee on bank deposits would, overnight, create a whole new risk-free asset class — in a world where we’ve learned time and time again that risk-free asset classes are a Really Bad Thing. Investors tend to put inordinate value on safety, when what we really want to encourage is risk-taking. And highly-regulated banks with massive government-guaranteed bank deposits are not the best mechanism for allocating risk capital. Markets might not be perfect, but they’re surely better at capital allocation than that.

As companies like Apple build up their cash reserves into the tens of billions of dollars, we’re already beginning to see a world where bank deposits are becoming something of an asset class. It’s not a world we should encourage — let alone one we should institutionalize with a blanket government guarantee. Money should be invested; the government has no business encouraging corporations and institutional investors to simply park it in a bank instead.

Amar Bhidé is a smart man with a very stupid idea:

We need to take away the reason for any depositor to fear losing money through an explicit, comprehensive government guarantee. The government stands behind all paper currency regardless of whose wallet, till or safe it sits in. Why not also make all short-term deposits, which function much like currency, the explicit liability of the government?

Why not? I can answer that question in one word: Ireland. That country’s blanket government guarantee of all bank deposits was the single dumbest decision of the global financial crisis, and I can’t quite believe that anybody thinks it would be a good idea here. Yes, I understand that the US can print money while Ireland can’t. But that doesn’t mean it makes sense for the US government to take on untold trillions of dollars in extra contingent liabilities.

But let’s rewind to the beginning of Bhidé’s op-ed, and try to work out how on earth he arrived at this rather crazy notion. He begins by saying that “central bankers barely averted a financial panic before Christmas by replacing hundreds of billions of dollars of deposits fleeing European banks” — a statement which comes with no footnote or hyperlink, which makes it hard for me to know exactly what he’s referring to. I suspect it might be the coordinated liquidity operation which was announced on November 30, but I don’t recall anybody at the time talking about “hundreds of billions of dollars of deposits fleeing European banks”.

There was certainly a liquidity crisis in the European banking sector at the time, but there’s a world of difference between a liquidity crisis and a bank run. A liquidity crisis is when banks don’t lend to each other; a bank run is when depositors withdraw the money they have on deposit and move it elsewhere. And while deposits have certainly been flowing out of Greek banks in particular and the European periphery in general, I haven’t seen reports that European banks in toto are seeing massive deposit flight, or that deposit flight was in any way the reason for the November 30 move.

But Bhidé is convinced that there was a bank-run panic in Europe and that there might be one in the US as well:

The Federal Deposit Insurance Corporation now covers balances up to a $250,000 limit, but this does nothing to reassure large depositors, whose withdrawals could cause the system to collapse.

Again, I’d need a lot of argument to be persuaded that a bank run by large depositors in the US is a real danger. According to the FDIC’s Statistics on Depository Institutions, total deposits in the US, as of September 30, were pretty much exactly $10 trillion. Of that, $8.5 trillion was held domestically, and of that, $5.4 trillion is insured. Which means that there’s about $3.1 trillion of uninsured deposits in the US, and $4.6 trillion of uninsured deposits at US financial institutions. (Although some of those international deposits will be insured by the countries where they’re held.)

Certainly a $3.1 trillion bank run would cause the US banking system to collapse — there’s no doubt about that. But where does Bhidé think the money would go? And what makes him think that such a bank run is a real possibility? I can certainly see a run on some individual bank, if it looks like it might be in trouble — we saw that in 2008, at WaMu, although in the end there all depositors ended up with 100 cents on the dollar. But what I can’t envisage is a run on the whole system, where depositors move their money somewhere else entirely — partly because I have no idea where they might move it.

It’s worth noting here that the US differs from Europe in two crucial ways. The first is that companies can’t deposit their money directly with the central bank, in the way that Siemens for instance does. (The only exceptions are the handful of companies which own banks, like GE and Target.)

More importantly, deposits in the US are senior to banks’ bonds: depositors get their money back before bondholders get anything. In Europe, by contrast, depositors are often pari passu with other unsecured creditors. Which means that deposits are riskier in Europe than they are in the US.

All of which helps explain why the total amount of uninsured deposits in the US has continued to rise since the crisis hit: when I ran the numbers in September 2008, using July 2008 data, total domestic uninsured deposits were $2.1 trillion. Which seemed like a lot of money at the time, but it’s gone up by a full trillion dollars since then.

All evidence, then, points to the fact that US bank depositors aren’t worried about the safety of their deposits at all, and that they believe — correctly — that US banks, in general, are a perfectly safe place to park their funds.

But Bhidé’s not happy with that: he wants short-term deposits to be guaranteed just in the way that paper currency is guaranteed. But here’s the thing: the guarantee of paper currency is meaningless, because paper currency isn’t a government liability in the way that a deposit at a bank is a bank liability.

You can walk up to a bank and ask for the money you have on deposit to be converted into paper currency, and the bank has to give it to you in cash. But if you have cash and you walk up to Treasury, there’s nothing the government is obliged to give you in return. That’s the whole point of fiat currency: it is what it is. You can buy stuff with it — you can even buy a Treasury bill, and turn your cash into a US government obligation. But when that Treasury bill matures, it just becomes cash again.

And the fact is that we really don’t want a blanket guarantee of bank deposits in any event. Bank deposits are dangerous things — they’re informationally-insenstive assets which do a really good job of housing tail risk in an invisible and impossible-to-measure manner. If there were a blanket deposit guarantee, you can be quite sure that total domestic deposits would rise substantially from their current $8.5 trillion, and I’m not at all sure that I want to give trillions more dollars to the US banking sector, which has proved itself time and time again a very bad custodian of such funds. Bhidé seems to think that you could regulate away any risk: that’s naive in the extreme. If banks don’t take risk, they’re not banks any more.

Sometimes, banks will fail. That’s a feature, not a bug: it’s necessary to impose discipline on them. In Bhidé’s utopia, banks are so stringently regulated that they never fail. That places an impossible burden on regulators, and infantilizes the important capital-allocation function that banks provide in the economy.

“The next time a panic starts,” writes Bhidé, “markets may just not believe that the Treasury and Fed have the resources to stop it.” He’s right about that. So what makes him think that markets will believe a blanket deposit guarantee? If you guarantee everything, you guarantee nothing. Let’s keep private banks private. Because as Peter Thal Larsen says, the logical conclusion of what Bhidé wants is the nationalization of every bank in America. And even François Mitterrand never went that far.

Update: This page says there’s a total of $6.8 trillion in insured deposits, although it doesn’t say how many uninsured deposits there are. And it’s worth answering the point that Ireland guaranteed all bank debt, not just deposits. Which is true. But if there’s an unlimited government guarantee on bank deposits, then banks will simply fund themselves through deposits and not through bank debt at all.

A year ago, I spoke to the University of Pennsylvania’s Michael Kearns about whether we might be able to do something to help prevent a much worse reprise of the May 2010 flash crash. The short answer is that no, we can’t — or won’t, in any case. But the longer answer is that there is something we could do, if we just had some will and a lot of money:

You can imagine trying to build an ambitious, reasonably faithful simulator of our current markets. You’d have high-frequency algos, shorter-term stuff, dark pools, multiple exchanges, etc. A giant sandbox.

If you do a simulation and you try some perturbation or stress, and it tells you that a disaster happens, then it’s worth thinking hard about our current markets. But if you don’t find a disaster, that’s not reassurance that some other disaster won’t happen.

I’m proposing a quant version of the stress tests that were proposed for banks.

A car company, before they roll out a product, have a lab environment where they put it through tests. And in reality problems which weren’t tested for get discovered. We’d be much better off with a simulator.

We have no such lab for our financial markets. This strikes me as a little off.

People on Wall St think about simulation, but not for catastrophe prediction, just for their own trading purposes.

Kearns’s idea didn’t get anything like the traction it needs, and it’s not going to happen. But now a new paper from the UK’s Government Office for Science, written by Dave Cliff and Linda Northrop, lays out the case for building such a simulator over the course of 47 very interesting pages.

First of all, they write that the whole global economy “dodged a bullet” on May 6, 2010: if the Flash Crash had just happened a couple of hours later — and there’s no reason it couldn’t have done so — then the US markets might well have closed before the Dow had a chance to recover. The US sell-off would have triggered big market swoons in Asia and Europe, with very nasty consequences for, among many other things, Greek debt dynamics.

More generally, they write,

The global financial markets have become high-consequence socio-technical systems of systems, and with that comes the risk of problems occurring that are simply not anticipated until they occur, by which time it is typically too late, and in which minor crises can escalate to become major catastrophes at timescales too fast for humans to be able to deal with them.

Cliff and Northrop say that we should do exactly as Kearns suggested:

The proposed strategy is simple enough to state: build a predictive computer simulation of the global financial markets, as a national-scale or multinational-scale resource for assessing systemic risk. Use this simulation to explore the “operational envelope” of the current state of the markets, as a hypothesis generator, searching for scenarios and failure modes such as those witnessed in the Flash Crash, identifying the potential risks before they become reality. Such a simulator could also be used to address issues of regulation and certification. Doing this well will not be easy and will certainly not be cheap, but the significant expense involved can be a help to the project rather than a hindrance.

There are many reasons why this is not going to happen, starting with the fact that no one, right now, can afford to do it. Cliff and Northrop rather hopefully say that if this market simulator is expensive enough, then lots of Wall Street players will pay up to have access to its results — but in reality they’re much more likely to do everything they can to stop it from being built in the first place. Because if it is built, the certain consequence will be more regulation:

It may also be worth exploring the use of advanced simulation facilities to allow regulatory bodies to act as “certification authorities”, running new trading algorithms in the system-simulator to assess their likely impact on overall systemic behaviour before allowing the owner/developer of the algorithm to run it “live” in the real-world markets. Certification by regulatory authorities is routine in certain industries, such as nuclear power or aeronautical engineering. We currently have certification processes for aircraft in an attempt to prevent air-crashes, and for automobiles in an attempt to ensure that road-safety standards and air-pollution constraints are met, but we have no trading-technology certification processes aimed at preventing financial crashes. In the future, this may come to seem curious.

Even if regulators don’t have to sign off on trading strategies on an algo-by-algo basis, there’s really no point in building a hugely expensive and complex market simulator if the results of the simulations don’t result in constraining market participants somehow. And I can assure you that no amount of “you’ll all be safer” pleading with banks will persuade them that more regulation and constraint is ever going to be welcome.

Gillian Tett, too, is skeptical that anybody’s going to go ahead with a project of this magnitude:

Most regulators still prefer to forget May 6 rather than admit in public that they are struggling to understand how modern markets really work. And that, sadly, is unlikely to change, unless there is another flash crash.

And there’s a bigger reason, too, why it’s not going to happen: for all its ambition, a financial-market simulator wouldn’t actually address any of the causes of the financial crisis we just had, and probably wouldn’t address any of the causes of the next one, either. As Cliff and Northrop write,

The concerns expressed here about modern computer-based trading in the global financial markets are really just a detailed instance of a more general story: it seems likely, or at least plausible, that major advanced economies are becoming increasingly reliant on large-scale complex IT systems (LSCITS): the complexity of these LSCITS is increasing rapidly; their socio- economic criticality is also increasing rapidly; our ability to manage them, and to predict their failures before it is too late, may not be keeping up. That is, we may be becoming critically dependent on LSCITS that we simply do not understand and hence are simply not capable of managing.

We could try to spend hundreds of millions of dollars simulating and examining the fine-grained architecture of securities trading and high-frequency algorithms; and even if we were incredibly successful in that endeavor, there would still be hundreds if not thousands of other large-scale complex IT systems which can and probably will fail catastrophically at some point. We can’t simulate them all. So why pick on the stock market?

Historically, it was hard for institutions to reply in any effective manner to press reports which they thought were full of egregious errors and mistakes. They could complain to various editors, and maybe even get a short response on the letters page, but they rarely got the opportunity to reply in their own words and at the length they thought the reply deserved.

The web, of course, has changed all that, and ISDA’s media.comment blog is a great example of a criticized institution taking matters into its own hands. It names and links to the articles it’s criticizing, and I’m pretty sure that it would happily engage in real debate, if those organizations ever deigned to reply. Which they don’t. As a result, ISDA seems — is — more transparent and open than the likes of the New York Times and Bloomberg.

The Federal Reserve, on the other hand? Not so much.

In a six-page letter today addressed to the Senate Banking Committee, Ben Bernanke lashes out at “a series of articles–one just last week–concerning the Federal Reserve’s emergency lending activities”. He says those articles “have contained a variety of egregious errors and mistakes”. And he encloses “a memo prepared by Board staff that addresses some of the most serious errors and claims in those articles”.

Nowhere in those six pages is a single article actually identified. The Fed memo, similarly, has no named author. And the whole thing is available only as one of those PDFs-from-a-copy-machine, which makes it impossible to copy-and-paste or to search. The Fed put the letter up on its website and made sure that various economic journalists, like myself and Binyamin Appelbaum, knew all about it. But the whole thing is an incredibly passive-aggressive way of attacking Bloomberg, which, to reiterate, is never actually named.

Bloomberg did not let the opportunity go to waste. It’s clearly the main object of the Fed’s ire, but because it isn’t named, it can do two rather clever things in its official response. The first is to respond to the Fed’s complaints by citing various different stories it’s written over the years — since the Fed never actually specified which story or stories it had issues with. And the second is to simply deny that it said what the Fed is complaining about at all. When the Fed, for instance, says that “the articles misleadingly depict financial institutions receiving liquidity assistance as insolvent,” Bloomberg simply and effectively replies that it “never described any of the financial institutions mentioned in its bailout stories as insolvent”.

All of which makes the exchange less of an actual debate and more of a case of two powerful institutions talking past each other.

The Fed has various blogs; it could easily have used one to single out specific errors in the Bloomberg article, which Bloomberg would then have had to respond to directly. But instead it just writes a memo talking vaguely about “these articles”, and in doing so plays straight into Bloomberg’s hands.

And of course both the Fed memo and the Bloomberg response perpetuate the myth that Fed officials don’t talk to Bloomberg reporters on a daily basis. There’s lots of back-channel noise, here, which isn’t seeing the light of day; the memo and official response are just the carefully-chosen public face of a debate which is happening primarily in private. (The Fed’s a bit like Goldman Sachs: it loves talking “on background”, but hates saying anything on the record. Which is why a large part of Fed-watching is working out which reporters are getting the coveted phone calls from Fed board members, and then reading between the lines to work out who’s telling them what.)

Bloomberg has won this particular round, just because it’s being very open about what it’s saying, while the Fed memo seems mealy-mouthed and less than fully open about what it’s trying to say. If you’re going to complain about “egregious errors and mistakes”, it behooves you to be specific about exactly where the errors and mistakes lie, and to quote them directly. If you don’t do that, you automatically look as though you have a weak case, and you open yourself up to counterattacks like the one from Bloomberg.

Which is not to say that the Fed is being completely disingenuous here. The Bloomberg article in question ginned up rather more scandal than there really was. “Details suggest taxpayers paid a price beyond dollars as the secret funding helped preserve a broken status quo and enabled the biggest banks to grow even bigger,” it says, breathlessly — but really they don’t: the details that Bloomberg managed to obtain really don’t tell us anything about the Fed’s lender-of-last-resort operations in aggregate that we didn’t already know. They do give us new information about a few specific banks, none more so than Morgan Stanley.

Or, take this passage, under the sub-head “$7.77 Trillion”:

The amount of money the central bank parceled out was surprising even to Gary H. Stern, president of the Federal Reserve Bank of Minneapolis from 1985 to 2009, who says he “wasn’t aware of the magnitude.” It dwarfed the Treasury Department’s better-known $700 billion Troubled Asset Relief Program, or TARP. Add up guarantees and lending limits, and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the U.S. that year.

If you read the passage very carefully, there’s nothing actually inaccurate there. But the impression given is that “the amount of money the central bank parceled out” was $7.8 trillion, a sum which “dwarfed” TARP and is more than half of US GDP. And that’s not true — the actual amount that the central bank parceled out never exceeded $1.2 trillion, a fact you won’t find in the Bloomberg article.*

And this, too, is misleading:

Dean Baker, co-director of the Center for Economic and Policy Research in Washington, says banks “were either in bad shape or taking advantage of the Fed giving them a good deal. The former contradicts their public statements. The latter — getting loans at below-market rates during a financial crisis — is quite a gift.”

The Fed says it typically makes emergency loans more expensive than those available in the marketplace to discourage banks from abusing the privilege. During the crisis, Fed loans were among the cheapest around, with funding available for as low as 0.01 percent in December 2008, according to data from the central bank and money-market rates tracked by Bloomberg.

The 0.01% funding was one loan, to one bank, on New Year’s Eve, as the emergency-lending program was coming to an end: in no way is it indicative of the interest rates charged by the program as a whole. And Baker’s characterization of the Fed loans as being “at below-market rates” is left conveniently undefined, in the context of the fact that the credit market had seized up and that there were no real “market rates” any more in the interbank market. Indeed, the comment makes it into a caption in the article, which says that “banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates”.

The fact of the matter is, as the Fed points out in its letter, that the Fed set the interest rates on the lending at a penalty over normal market rates. And — you really have to work to get this — Bloomberg’s methodology doesn’t actually take into account the interest rates charged by the Fed at all! Bloomberg just takes the amount of money that the banks borrowed from the Fed, and then multiplies it by their net interest margin — the profit they reported on loans. The Fed could have been lending at a penalty rate of 25%, and according to Bloomberg the banks would still have made $13 billion in profits on the loans, so long as their net interest margin didn’t change. Just because the banks had a positive net interest margin does not mean that the Fed was lending them money at below-market rates, as Bloomberg would have you believe.

The Bloomberg article reads like a highly partisan attempt to paint the Fed in the worst possible light, with misleading assertions and extensive quotes from Fed critics. The Fed could, if it wanted to, have spelled this out. But in attempting to be high-handed and refusing so much as to utter Bloomberg’s name, it just seems out of touch and opaque — which is exactly the impression Bloomberg would love you to have.

So Bloomberg wins — and the Fed ends up looking even worse. Maybe next time the Fed will be a bit more transparent and heartfelt and honest. It will find itself in a much stronger position if it goes there.

*Update: You will find the fact that the banks never borrowed more than $1.2 trillion in the article, but it’s subtle enough that I missed it on multiple readings. At the top of the piece, we’re told that the banks”required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day”.

I can highly recommend Nick Dunbar’s new book on the financial crisis; I’ll have a full review of it soon, but for the time being let’s just say that for my money it’s the best crisis book so far. Fair, detailed, unsparing, and — most importantly — written by someone who was reporting on the structured-products market all the way through the boom, instead of just looking back after the bust and asking what happened.

There’s a lot of reporting in this book, too, and today Reuters has an excerpt of how the Federal Reserve in general, and the New York Fed in particular, failed in its job of overseeing Citigroup. When DC-based examiners started asking tough questions, they were met with stonewalling from the New York Fed, which behaved exactly as you would expect from an institution captured by its big-bank shareholders.

The market and liquidity risk team and others in the Federal Reserve Board supervision division had grown concerned that as large banks built up their trading businesses and accounting rules gravitated to fair value measurement, bank balance sheets were increasingly subject to short-term market moves that could lead to rapid falls in regulatory capital. A memo produced by the team pointed out the issues and risks involved in increased use of fair value and warned that a sudden freeze in certain markets might imperil bank solvency. But when the market and liquidity risk team tried to interest Dahlgren in their findings, she retorted, “I think our banks know how to manage to fair value,” ending the discussion.

In 2006, the market and liquidity risk team attended a Citigroup risk assessment presentation to a committee of Fed examiners. When asked for the rationale supporting the designated satisfactory rating for interest rate risk, the New York Fed team could not provide any information. At another Citi meeting the market and liquidity risk team attended, the New York Fed examiners had been asked to come up with a list of supervisory priorities for the bank. They identified approximately twenty items and patiently explained why each one was important. Near the end, Peters interrupted and told his staff to cut the number of priorities to five or six because twenty was “too many.” The Washington, D.C., team was stunned—twenty was too many things to check regarding the largest and most complex bank in the United States?

This is a perennial problem — and the only reason we know how bad things were is because one small group of examiners, in Washington, was marginally less bad at regulating banks than another group in New York. Most of the time, there’s only one group of bank examiners, and they never blow the whistle on themselves.

At the end of the passage, Dunbar reveals that even if the full list of 20 priorities had been implemented in full, Citi would still have blown up, since no examiners had a clue that Citi was hiding $43 billion of CDO exposure off its balance sheet and outside its value-at-risk calculations.

Dunbar reports one particularly vivid conversation, in the wake of a carbon-trading desk blowing up:

One person on the market and liquidity risk team vividly remembers a New York Fed bank examiner shrugging off the emission trading losses, arguing, “Don’t worry about that. We just have to respond to these things when they happen. We can’t get ahead of these problems. We don’t have enough people, and the bankers have a lot of smart people.”

The sad thing is that the New York Fed examiner is probably right. They couldn’t get ahead of these things. And they still can’t.

An ounce of prevention, we’re all taught at an early age, is worth a pound of cure. But central banks are really bad at the prevention side of things. Which is why they have to put so much effort into their attempted cures.

Ladies and Gentlemen, this is what a lender of last resort looks like. What you’re looking at here are three lines. The black line is Morgan Stanley’s market capitalization, which tends to hover in the $40 billion range but which fell as low as $9.8 billion in November 2008. The orange line is the amount that Morgan Stanley owed to the Federal Reserve on any given day — an amount which peaked at $107 billion on September 29, 2008. And the red line is the ratio between the two: Morgan Stanley’s debt to the Federal Reserve, expressed as a percentage of its market value. That ratio, it turns out, peaked at some point in October, at somewhere north of 750%.

Many congratulations are due to Bloomberg, for extracting this information from the Fed after a long and arduous fight. It couldn’t have come at a timelier moment: if the ECB wants to avert a liquidity crisis, charts like this give a sobering indication of just how far it might have to go, and how quickly it might have to act.

On September 16, 2008, Morgan Stanley owed $21.5 billion to the Fed. The next day, that number doubled, to $40.5 billion. And eight working days later, on the 29th, the bank’s total borrowings from the Fed reached $107 billion. The Fed didn’t blink: it kept on lending, as much as it could, to any bank which needed the money, because, in a crisis, that’s its job.

The Fed likes to say that it wasn’t taking much if any credit risk here: that all its lending was fully collateralized, etc etc. But it’s really hard to look at that red line and have a huge amount of confidence that the Fed was always certain to get its money back. Still, this is what lenders of last resort do. And this is what the ECB is most emphatically not doing. I find it very hard to imagine the ECB lending some random European investment bank €100 billion just for the sake of keeping liquidity flowing.

And it’s frankly ridiculous that it’s taken this long for this information to be made public. We’re now fully ten months past the point at which the Financial Crisis Inquiry Commission’s final report was published; this data would have been extremely useful to them and to all of the rest of us trying to get a grip on what was going on at the height of the crisis. The Fed’s argument against publishing the data was that it “would create a stigma”, and make it less likely that banks would tap similar facilities in future. But I can assure you that at the height of the crisis, the last thing on Morgan Stanley’s mind was the worry that its borrowings might be made public three years later. When you need the money, and the Fed is throwing its windows wide open, you don’t look that kind of gift horse in the mouth.

Every time the Fed fights tooth and nail to prevent certain information from being made public, and loses, there’s a certain feeling of anticlimax: we get the information, and ask what on earth is so dangerous about normal people knowing it. The Fed is one of the most vital and least trusted institutions in America, and there’s a reason why a book called End the Fed is still riding high in the Amazon charts, more than two years after it was published. If the Fed wants to get Americans back on its side — and it needs to get Americans back on its side — then it will have to stop fighting these silly battles against transparency. Especially since the release of this data has a lot to teach the Fed’s counterparts in Frankfurt.

We have an excerpt of Emanuel Derman’s new book today. I can highly recommend both the excerpt and the whole book, which is a very readable generalist’s guide — by a physicist-turned-quant — to models, their uses, and their abuses.

“First,” writes Derman, “one must recognize that there are no genuine theories in finance.”

To understand this, you need to understand how a physicist views a theory. So let me also excerpt for you one of the more wonderful passages in the book:

Newton’s theory is general and precise. The gravitational force is inversely proportional to exactly the square of the distance between the planets; Newton was confident that the power of the distance is precisely 2. Had he been a social scientist performing statistical regressions in psychology, economics, or finance, he would probably have proposed a power of 2.05 ± 0.31.

A theory is not a fetish; when it is successful (see the quantum theory of electricity and magnetism in chapter 5) it describes the object of its focus so accurately that the theory becomes virtually indistinguishable from the object itself. Maxwell’s equations are electricity and magnetism; the Dirac equation is the electron; the Weinberg-Salam model of weak and electromagnetic interactions matches the electrons and quarks in almost every detail, as closely as one can measure. You can layer metaphors on top of the equation, but the equation is the essence.

This takes me back to Nigel Wood, my great high-school physics teacher, and the three-volume Feynman Lectures on Physics that my dad gave me as a birthday present one year. It’s infectious and addictive stuff — but it’s also very dangerous when, as happens with great frequency, physicists come pale and blinking out of their post-doctoral studies and get thrown into the bowels of an investment bank somewhere.

The point is that when you’ve spent a decade or so in a world of true theories, it’s incredibly hard to understand, on a deep level, any series of pro-forma warnings about how there aren’t really any theories in finance and how models can explode. And it’s not just quants, it’s regulators, too, who pine for a world of certainty and who can be astonishingly blind to real-world risks that live outside their models.

How do we fix this problem? With great difficulty. Wilmott’s Certificate in Quantitative Finance is a start: if we’re going to have quants, and we are, then they should be trained well, in the real world. But I think in general this is one of those endemic and unhedgeable risks. And a decidedly unexpected side-effect of the amazing accuracy of forecasts in the world of quantum physics.

Sheila Bair aims her fire squarely at Europe’s banks and their regulators today, contrasting the high degrees of leverage and low degrees of capital in Europe to the safer banks we have here in the US.

The U.S., which has tighter rules governing how FDIC-insured banks determine the riskiness of assets, requires well-capitalized banks to hold capital equal to at least 5% of total assets, regardless of how risky they think the assets are. So for any asset, be it cash, U.S. Treasury securities, or supposedly safe mortgages, banks must hold at least 5% capital against it. European banks do not have this kind of “leverage ratio,” and Basel II has allowed them to treat sovereign debt as having zero risk. That is one of the main reasons they have loaded up on nearly $3 trillion of it…

European regulators should supplement this [9% common equity capital] requirement with the Basel III 3% leverage ratio — or even better, the U.S. 5% requirement, adjusting for accounting differences. The EBA should also use realistic loss estimates more in line with those of the IMF and private analysts. If banks have to accept dilution of their stock or temporary nationalization, so be it…

U.S. regulators made many mistakes, but because we maintained our leverage ratio and delayed Basel II implementation, FDIC-insured banks have remained much more stable than other financial institutions. Bank capital standards should not be an insider’s game. The public deserves better. Bank regulators should do their job, and it is their job, not the job of conflicted bank managers, to set minimum capital levels.

I’m sure that Bair feels that it’s her intrinsic toughness and common sense which resulted in US banks being held to tougher standards than their European counterparts. And she’s absolutely right that when it comes to capital and leverage, US regulators came out of the crisis looking better than European regulators. But not by much. US investment banks were allowed to increase their leverage and decrease their capital as much as they liked — which is one reason why Bear Stearns and Lehman Brothers collapsed so quickly. And other countries, like Canada and India, were much tougher even than the US.

The fact of the matter, however, is that all regulators are captured by banks. Or, to be a little more precise, all legislatures are captured by banks, and all regulators do what the government tells them to do.

In countries like Canada and India, there’s a very small number of strong, well-capitalized banks with a vested interest in maximizing barriers to entry. So they’re happy with very tough standards. In Europe, national banking systems are also concentrated, so in theory they could go the same way. But European banks are more likely to have cross-border and global ambitions, and in any case as a matter of contingent fact they’re not very well capitalized. So they get the regulation they want — which allows them to grow fast without having to raise lots of expensive new equity capital.

And then there’s the US, which is pretty much unique among major economies in having thousands of pretty vibrant small banks. Those small banks have a lot of political clout in Congress, and they hated Basel II, because they’re not nearly sophisticated enough to take advantage of it. So they essentially bullied Congress into keeping the old Basel I standards, for fear that otherwise they would be at a massive competitive disadvantage with respect to the big US banks like JP Morgan Chase. Congress obliged, and used the FDIC as its chosen mechanism for blocking the adoption of Basel II in the US.

Does that make the FDIC particularly virtuous? No: it makes the FDIC just as beholden to the banks as any European regulator. Look at the banks’ contributions to the FDIC insurance fund, for instance: they fell to zero, for no good reason, just because the banks didn’t like making those payments.

So Bair is hopelessly naive if she thinks that European regulators — or even American regulators — can really ever force banks collectively to do something they don’t want to do. The only reason the FDIC has any teeth at all in terms of capital requirements is that it’s in the small banks’ interest, and those small banks have a lot of political influence. There really aren’t any small banks in Europe, and European taxpayers are now on the hook for much bigger potential financial-sector losses as a result. That’s bad for Europe, and the world. But the US, and Bair, are in no particular position to deliver lectures on this subject.

Is the SEC colluding with Wall Street’s biggest banks to let them off lightly with respect to their dodgy CDOs? Jesse Eisinger and Jake Bernstein get an astonishing on-the-record admission today, from a Citigroup flack, that might indeed be the case:

The bank says it has settled all of its potential liability to a key regulator – the Securities and Exchange Commission — with a $285 million payment that covers a single transaction, Class V Funding III…

[The SEC] made no mention of the dozens of similar collateralized debt obligations, or CDOs, Citi sold to investors before the crash.

A bank spokesman said the SEC would not be examining any of those deals. “This means that the SEC has completed its CDO investigation(s) of Citi,’’ the spokesman asserted in an e mail.

The SEC, of course, denies this — but it carries the ring of truth. Just look at the SEC’s own list of CDO prosecutions to date: there’s exactly one enforcement action per bank.

And the idea is held more broadly, too — look for instance at Peter Henning’s article on the subject today.

The settlement — in which the financial firm agreed to pay $285 million without admitting or denying guilt — appears to be of little concern to Citigroup investors. They’re likely to be happy that the bank has put the issue to rest.

What makes Henning think that Citigroup has put this issue to rest? As Eisinger and Bernstein demonstrate, Citi had lots of synthetic CDOs — not just Class V Funding III — where someone other than the ostensible CDO manager was intimately involved in choosing the contents, and had a vested interest in picking securities which were extremely likely to fail.

There’s every indication, here, that the banks are doing nod-and-a-wink deals with the SEC. The SEC brings its single strongest case, and the banks agree to a nine-figure fine, on the implicit understanding that the fine covers all their other CDO deals as well. That saves the SEC from having to laboriously put together a separate case for each CDO deal, and it allows the banks to put much of their contingent liability behind them.

But if that is going on, it’s a scandal. For one thing, it’s incredibly unfair to everybody who bought one of the dodgy CDOs which is not prosecuted. Investors in Class V Funding III, for instance, are getting all their money back as a result of this latest settlement. But what about investors in Citi’s other synthetic CDOs, like Adams Square Funding II, or Ridgeway Court Funding II, or even Class V Funding IV? Not to mention the $6.5 billion of Magnetar deals, where — according to all ProPublica’s reporting — Magnetar was intimately involved in choosing what went in and what didn’t. The big sin, remember, in both the Goldman and Citi deals, was one of disclosure: the banks didn’t disclose to investors that the short side of the trade was hand-picking the contents of the deal. And you just know that there were dozens of deals — not just one per bank — where that key disclosure was missing.

Is the SEC trying to protect the banks it’s meant to be prosecuting? Is it quietly agreeing on a one-prosecution-per-bank model? If so, we should be told. And if not, it had better bring prosecution #2 against someone pretty soon. Because right now the pattern is decidedly fishy.

Bloomberg had a story, a couple of days ago, about BofA moving Merrill Lynch derivatives to its retail-banking subsidiary. The story was quite long and hard to follow: there were lots of detours into explanations of what a derivative is, or explorations of what the BAC stock price was doing that day. So let me try to cut away the fat.

Bank of America is being hit with downgrades. And as we saw with AIG, when a derivatives counterparty gets hit with downgrades, it has to post lots more collateral. In BofA’s case, the numbers are very large indeed:

Bank of America estimated in an August regulatory filing that a two-level downgrade by all ratings companies would have required that it post $3.3 billion in additional collateral and termination payments, based on over-the-counter derivatives and other trading agreements as of June 30. The figure doesn’t include possible collateral payments due to “variable interest entities,” which the firm is evaluating, it said in the filing.

On the other hand, retail banks are much safer, because they’re protected by the FDIC. If a retail bank is a derivatives counterparty, then it doesn’t need to post nearly as much collateral. The derivatives aren’t themselves insured by the FDIC, but they have extremely senior status, which means that the bank can use its deposit base to pay off derivatives counter parties. And then if there isn’t enough money left to pay depositors, the FDIC will step in and make those depositors whole.

So Bank of America decided to move some unknown quantity of derivatives from Merill Lynch — which doesn’t have an FDIC-insured deposit base — over to its Bank of America retail subsidiary, which does.

The FDIC was not happy about this — it makes it more likely that they will have to pay out in the event that Bank of America runs into trouble. And when the FDIC pays out, that’s a hit to taxpayers, the letter of the law notwithstanding. Jon Weil explains:

The market harbors serious doubts about whether Bank of America has enough capital…

Dodd-Frank lets the FDIC borrow money from the Treasury to finance a seized company’s operations for as long as five years. While the law says the FDIC is supposed to tap the banking industry to pay for any eventual losses, it’s hard to imagine the agency could ever charge enough to cover the costs from a failure at a company with $2.2 trillion of assets

Now it’s worth pointing out here that other big derivatives houses, most notably JP Morgan, have used their retail-banking subsidiary as their derivatives counterparty for years. Now that Merrill is part of BofA, there’s no obvious reason why it should be worse off than JP Morgan is with access to Chase. But Yves Smith makes the case that the two are in fact significantly different:

JPM runs a massive derivatives clearing operation, and a lot of its exposure relates to that. This and the businesses of the other large banks have been supervised by the regulators for some time (you can argue the supervision was not so hot, but at least they have a dim idea of what is going on and gather data). By contrast, no one was supervising the derivatives book at Merrill. The Fed long ago gave up supervising Treasury dealers, and the SEC does not do any meaningful oversight of derivatives. And Chris Whalen confirms that Merrill was and is the cowboy among derivatives dealers.

I’m not entirely convinced by this. I don’t think that JP Morgan’s derivatives operations are particularly assiduously regulated — certainly not to the point that would make the FDIC happy. But I also hate the “everybody’s doing it” defense. The whole point of the Volcker Rule was to stop banks with retail-banking privileges from abusing those privileges in their risky investment-banking operations. And that’s exactly what’s going on here. And as Bill Black points out, the whole thing is dubiously legal in any case:

I would bet large amounts of money that I do not have that neither B of A’s CEO nor the Fed even thought about whether the transfer was consistent with the CEO’s fiduciary duties to B of A (v. BAC).

The point here is that regulators care much more about Bank of America, the retail-banking subsidiary which holds depositors’ money, than they do about BAC, the holding company which owns Merrill Lynch. And the senior executives at Bank of America have a fiduciary duty to Bank of America — never mind the fact that their shareholdings are in BAC. The Fed, in allowing and indeed encouraging this transfer to go ahead, is placing the health of BAC above the health of Bank of America. And that’s just wrong. Holdcos can come and go — it’s the retail-banking subsidiaries which we have to be concerned about. The Fed should not ever let risk get transferred gratuitously from one part of the BAC empire into the retail sub unless there’s a very good reason. And I see no such reason here.

Pace the president, does Bank of America’s $5 debit-card fee really show the need for the Consumer Financial Protection Bureau? Not really: the CFPB does not exist to prevent banks from charging stupid fees as part of a self-defeating protest against the Durbin amendment. If BofA wants to charge $5, or $50, or even $500 to people using its debit cards, then so long as it gives them fair warning, does so transparently, and is happy to see them close their accounts, it should be allowed to do so.

The fact that the fee was a mistake can be seen easily by the fact that it caused a huge uproar, while much bigger increases to Citibank’s monthly checking-account fee went largely unremarked-upon. At Citibank, the basic free-checking account now carries a $10 fee, waived if you use direct deposit or have a $1,500 average balance. And Citi’s more fully-featured checking account, which used to have a $12 monthly fee, has seen that increased to $20; in order to avoid that fee, the average balance has also been raised, from $6,000 to $10,000.

The era of big-bank free checking is over. But that has nothing to do with Durbin, and everything to do with the regulation of overdraft fees. (And, of course, low interest rates.) If banks need to charge a monthly fee in order to make money on their checking accounts, then so be it. But I do think that the current level of checking-account fees is excessive, and that charging for debit transactions is downright idiotic.

All four of the big banks have a standard checking account with a monthly fee which is waived once you keep a monthly balance of more than $1,500. At Wells Fargo, that fee is $5. At Citi, it’s $10. At Chase, it’s $12. And at BofA, it’s also $12, rising to $17 if you use your debit card.

Then there’s the next tier up, where fees only get waived once you have a significant amount of money on deposit. Again, Wells Fargo has the best deal: the minimum is $5,000, and if you drop below it, the charge is $15 per month. At Citi, it’s $15,000 or $20/month. At Chase, it’s $15,000 or $25/month. And at BofA, it’s $10,000 or $25/month — plus that $5/month fee for debit-card usage, even for people keeping a five-figure sum on deposit. That fee only gets waived once you reach $20,000 on deposit.

What expensive services are the banks providing which require fees of hundreds of dollars a year? Branches, mainly, and tellers, and paper statements. And, of course, the enormous overhead associated with being a huge global bank. It’s certainly not debit-card payments — which are pretty much the cheapest way that any customer can transact, from the bank’s perspective. It costs vastly more for a bank to process a paper check than it does for them to process a debit-card payment — so why would they charge an extra monthly fee for the latter and not for the former?

I’m all in favor of banks charging a reasonable fee for expensive services, rather than trying to hide the cost of those services in painful and unexpected charges. But my idea of “reasonable” is more or less what we charge at Lower East Side People’s: $3 a month, for people carrying a balance of less than $75 — essentially, a way to discourage people from keeping bank accounts open and unused with no money on deposit.

As for the proper role of the CFPB, one thing I’m desperately looking forward to is a simple public database of all the banks offering federally-insured checking accounts, with a very easy way of comparing the features and fees of each. It would be particularly great if the CFPB could bestow some kind of gold star on the best and cheapest products, and could thereby help steer Americans away from bad accounts at megabanks, and towards much better accounts at smaller banks and credit unions.

Although, if BofA continues to carry on like this, I reckon it’ll lose a lot of customers anyway, sooner or later.