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How to regulate banks?

by Jerome a Paris Wed Nov 28th, 2007 at 06:52:31 AM EST

Now that it's probably too late for this (massive) round of excessive risk taking by banks, Martin Wolf asks the right questions about how to deal with banks:

Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation.


Either the banking industry should be treated as a utility, with regulated returns, or it should be viewed as a profit-seeking industry that operates in accordance with the laws of the market, including, if necessary, mass bankruptcies. Since we cannot accept the latter, I suspect we will be forced to move towards the former. Little can be done now. But when the recovery begins, we must impose higher capital requirements.

Banks play strategic functions in our economies, and thus cannot be allowed to fail. Knowing this, they take more risks than they would otherwise (to earn more when things go well, with the certainty to minimize losses when things go wrong). Governments do know that, and do try to regulate banks, but given the potential gains, banks employ legions of smart people dedicated to finding loopholes in the regulation of the day - and who get rewarded handsomely to do so.

Aswe know, there is no morality in business. Whatever you can get away with is good - and in banking when you get to keep a good chunk of it, you do whatever it takes...

The New Deal found a solution with unsubtle, strict regulation (notably separating commercial and retail banking from investment banking). These limits have been taken down in the past 20 years, in the name of "efficiency", and at the obvious cost of resiliency - and at the expense of citizens and taxpayers. They need to be brought back in. Increasing capital requirements is just one small part of it.

As Martin Wolf notes, banks in fact manage to get even more highly leveraged than other players ever get to be - even after the excesses of the recent debt bubble.

Capital requirements would indeed be a real way to limit that risk, and reduce overall systemic risk in a real way.

(And a note to Chris - banks need not create money to be so leveraged: they just borrow it on the markets. Being at the intersection of investors and borrowers, they have access to huge pools of existing capital and have no need to create any more).

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Nov 28th, 2007 at 06:56:18 AM EST
And a note to Chris - banks need not create money to be so leveraged: they just borrow it on the markets. Being at the intersection of investors and borrowers, they have access to huge pools of existing capital and have no need to create any more

Hmmm....well, bringing investors with existing wealth together with investment opportunities is what I call investment banking, and I see it as a desirable and "value added" profession and skill.

It's then a question of the characteristics of the "investment" and here I believe that the conventional "Equity" and secured "Debt" combine to form a conflicted cocktail of two sub-optimal and ethically questionable legal mechanisms.

Simply dividing revenue/production  streams into proprtional "nth's" gives one continuous asset class instead of two conflicted ones.

That's one point: but of course, if all we do is move around existing wealth we won't get very far, do we?

Credit is necessary for development, but I do not believe that credit intermediaries are necessary to create it.

Banks should instead act as service providers in managing the bilateral creation of the necessary "trade" credit.

This is the "Clearing Union" approach advocated by Keynes at Bretton Woods, and I advocate mutual "Guarantee Societies" to underpin such a Union, backed by provisions into mutually owned (not bank owned) default pools.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Nov 28th, 2007 at 07:22:25 AM EST
[ Parent ]

Banks should instead act as service providers in managing the bilateral creation of the necessary "trade" credit.

That's EXACTLY what they have done in recent years (in fact, it's the very definition of what investment banks do), and it's at the root of the problem: given that they have no skin in the game to speak of, they don't really care if the risks are bad, as long as they manage to dump them on naive or greedy investors.

Fools and greed will never go away. Thus, a working bank system has to structurally limit their ability to do stupid things on such a scale that it becomes a systemic problem. Having banks as irresponsible service providers is NOT the way to do that.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Nov 28th, 2007 at 08:17:20 AM EST
[ Parent ]
You're confusing credit and investment again: because your thinking is based upon money as debt.

Money need not be debt.

Secured credit is one thing: bilateral "trade" credit between suppliers and customers eg a supplier and a buyer of LNG is quite another. This does not involve "investment" (of existing "wealth") at all, but rather value circulation and the bilateral creation of "wealth" through transactions on guaranteed credit terms between "productive" counterparties.

Banks will be service providers in two ways:

(a) managing bilateral and mutually guaranteed "trade" credit within a Clearing Union framework - ie quasi merchant banking;

(b) bringing investors together with investments, and possibly providing liquidity - investment banking.

In the former case the bank - as system manager,and appraiser of "guarantee limits" (formerly known as credit limits) - would have an interest in minimising defaults, since it would receive its remuneration via a subscription from system members and participation in the default pool.

I think we are condemned to jousting past one another on this.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Nov 28th, 2007 at 09:06:41 AM EST
[ Parent ]
when the infrastructure already exists, and you're talking about playing with existing flows within a single business (gas trading, or LNG, as in your example).

It breaks down when you need to build the infrastructure. The players that build the infrastructure have no interest in playing any role in the flow business. They just want to be paid for building the pipes and faucets. The money needed to pay for that can only be apportioned by "taxing" each future flow through that infrastructure and allocating that to whoever is paying today for the construction.

That transaction requires someone to put up money upfront, in exchange for future payments. That someone takes a risk on the infrastructure being built, and on the flows happening as promised/contracted. That someone puts money on the table, and wants money out, on a (mostly) predictable schedule.

That someone may take various risks (on the volume of flows, on the tariff paid, on the fraction of the value of the flows, etc...) and its repayment can follow many scenarios. That's fine, and that's happening via existing commercial/banking structures (which use a bewildering variety of legal entities according to needs). And that's called commercial banking.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Nov 28th, 2007 at 10:39:15 AM EST
[ Parent ]
To the extent that people who build infrastructure are not willing (or able) to accept "Equity" (ie proportional shares) in the outcome, then investors of risk capital are necessary, of course.

I've been involved in a couple of those, particularly a film, where we needed "Capital Partner" punters to pay for lights, cameras and pizza. Which they did, for a 20% "Equity Share" in the revenues (if there are any).

Once a project is complete, then these risk-friendly investors may exit by selling to risk averse investors. Just like PFI. But a non-toxic version.

The other mechanism available to raise some or all of the necessary investment is to raise finance by selling production forward to investors - possibly stakeholders interested in hedging purchases - in "Pool" funds structured as LLC's or LLP's.

These are essentially "exchange traded commodity" funds, with the difference that the return of investment will be denominated in (say) energy units or land rental units (themselves exchangeable for other value).

I believe that it is possible for (say) Qatar to refinance existing LNG debt by selling part of their production forward to stakeholder investors (eg the Japanese or Chinese), and for this (interest-free) finance then to be used for further LNG infrastructure etc.

The result would be what is essentially an energy pool ( a tradable liquidity pool, moreover, without the fragmentation of monthly futures prompt dates) of fungible energy-based "value units" - ie "carbon dollars" based on energy content of carbon, not some nonsensical price based upon the entirely unrealistic trading in carbon emissions.

These value units are essentially undated and ungeared futures contracts. A bit like Redeemable Preference shares in the LLP but without an income, and with a return of capital in kind instead. ie market participants who have bought such units as a "hedge" could present them, instead of conventional $ to a seller in settlement for physical energy bought through the Pool.

The market price of LNG is the price at which LNG is sold into and out of the pool, and investors - by definition - would not participate in that market auction price.

Anyway, I'm hoping that The Gulf Research Center (www.grc.ae ) will be publishing a fairly long article on the subject shortly in their journal (they said they would).

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Nov 28th, 2007 at 11:40:43 AM EST
[ Parent ]
I also think one has to distinguish between linear (basically industrial) processes and non-linear processes such as you find in the so-called knowledge economy.
I am not saying that the asset-based LLP model cannot be applied to construction, manufacturing, transport, energy plant etc (You have examples of these, Chris - or at least proposals). But I think the LLP is especially suited to connecting people and groups and companies in endeavours involving knowhow and knowledge as the assets - in non-linear enterprises.

The partnership, the cooperative, the trust, are common enough business models in consultancy, accounting, law, advertising, marketing and especially in the entertainment industry. It is hard indeed to find a modern law firm in the UK that is NOT an LLP now. Hollywood has long used some of the collaborative, risk taking, lien and forward purchase elements of LLPs to put together movies.

In the creative and content industries, the LLP is perfect. There is no real capital investment involved. What do you need? An office, some mobiles, some work stations - everything can be leased. What you need is people/minds working together - and preferably not employees. These kind of loose groupings have been around for a long time in these industries. But they require a stack of bilateral contracts that are only brought out when there is a dispute - otherwise people work on trust, as long as there is transparency.

The LLP provides a much simpler way of assembling these groupings, with a much smaller overhead because the overhead is distributed away from what is essentially not a company but a networked agreement that can join together many disparate 'assets'.

You can't be me, I'm taken

by Sven Triloqvist on Wed Nov 28th, 2007 at 12:25:37 PM EST
[ Parent ]
Quite right.

The LLP (and LLC) enables an enabling "framework" for self organisation  - rather than a self serving "organisation" - which is easier to apply to people aka "Human" Capital and to intangible "Intellectual" Capital than to tangible assets - particularly land where "ownership" and "use" are pretty complex subjects.

It's no coincidence that the "peer to peer" disintermediation phenomenon began with intangible "Intellectual Property" ie Napster.

But the process of "Napsterisation" has only just got started and credit intermediaries are - now that banking is almost entirely electronic - just as redundant as the Titans of music who are now looking back and commenting on their own demise...

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Nov 28th, 2007 at 12:54:56 PM EST
[ Parent ]
The gas industry is probably the least relevant for Chris's theories. But what you say about knowledge industries make a lot of sense.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Nov 28th, 2007 at 03:11:22 PM EST
[ Parent ]
The gas - particularly LNG - industry is most in need of a coherent global market structure and best placed for its introduction, because it's relatively undeveloped in structure, and three or four countries have the market sewn up, who are already talking to each other.

It wouldn't be as difficult as you think to introduce a different financial structure to the one you are used to.

Particularly when the outcomes of the model I advocate are so compelling for end users, who are currently being fucked thrice over:

  • directly by oil market intermediaries in respect of their oil;

  • indirectly for gas priced against oil;

  • by financial intermediaries and the whole consultancy/ legal/ accountancy circus that feeds off  them in respect of complex and costly structured gas market financial infrastructure.

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Nov 28th, 2007 at 05:45:40 PM EST
[ Parent ]
  • oil and gas are pretty different industries;
  • there's a good reason gas is priced against oil: it's a direct substitute for many uses ( a BTU is a BTU);
  • the oil & gas industry is so powerful that most companies are better rated than banks and can borrow cheaper than banks do. If they use the financial structures we propose, there must be a reason.

I'll be able to post soon that paper I wrote  explaining how gas infrastructure is financed, and why it's a lot more complex than most pundits and observers seem to realise. I hope you will read it.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Thu Nov 29th, 2007 at 01:17:58 AM EST
[ Parent ]
I am well aware how complex gas financing currently is, and it goes without saying that I look forward to reading your paper to acquaint myself with the "State of the Art".

However, the world is changing, and on the one hand the balance of market power has irreversibly swung back to state owned oil and gas companies, and on the other I think we are seeing a new militancy generally on the part of energy consumers (in the US, a renewed government effort by Democrats eg Levin on their behalf) and in particular an antipathy to perceived "gouging" by intermediaries.

The oil trading middlemen are, as you imply, symbiotic with banks - eg BP and Goldman Sachs have IMHO been in unholy alliance for at least the last ten years - and like banks will have to come up with a new and disintermediated "service provider" model.

Simple solutions, like the partnership-based mechanisms I observe emerging, are not in the interests of either intermediaries - who thrive on complexity and opacity  -  or professionals, paid by the hour, rather than the outcome, who support them.

It's interesting that you should point out that a BTU is a BTU, because that is exactly why I have suggested that an energy based "Carbon Dollar" (ie a "dollar's worth" of BTU's at launch date) - backed by a pool of production - makes sense as a quasi "Bancor" Energy Value Unit on an International Energy Clearing Union platform.

So maybe rather than gas being priced off oil, who knows, in due course oil - in all its multiplicity of qualities - may be priced by reference to gas. Plus electricity has a fairly straightforward relationship with gas in many markets.

It is the homogeneity of gas, and the fact that very few sovereign suppliers who control the market that attracts me. I really do not think that they would find it too difficult to accept the logic of the case for a neutral partnership-based market platform.

Let's face it, Brent has long passed it's "sell-by" date as an oil benchmark, and it continues in use purely for lack of a credible alternative.

Moreover, because Norway, Russia, Qatar etc are not in hock to the financial system (rather the reverse) - and because Russia still has a nuclear deterrent -there would not be a great deal the US/Big Money could do about it.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Nov 29th, 2007 at 08:25:43 PM EST
[ Parent ]

BoJ warns of `disease' in world markets

The yen hit a two-and-a-half year high against the dollar on Tuesday as Toshihiko Fukui, governor of the Bank of Japan, expressed strong concern about the turbulence in world markets, comparing it with "a serious disease".


Mr Fukui said the volatile movements in financial markets since July suggested global markets were paying the price for "euphoria and excessive risk-taking". It was the central bank's job, he said, "to help markets adjust themselves in an orderly manner as far as possible, while keeping markets functioning at all times."

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Wed Nov 28th, 2007 at 07:05:09 AM EST
"But when the recovery begins, we must impose higher capital requirements."

DL, I can understand now why you read the FT with such avidity.

These naifs or shills sure are a barrel of laughs.

"When the abyss stares at me, it wets its pants." Brian Hopkins

by EricC on Wed Nov 28th, 2007 at 07:58:47 AM EST
Two comments (one slightly off topic).

  1. When there is a revolving door between government and business or when legislators owe their campaign funding to the business community there is little incentive for tougher regulation. The New Deal represented a period when the banks had failed (literally and in terms of political power) and it was possible to impose new restrictions. It is not clear that such a unique circumstance will happen again any time soon.

  2. There is an article in the NY Times today about petrodollars being used to buy into western firms. Two that are relevant are the cases of the Carlyle Group and Citigroup. While several of these transactions are supposed to be "hands off" (no seat on the board, for example), this is obviously a sham. You don't sink $7 billion into a firm and cede all influence.

For the past 50 years the big banks have been an arm of foreign policy. They have made investments into countries where the US wanted to gain influence and have been able to call on the US government (and it's clients the IMF and World Bank) to enforce domestic policy changes in these states when things didn't go according to plan.

It seems likely that there will be a shift in emphasis and these international firms will start to become a tool of the oil states, at least in part. How this will play out remains to be seen.

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Wed Nov 28th, 2007 at 09:59:52 AM EST
If banks can not be allowed to fail, why should the state accept private ownership of banks? The owners takes no risk if it goes bad and cashes in if it goes good.

I believe the socialist parties used to have nationalisation of banks on their agendas, perhaps for this reason. So is it a good idea, bad idea or something else?

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Wed Nov 28th, 2007 at 01:56:37 PM EST
Well, many French banks were nationalised after WWII. The Crédit Lyonnais scandal wasn't the French state's finest hour, though...

Un roi sans divertissement est un homme plein de misères
by linca (antonin POINT lucas AROBASE gmail.com) on Wed Nov 28th, 2007 at 02:19:14 PM EST
[ Parent ]
Something else like a Banking public/Private Partnership.

ie Public ownership of credit creation, with private operation, and with costs and defaults shared equitably.

Not far off what is going on with Bank of England and Northern Rock now, actually, except they haven't sorted out the equitable sharing bit yet.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Nov 28th, 2007 at 02:19:37 PM EST
[ Parent ]

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