Posts Tagged ‘financial regulation’

Financial marketers know that human wiring encourages us to judge decision-making skill based on the recent outcome. This is true even if that outcome is a random result. So in the investment world, tossing a coin and producing heads three times in a row is seen as skillful. Predicting the wrong result of a toss is viewed as a repeatable and flawed approach, and this is true even though the probabilities for the next toss remain unchanged. My take is that it is much easier to focus on short term results than to try and uncover whether-or-not an approach is increasing the probability of success for a significant period of investment results. Counting and sorting random results has the illusion of a scientific method. It can also encourage manipulation of meaningless periods of data so as to infer skillful management and decision-making. It opens the door to manipulation by inference.

Unfortunately, from a purely statistical basis it takes about 30 years of data to make a confident assessment of skill for investment management.  The evidence of “beating the street” simply cannot be identified in one, three and five year tables.  For practitioners, this presents a big problem as 30 years is an investment lifetime. Also, the skillful manager is generally about to retire once you have confidently identified his or her ability. It would be much more convenient if we could confidently identify future out-performance. Unfortunately, there is always uncertainty. If we knew the outcome, returns on stocks would be equal to returns on bonds.

In my opinion, the time and effort to identify a hot hand is better spent on good portfolio construction. Good financial advisors have processes that generally guide clients towards strategies designed to minimize errors of judgement. They focus on cost control. They provide guidance around matching fixed income from your portfolio to income you require from the accounts in retirement. Good advice often encourages investors to patiently allow stock market return to be realised by the portfolio in a consistent repeatable approach. There is generally much less of a focus on market timing. They recognise that the recent past offers little in the way of predictive power.

In our practice we focus on repeatable investment success. Our portfolio approach has been refined through more than thirty years of combined, on the job, experience. If we are already working with you great – if not, let’s meet to see if we can be of service.

Patrick

A review of the US monetary System – Suppliers, Dealers and Users

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.

We are learning more about the US Feds efforts to improve securitized mortgage markets. Specifically, the legacy loans program and the legacy securities program are designed to entice private investment involvement in turning around the credit crises. There is a good review of the Toxic-asset proposal in today’s Wall Street Journal.

The incentives have to be generous enough so as to attract private investors but not so generous that a risk free return is funded by tax dollars to the benefit of private interests. So what is a reasonable return for assuming this risk? How will these prices be established?  The public purse will be best served by a wide and broad market with many participants. Some will get better deals than others but on average many participants will serve to get the prices right and move the market to an equilibrium position, balancing risk assumed and return yielded. If we end up with a closed shop -where access is limited to a few players, then the likelihood of a subsidy from taxpayers to a small number of market dominant players is enhanced.  PIMCO spokesman Bill Gross has already voiced his firm’s intention to support the program.

Joint ventures between government and private investors are complex and rightly the subject of increased scrutiny by all interested parties. If you are a tax payer then you are a stakeholder. There is a big cost to focusing on limiting return through regulation.  There have been a series of announcements from AIG that executives will return some bonuses. These relatively small victories act as a dis-incentive to those that are considering participation. There is a view that so called excessive future gains may be clawed back by government after the fact. Increased perceived risk (regulation) will require an offsetting increased future return.

In my view, well executed programs will result from a large number of independent private interests bidding for these assets. More participants results in better asset pricing. Better asset pricing will reduce the likelihood of subsidies to private interests from taxpayers.  It is in all of our interest that the program become accessible to all parties willing and able to assume the risk. We need many participants and we should encourage bidders. We have had enough focus on punishing executives and managers of financial firms. It will not help to discourage their participation. We need to get past the need to find and punish the  parties responsible for this mess and instead focus on the task at hand. Increased effort to identify and pursue manager bonuses is an unnecessary additional cost to the bailout.

The top rated banking system in the world – Canada, really?  I guess it had to happen sometime. It seems after the recent global carnage, banks that leveraged their assets the least have won. European Banks had borrowed more than fifty times their assets to increase the size of their operating business.  So a 2% loss in net operations pretty much wiped out their equity. The U.S. banks levered north of 25 times so it took a 4% net asset write off. Canada at 15 times has a 6 % cushion. It should be noted that much of the global bank liabilities are guaranteed through deposit insurance, reducing the risk. As we have recently found, relatively small, highly risky ventures can spin out of control. You and I can’t get a loan with 2% equity backing the note. If we did we might be too big to fail as well.

Last week Chancellor of Queen’s University and former Governor of Bank of Canada, David Dodge spoke at a lunch presented by the Canadian International Council (CIC). His topic -Rebuilding the Global economic and financial Order. He had a couple of insightful statements about leverage. In his view changes to accounting standards (FASB)  are adding volatility to stock markets in marking assets to market while leaving debt largely at cost. If debt isn’t repriced  as equity on the balance sheet then you get bigger reductions in earnings in recessions and larger growth in earnings in good times.  Higher highs and lower lows add risk without a corresponding increase in return since debt and equity will end up priced at liquidation value in any case. Transparency is always desired but only if  assets and liabilities ares  treated equally. Mark-to-market is really made up numbers since you only really know what something is worth when someone else pays to buy it.

Mr. Dodge is also a proponent of good regulation. He thinks that Canadian Banks may have ended up in a deeper problem without strong  federal guidelines. He concludes that upcoming G20 meetings present the best opportunity to co-ordinate meaningful global improvements in the economy.

In my opinion,  Canadian Banks would find themselves in the same position as  U.S. Banks had they been allowed to operate unfettered from regulation. For example, foreign ownership limits are federally imposed on the sector. Canadian banks lobbied to have them removed so that they might merge and invite larger interests to invest. It is lucky for them that they were unsuccessful in that effort.

I think increased regulation of the financial services is here to stay. We simply can’t afford another episode like our current financial turmoil. We need to ensure transparency. Back room (off balance sheet) deals need to be minimized, if not eliminated. The big but here is that care should be taken to ensure that entrepreneurs are given the latitude to re-energize the economies of the world. Bureaucratic institutions can’t be expected to be effective in that role. There should be a market discipline to the spending and hiring so that small business is not crowded out by large numbers coming out of governments.

Dan sullivan of the Strategic Coach has a definition of entrepreneurs as true creators of value. He quotes 19th century economist Jean-Baptiste Say: “An Entrepreneur is someone who takes resources from a lower level of productivity to a higher level of productivity.” I like this  definition becuase it speaks to the fundimental role of the entrepreneur as a creator of value for the economy.