In 1873, Walter Bagehot wrote that "the business of banking ought to be simple; if it is hard it is wrong." He would have struggled to recognize today's banking system.

It is not just ever more ornate derivatives that bend the mind. Financial firms themselves have become fabulously complicated. Citigroup lists 2,061 subsidiaries and affiliates while the institutional chart of JPMorgan Chase is 267 pages long.

Complexity -- as Bagehot predicted -- has become a curse. If nobody can understand financial firms, they will become ever more accident prone.

The crisis that exploded a year ago offered a salutary lesson in the dangers of complexity. Many shareholders and creditors simply did not fully comprehend their investments. Instead they were forced to trust managers and the rating agencies.

Regulators too could be forgiven for scratching their heads.

"Supervisors are at a decided disadvantage in understanding risk-taking and compliance for firms that might involve dozens of jurisdictions, hundreds of legal entities and thousands of contractual relationships," former Fed official Vincent Reinhart has written.

Indeed Basel II -- the international capital code -- was an admission of defeat by regulators. The message from the banking accord was that institutions had become so convoluted that only they were able to understand the risks they were taking.

Yet many intelligent executives of these same institutions failed spectacularly. It is no mean feat keeping tabs on an army of specialized financial engineers, lawyers and accountants.

As Robert Rubin, the former Treasury Secretary and Citigroup executive, acknowledged last year on the Charlie Rose show: "Unless you are either running the trading operations or running the independent risk management, you are not going to know the risk well enough to have a real sense of where those risks are."

Making financial firms simpler will be far from simple.

One approach is coercive. Regulators can make it very uncomfortable to be big. Capital requirements that ratchet up with size would encourage firms to split themselves up into their component parts, giving managers and regulators a better shot at following what is going on. On the whole, smaller firms tend to be more straightforward.

Failing this, Reinhart has proposed a Lego model, in which financial firms would be composed of "well-defined modules." A company made of units that can be easily disconnected from the whole would be easier to manage, with individually simple parts. Regulators can foster this model by insisting on a "living will," complete with plans for how companies would salvage their firm in the event a single unit implodes.

Regulators need to make it much easier to understand financial statements. First, they should impose a strict consolidation of bank balance sheets, forcing them to incorporate all special purpose vehicles.

In addition, more information should be made available about banks' risk-taking. Firms should be compelled to publish monthly indicators drawn up by regulators, including a measure of the relationship between short-term borrowing and long-term lending.

This would enable creditors to exercise proper discipline over the banks by pushing up their borrowing costs if they become too reckless. The notion that only banks themselves can understand their own risk-taking needs to be jettisoned.

Lastly, the government should also reduce the incentives for complexity. Financial institutions mirror the Byzantine structure of regulation, tax and accounting rules. They become complicated in order to shop for the most lenient regulator, lightest capital requirements and most tax efficient structure.

Paring down these rules and structures should be an underlying goal of any regulatory overhaul.

The first step to reducing the magnitude of future mishaps is to ensure that we can make sense of our financial institutions. The respect and awe often accorded to "black box" financial institutions is misplaced and dangerous. Instead we need to embrace simplicity.

The Year Since Lehman -- related columns:

"Living wills" are easier said than done

A year on, it's still a housing story

– James Saft is a Reuters columnist. The opinions expressed are his own –

U.S. bank operating earnings are going to have a hard time outrunning credit losses, making the massive rally in bank shares look ready to be marked-to-market.

A series of positive statements about profitability in the early part of the year from major U.S. banks, notably Bank of America, Citigroup and JP Morgan helped to spring a rally in the beaten down sector, as investors bet that with government assistance they could earn their way out of their troubles.

The KBW bank index has enjoyed a blistering rally, rising 51 percent from its March 8 low, though it is still down almost 40 percent from where it ended 2008.

To be comfortable with that, you have to believe two difficult things; that investors will value the earnings banks are now making as if they were sustainable and that banks won’t be swamped by credit losses and potential forced dilutions of shareholders.

“We are unconvinced that the banks have turned a corner,” FBR Capital Markets analyst Paul Miller wrote in a note to clients. “Investors who believe that the recent financial rally is here to stay expect that most banks will remain profitable.

We expect that profitability at these banks will be driven by favorable fixed-income trading revenues, as well as mortgage banking revenues.”

In some ways, balance sheets aside, it’s a pretty good time to be a bank in America. Competition has thinned out and margins should fatten commensurately.

U.S. bank profits from trading and mortgage banking are both problematic. Trading income, because it varies wildly, is hard to predict and hard to value.

If the past two years has taught us anything, it’s that paper profits can evaporate and risks can be hard to spot.

On the positive side, the fact that banks are now putting less balance sheet to work as market makers means that those banks which still operate can make considerably more on the difference between where they buy and sell securities. But given the huge uncertainty about who will be around in a year’s time, especially given the by its nature unpredictable role of government, its hard to know how much competition there will be or even how much capital banks will be forced to hold against trading activities.

LOAN COLLECTING BLUES

Mortgage banking is also going to be bigger this year. The Mortgage Bankers Association predicts refinancing will total $1.96 trillion and purchase loans increase $821 billion, which could make it the fourth-biggest year on record. This is mostly because the Fed has driven interest rates down in a bid to reflate the economy. That makes it profitable for many Americans to refinance their mortgages and is luring a much smaller number back into the house purchase market despite falling prices.

But again mortgage banking is a notoriously tough business, and though a scarcity of lending capital has driven fees up, the record of banks in the U.S. engaging in it profitably is not good.

Mortgage banking, as distinct from mortgage lending, is the business of originating loans, these days almost exclusively for Fannie Mae or Freddie Mac in exchange for a fee and the right to earn more fees by collecting payments in exchange for servicing the loan for the lender.

But the mortgage servicing right that a bank gets when it makes the loan is usually recognized as income based on the current value of the cash it is expected to generate over time.

That means that banks that originate lots of mortgages show huge gains in income during refinancing booms. It does not mean, however, that they necessary make money out of the deal. Servicing rights can go wrong in many ways.

First, people can stop paying their loans back. The servicer usually has to advance the first few payments if a borrower is late and doesn’t get the money back until the loan is resolved. It’s also a lot more expensive to service bad loans than regular payers, making the economics of the business particularly tough right now.

Banks can also lose out if loans are refinanced sooner than they expect, robbing them of the future fees they were counting on.

And what about credit losses? Unemployment, which drives losses on commercial loans, on mortgages and on consumer loans, will be going up for some considerable time.

For example, the baseline forecasts released by the Organization for Economic Cooperation and Development (OECD) this week were considerably more bearish than even the “more adverse” numbers being used to run the U.S. stress tests now being run on banks.

Blog Calculated Risk does a nice job running the numbers here, but the highlight has to be the third q here, but the highlight has to be the third quarter, where the OECD is predicting an economy shrinking by 1.9 percent, as against a rather miraculous recovery to minus 0.2 percent in the “tough” scenario used by Geithner et al. Similarly, the unemployment rates predicted by the severe stress test are lower than the OECD base case all the way out to the end of 2010.

So then, it won’t be the stress test that undoes many banks, it will be reality.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —

—James Saft is a Reuters columnist. The opinions expressed are his own. –

By all means reform accounting, but for pity’s sake take your time and keep your expectations low.

Suspending mark-to-market accounting immediately as a means of levitating banks out of peril simply won’t work. While transparency may or may not be the foundation of banking, trust undoubtedly is.

“Adjusting” or suspending fair value accounting, even if you swear up and down that this time it’s even more fair will erode rather than build trust and repel rather than attract capital.

The House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, led by Congressman Paul Kanjorski of Pennsylvania today is holding a hearing on mark-to-market and already the industry knives are out.

A group of 31 industry groups and financial institutions, including the American Bankers Association, Mortgage Bankers Association and U.S. Chamber of Commerce, have petitioned the committee to take “immediate action” to stop the “spiral of accounting-driven financial losses,” according to the Los Angeles Times.

They argue that current rules, which force banks to carry some securities on their books at levels that reflect current market prices, mean they have to recognize losses that “do not have a basis in economic reality”.

That’s as may be, but so far market prices have arguably been a better directional indicator of the future performance of collateral than some hopeful internally generated marks. Is mark-to-market perfect? No. Might reform, in the fullness of time, adjust some of its pro-cyclical effects? Yes. Will doing that in the midst of a crisis have the desired effect? No.

This whole effort fundamentally misunderstands the situation facing banking.

The problem facing the banking industry is not just solvency on some accounting or regulatory basis, it is solvency on, for want of a better phrase, a solvency basis. Thus banks are unwilling to do business with one another and investors unwilling to lend banks money or invest in them. They do not reliably know who is bust and who is not.

Some may possibly be tarred unfairly by mark-to-market, but allowing everyone to step back from market discipline will make investors less willing to commit capital to banks and banks less willing to do business with one another.

Regulators and accountants may turn a blind eye, but given the current set of economic circumstances people with money on the line won’t find internally generated prices for assets more inspiring of confidence than market derived ones. Quite the opposite.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– Paul Danos is the dean of the Tuck School of Business at Dartmouth College. The views expressed are his own. –

A major question in the government response to the banking crisis is choosing between the “evils” of nationalization of banks that would however provide stability, versus the “benefits” of saving of the private banks that would innovate and compete in a market system.

As the dean of the Tuck School of Business I’m privileged to speak with a wide range of economists, bankers, Wall Street executives and our own students, and what I’m interested in is finding an answer somewhere in the middle ground:

* First decide what major businesses absolutely need in banking services and then set up a ‘facility’ to assure that that those prime banking services will be available. This facility would initially be owned by the government but with an explicit goal of going to full private ownership as soon as feasible.

* Make that facility a separate legal entity from private banks.

* Let the private banks operate these “franchised” facility under close scrutiny.

* Have a process by which the private banks ultimately benefit from the operations of the ‘facility’ by having them acquire an increasing ownership in them.

* Though managed by private banks after absorption, the facilities would remain legally separate.

The trick is to be able to absorb the facility into the private banks after the crisis and not along the way destroy the private banking system as we know it, which means that the private banks must seen as benefiting from the scheme. To the extent that the facility does well, the banks would benefit in that they would have the ultimate ownership; and if the facility does poorly the government would have to absorb the losses, at least in the initial stages.

If the government did set up an initial $200 billion facility it could then be leveraged to say $2 trillion in loans. The “good” facility would be available to all companies for a limited list of transactions for the duration of the crisis, with say a minimum of five years. We could then let the markets settle the bad assets issues in the private banks. Some would fail and some would survive.

After the absorption of the facility the resulting private banks would have two parts, one highly regulated that would provide on-going assurances to the business community, and one relatively unregulated that would allow innovation and society would glean whatever benefits we are supposed to get from that kind of activity.

The government would over time get compensated by the investments made by the payment for the ownership of the facilities.

– Alexander Smith is a Reuters columnist. The opinions expressed are his own –

People are up in arms about bankers receiving bonuses when the banks they worked for have gone down the pan. But isn’t it just as shocking that so many state-backed financial firms still subsidize the eye-popping wages of sporting superstars through rich sponsorship deals?

It’s the same story on both sides of the Atlantic. Citigroup, which received $45 billion from the U.S. government, is sticking with a $400 million marketing deal from 2006 which includes the naming rights for the new home of the New York Mets baseball team, which will be called Citi Field.

Meanwhile Royal Bank of Scotland announced it had renewed its sponsorship of the 6 Nations rugby competition last month, only 10 days after reporting the biggest loss in British corporate history. And it continues to sponsor the Williams Formula 1 team, a sport known for eating up tens of millions a year.

There is indeed a strange correlation between failed companies and sporting sponsorships.
Manchester United sponsor American International Group (AIG), Newcastle United supporter Northern Rock and failed British bank Bradford & Bingley, which sponsored not one but two soccer clubs, Bradford City FC and Barnet FC, have all crashed spectacularly since during the credit crisis.

And it isn’t just financial firms which have run into trouble and seen their names stripped from team shirts and hoardings. English premier league club West Ham United lost their sponsor when tour operator XL Leisure Group folded.

But this shouldn’t really be a big surprise. Some have even made a direct link between sporting sponsorship and corporate underperformance. A recent report by U.S. fund advisory firm Advisor Perspectives crunched the numbers for U.S. companies that entered into so-called “naming rights agreements” and believes it has established a statistical connection.

Its study of 69 U.S. naming deals shows the performance of companies that purchase such rights trails the S&P 500 index by 4.7 percent over the course of the deal. If you invested in a company the day it announced a naming agreement and sold when the agreement was done (or still held onto it for current name holders), your portfolio would be down 9.1 percent, versus a fall of 4.5 percent for the S&P 500.

Advisor Perspectives argues that poor corporate governance, leading to risky or bad decisions on capital allocation, is to blame for this underperformance and points out that three of the top five largest bankruptcies in history, Worldcom, Enron and Conseco all sponsored major U.S. sports venues.

They also point the finger at executives who benefit from the luxury boxes, hospitality packages and privileged access to sporting celebrities, all at the expense of shareholders.

So when Royal Bank of Scotland struck its Formula 1 deal with the Williams team, Citigroup signed its Mets deal or AIG paid to have its name on the shirt of the world’s most successful soccer team

Manchester United, investors should have read these as clear sell signals for the stock.

Given the financial wall some of the banks have hit it is puzzling why they haven’t pulled the plug on these embarrassing deals. After all the CEOs of RBS, Northern Rock and Bradford & Bingley have all been jettisoned, as have the bosses of Citigroup and AIG.

But with some lengthy sports sponsorship deals, ending them would in most cases be counterproductive, wiping out any value left. And where banks have been nationalized, political factors come into play. In the case of Newcastle United, any damage caused by ending the sponsorship agreement with Northern Rock and alienating a fiercely loyal soccer fan base would have far outweighed the cost savings of scrapping the deal.

So for an early warning signal of a company with a vain or out-of-control CEO, a poor record of capital allocation, a likely share price underperformance and in the worst case scenario an above average chance of going bust, look no further than the big sports signings, not of players but of sponsors.

– At the time of publication Alexander Smith did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

Nassim Nicholas Taleb,  the author of  "The Black Swan: The Impact of the Highly Improbable", has a simple proposal to as he puts it, "save capitalism and free markets from the banks."

Nationalise the banks, limit the rewards to those who work in what he calls the "utility" part of the system and have a completely uninsured second leg that can take all the risks it wants and lose its shirt, he said in an interview in Davos at the World Economic Forum.

"They rigged the game. We pay them for their profits, there is no clawback so their incentive is to hide the risk they are taking."

"Which is why eventually as someone who loves free markets,  a total nationalisation of the part of the business that requires insurance and does clearing and payments needs to happen."

"I am angry with U.S. policy. What we had is exactly the opposite of socialism, they got TARP to pay their bonuses and to take more risk."

He describes his plan as Capitalism 2.0. It would have a barbell structure, with the insured utility-like part on one end and the free market bit with privatized risk on the other.

He describes banking bonuses as asymmetric because the banker gets the upside but does not share in the liability which ultimately may be funded by taxpayers, as we have seen.

Taleb, who as you may have noticed doesn't mince words, is no fan of private equity.

"Private equity has absolutely no reason to exist. The private equity holder has all the upside and the banks all the downside." He'd have no objection to a system where private equity funds itself via hedge funds, so long as neither party had any recourse to government insurance.

And a bit like an Old Testament prophet, Taleb is angry and wants those he thinks are responsible to suffer.

"I want them poor and they deserve to be poor.You can't have capitalism without punishment."

Oh, and another thing, he wants Bob Rubin, who trousered millions while chairman of Citigroup, to cough up.

"I want Bob Rubin to return his $110 million dollars to the American taxpayer."

James Saft is a Reuters columnist. The opinions expressed are his own.