Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors

This guest post was submitted by Peter Fox-Penner, a leading expert on regulation at The Brattle Group.  The views expressed here are those of the author alone.

Improving the regulation of the financial sector is a prime topic of conversation amongst financial economists, and appropriately so.  Most agree that massive failures of financial regulation were one, if not perhaps the largest, cause of the 2008 meltdown.     

When the conversation turns to the specifics of what needs to be regulated, how regulation should work, and what agencies should be involved, the range of views is tremendous.  There is agreement that some kind of prudent regulation is needed, as is investor and consumer protection, but that’s about it.  Fueled by billions of dollars of lobbying and purchased research, everyone has their own idea.  One super-regulator?  Council of regulators?  Control bankers compensation schemes?  Exchange-trade them?  The cacophony is deafening. 

As an industrial organization economist, I think this discussion would benefit greatly from a consensus on the role and goals of financial regulation.  Paul Joskow, a dean in the IO economics community, recently noted that:

 “. . .The one thing that we can be sure of is that we have no shortage of regulatory agencies with overlapping responsibilities for investor protection, financial market behavior and performance, and systemic risk mitigation (prudential regulation) that collectively were supposed to work to keep this kind of financial market mess, as well as scams that were allegedly employed by Madoff and others, from occurring.  These regulatory agencies have overlapping jurisdiction, opaque goals, arbitrarily limited authorities, and histories that can often be traced back to Great Depression era financial markets and economic conditions.  These regulatory institutions have evolved over the last seventy-five years in a haphazard fashion that has not responded effectively to the evolution of financial institutions, products, and market but more as a series of fingers in the dike to try to keep new leaks from damaging the integrity of the entire dam.  Regulatory changes, such as the 1999 repeal of the provision of the Glass-Steagall Act of 1933 that prohibited bank holding companies from other types of financial service companies, the SEC’s decision to end the uptick rule for short sales, and decision to allow “sophisticated investor” to fend for themselves, have been idiosyncratic… and increasingly driven more by ideology as financial markets began to change quickly than by the find of comprehensive framework for regulatory reform that has now become widely accepted by microeconomists in other industry contexts.” (http://econ-www.mit.edu/files/3875)

 In short, patchwork fixes don’t work.  You have to reform all of the institutions and markets that are sufficiently linked to the imperfections and externalities you need to fix.  As Joskow notes, it wasn’t that there weren’t any financial regulatory agencies – “the list of these agencies is as long as my left arm” — it is that there were too many of them, too many cracks between them, and no comprehensive analysis of what kind of processes, tools, and agencies modern financial markets need.  [As Exhibit A, see this list of agencies regulating consumer financial products from USA Today]

I agree with Joskow that a comprehensive assessment is lacking from the financial regulatory debate.  There is fairly broad agreement that some kind of regulation is needed for banking and other credit institutions (prudent regulation), regulation of securities and commodity markets, regulation of insurance markets, and [more acrimoniously] regulation of other consumer financial products.  I search in vain, however, for serious analyses of whether the same regulator, using the same enabling statutes and the same regulatory instruments, is right for each of these jobs.

It doesn’t appear likely.  The history of regulation shows that effective regulators should not have conflicting, complex, or multiple missions.  An agency should not have conflicting incentives, such as those posited by Raghuram Rajan, between the Federal Reserve’s role as inflation fighter and its role promoting bank stability via regulation.  Similarly, it seems obvious that the objectives of a bank regulator to promote well-capitalized and solvent banks conflicts directly with the objectives of consumer financial product regulation.

Regulatory agencies also should not have many non-regulatory tasks that interfere with their focus and compete for this leaders’ attention.  It is hard enough for a public agency to get good at regulating one kind of market or instrument.  Stand-alone agencies also have a better chance of getting the resources they need to do a good job, avoiding government budget processes and their attendant limits and delays.  This is not an argument for duplication, but rather for separating agencies that might have conflicting objectives.

Another lesson from regulation’s history is to keep the mechanics of regulation as simple and as transparent as possible.  Yes, regulation always creates incentives for the regulated firm to exploit information asymmetries, and regulators have imperfect incentives as well.  But experience suggests that regulatory mechanisms have to be fairly simple to work – often a lot simpler than most economists would prefer.  

One essential corollary of keeping it simple is that one has to sacrifice some product variety and customized trading for a more constrained set of regulated products that can be understood, measured, and watched.  Effective regulation always constrains product choices and trading options.  Intended or not, that’s what it does.  It is one way of making sure nothing falls through the cracks.  Nonetheless, today’s airwaves are filled with arguments that regulatory reform will stifle financial product innovation and attending benefits. 

In addition to limiting product variety within firms, successful regulation often has to limit the complexity of firms’ financial organization and size.  The history of utility regulation and liberalization suggests that there is a limit to the complexity of the firms that can be regulated effectively by regulators with limited time and resources.  I expand on this “too big to regulate” idea in a second post following.  

Finally, it is widely accepted that regulatory agencies must strike the right balance between independence and accountability.  The agency should not subject to immediate political pressure from industry or politicians, but through a process of checks and balances, such as staggered regulator terms, bipartisan appointments, post-employment restrictions, and a high requirement for expertise, the probability of capture should be minimized.  This is another reason to separate regulatory from non-regulatory organizations.  Similarly, stand-alone regulators are more likely to be free of burdensome government budget processes and are more likely have the freedom to hire and pay for the expertise needed to understand complex, fast-changing markets.

In the 1930s, Congress responded to the financial crisis with three extensive studies, the Pecora Commission, the Federal Trade Commission’s seven-year, 101-volume study of utility financial practices, and a similar two-year study by the House Commerce Committee. I sincerely hope that Congress’ financial reform commission or some alternate forum fills this need.  An earlier Baseline post reports that the initial signs were that the Commission will not delve as deeply as is needed. Since then, the commission has been largely silent in public.  I hope this is an indication that the commission is working hard away from prying political and media eyes to do a thorough, objective, and compelling look at the full scope of reforms that are needed.

The rolling discussion of financial regulation in this and many other blogs is a fantastic innovation in academic and policy discourse.  Perhaps it is the 21st century version of the Pecora Commission and its multi-year, multi-volume reports. Perhaps, it seems hard to imagine, a political consensus for comprehensive change will emanate from a blogosphere dialog amongst us policy wonks alone.

By Peter Fox-Penner

224 responses to “Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors

  1. To dig deeply and pin down the truly needed reforms would make it harder to politicize the process. The current, ill-defined hodgepodge lets bankers make of it what they want. I admire the piece and hope that such a vision of thoughtful reform is possible.

  2. The problem with discourse on this topic is not that there is a lack of consensus, but that few of the vocal people actually understand enough about the evolution of many of these products and their effects on organizations to get specific. As a result, everyone just exchanges platitudes like “we should limit the size and complexity of financial institutions.”

    From reading much that is written on this topic, it would appear that complex financial instruments (generally derivatives contracts) evolved in some distinct space from the rest of the financial world, and for purely superfluous reasons. I guess I can see where, if your most significant interactions with financial institutions are limited to a mortgage or credit card, it makes sense to you that we could just, say, ban the use of swaps or throw them on an exchange. And you just go about wondering why we can’t go back to savings and loans.

    People completely take for granted the machinery that goes on behind consumer and commercial finance to manage risk and obtain funding. Maybe if the Federal Reserve were good at its primary task, there would not be a need to hedge a mortgage portfolio with swaps (for example), but frankly, it isn’t. It isn’t an accident that the use of derivatives took off in the 80s. We learned a lot about interest rate and credit risk in the preceding years, which basically left the business model of our “simple” financial institutions DOA in the 80s.

    Unfortunately, from that period on, our financial institutions and regulatory institutions have been on completely different trajectories. If one does not participate in an innovation from the very beginning, one’s learning curve increases and at some point it will take a great deal to catch up with everyone else. Our regulatory agencies (you can debate why; I am amazed we can discuss this topic without discussing regulatory capture) have been out to lunch for decades now, and at some point, financial institutions became aware of that, and began exploiting the use of complex transactions and marketing complexity for complexity’s sake. But that does not mean that we can discard complexity generally, return to the simple model, and have everything turn out all right.

    My point here is that the capabilities of regulatory institutions cannot be the limiting factor on business activities, because if you bracket off the misbehavior, you will see that complex transactions exist for a reason. There is a difference between limiting dangerous or fraudulent use of an instrument and limiting the use of the instrument altogether, however.

  3. “consensus” See previous post. If the blogosphere is as captured as the terrestrial world, which it is, then any consensus we arrive at will be suspect, to say the least. Astroturfing is occuring here just as in every other corner of life. We feel like we’re generating our own consensus, but isn’t it really the influencers being influenced, and in turn influencing the rest of us?

    Time and time again we see our own august commenters embracing a new pundit uncritically: “Oh, they said all sorts of contrarian things before the storm hit, so they are the real deal.” “They argue publicly with evil politician, so they are worthy of my trust.”

    We have no idea who many of the top bloggers really are, what they do on their off hours, or how they are compensated. The Pecora commission is apt, however. Make a lot of noise and expose just enough corruption to generate some new laws that make everyone happy for a while. Also See: Warren Commission, 9-11 commission, etc. My favorite commission was “High Commission for Occupied Germany, HICOG,” running under inveterate wise-guy John J. Mcloy. He was responsible for the pardons of some pretty high level nazis, and achieved a big of infamy for advocating against bombing the tracks to Auschwitz. Coincidentally, he sat on the Warren Commission.

    http://en.wikipedia.org/wiki/John_J._McCloy

    Yes, the blog world is an innovation in discourse. You might have missed the discussion, but we’re a little leery of innovation here, especially when it is easily co-opted.

    “The cacophony is deafening” Yes, just as the lack of discussion of the role of organized crime in our crisis.

    Brattle Group… rings a bell. Isn’t Simon associated with the Brattle Group? Dr. Fox-Penner, it did not escape notice that you trained as an engineer. Nor did it escape notice that your cv mentions this, but does not mention the discipline for which you received your Phd. It does mention that you come out of the University of Chicago, and that you are frequently employed as an expert witness, with special expertise in electricity and “in the natural gas, communications, transportation, and environmental industries.”

    Not sure this is the sort of engineer we should be looking for to design the new structures. Not sure at all. Please don’t take that as a personal affront. You may be the nicest guy in the world, and a great family man, with dogs and a special place in your heart for Scottish folk songs, but people with resumes that look like yours are in the business of making money for wealthy people, not improving the world.

    May we get to know you better? What was the nature of your Phd? Also engineering, or something else? What did you do before Brattle Group? Your Linkedin profile is available only to premium members.

  4. “the machinery that goes on behind consumer and commercial finance to manage risk and obtain funding”

    Exactly. This is the Rube Goldberg device. Dismantle it. We don’t need it. It only exists to create opacity and facilitate rents.

    “But that does not mean that we can discard complexity generally, return to the simple model, and have everything turn out all right”

    Play devil’s advocate: assume we do discard complexity. You really, honestly, cannot imagine a world where this turns out all right?

  5. I can’t help feeling that to purchase a hedge against downside risk is an illusion. There is no such thing as having all the upside. Transactions that make this claim are fraudulent.

  6. Here’s an analogy: medicine. The number of people who understand the effects and side effects of various drugs compared to the number of people affected by them is pretty small. Yes, we try to regulate them, and test them, but crises happen, and when they do, whole categories of drugs get blamed for the fraud (or just ignorance) committed by a single drug manufacturer. I can use your exact same logic– “Drugs are just the Rube Goldberg device! Can you not imagine a world without them that doesn’t turn out all right?”

    No, I can’t. Yes, there are pitfalls and risks and bad things happen, but there’s plenty of good that comes from the “complexity” too.

    Financial instruments are the same way. Yes, some of them are created and used fraudulently and/or ignorantly, but this doesn’t mean that just because you don’t understand them, they are evil a.k.a. “The Rube Goldberg device” in your incarnation of reality.

    I do think it’s worth revisiting the need for some (or even most), but calling for an effective stoning of the derivatives business is short-sighted. Both I and BondGirl have mentioned swaps with respect to hedging mortgage portfolios and have seen responses to the tune of “MORTGAGES?!?! why do we need them?!?”

    It looks like the toxic lexicon is here to stay…

  7. …and did you exist before 1990? Google News archive search doesn’t seem to think so. The list of your publications on the Brattle site only goes back to 1990.

    This says: “Peter Fox-Penner, special assistant to the deputy secretary of the U.S. Department of Energy”

    http://tdworld.com/mag/power_revolution_power_delivery/

    Was the deputy secretary Elizabeth Moler? Same one that worked at Enron, among other things?

  8. What do you do for a living, Sam?

  9. When dealing with highly complex systems it is not possible to regulate out unanticipated problems or unanticipated fraudulent activity. The trick is how quickly the problems are identified and how quickly they are circumvented short-term (temporary regulation change being one possible tool in an economic system) and permanently fixed long-term (regulation policy change being one possible tool in an economic system).

    Early determination that a problem is occurring requires excellent monitoring tools and expert monitors or monitoring systems. Short term circumventions or fixes require expert systems trouble shooters who have a high level of authority and knowledge experts, with both having access to all relevant data, resources and information. Long term fixes require knowledge experts, systems builders and policy makers among others. A crisis manager and communications manager are required throughout.

    The basic process of crisis management is to 1) stop the bleeding (given the mortgage default rates, it is not obvious to me this has been done – it is very difficult to find data and information) – this is the sort-term fix – often there are series of fixes needed. 2) Determine the long-term fix, validate it and implement it. 3) Upgrade all relevant policies and tools.

    This is a gross oversimplification, but maybe it is time to start viewing the economic system from more varied points of view.

    I agree permanent system patches are risky as they add to complexity while increasing the incidence of unanticipated consequences.

  10. Can I honestly not imagine a world where this turns out well? Sure, I can. What does it look like? Well, interest rates are quite stable over the long-term and there is substantially less demand for debt products. Let me know when we get there.

  11. A grosser simplification: eliminate the complex systems that require complex monitoring and regulation.

    Everyone is so proud of themselves when they learn systems theory or chaos and complexity in college. We need to learn how to simplify. That is what we need to be teaching.

  12. We’ll get there faster if we don’t sit around waiting for it.

  13. As someone who uses derivatives in her everyday work, are you able to explain precisely how the system we had before 1980 wouldn’t work in the absense of non-vanilla non-interest-rate/currency/commodities derivatives. I think it would improve this debate if we could debate specifics.

  14. OTC derivative contracts are what distinguishes our current financial difficulties from ANY which occurred before 1994. Since then we have faced the Taquilla Crisis (Mexico), LTCM (1998), Enron (2001) and October 2008. All were provoked by derivatives. We now face a universe of $600 trillion off balance sheet derivative bets, and NO ONE KNOWS which company has what exposure. NO ONE KNOWS. Unless and until all OTC derivatives are publicly reported, EVERY investment decision is an ignorant guess.

    A 1% transaction tax on derivative transactions of United States Participants could retire the National Debt. Why is no one suggesting such an obvious expedient?

  15. Well, they aren’t having only upside, they pay to transfer risk. I think the problem is that they aren’t paying enough. The Swedish Bank prize (a.k.a. nobel) rewarded some people who underpriced the risk in a very sneaky way.

  16. As soon as I read “the cacophany is deafening” I stopped reading the article. Based on past experience, words like that signal that what is about to follow will be at best a complete waste of time.

  17. Why are you picking on systems and complexity theory? Anyone who knows them can tell you they either don’t apply, or are too theoretical or not sufficiently developed to apply here.

  18. Would you call that “total quality management”?

  19. I’m glad you at least keep hammering this point. Also, I’ve read estimates as high as 1 quadrillion…and growing…, which is more than the total value of all assets on the planet (of course some contracts net out with other ones…but still).
    Also, it’s really hard to make the point these days that derivatives are promoting financial stability after what’s happened to the taxpayer as a result of AIG.

  20. I have mentioned on a number of occasions that I work in finance. And yes, I am involved with derivatives on a daily basis.

    As an aside, any loan, or rather any loan a reasonable consumer would ever decide to get has an embedded call option, so for risk/hedging purposes, it’s treated as a derivative.

    Derivatives are portrayed as being these scary things that were invented to destroy others and generate “scam fees.” this is simply not true. It is true that OTC derivatives markets have grown to an arguably unmanageable size (far outpacing the markets for the underlyings in many cases, for starters) and many market players place bets with little knowledge of the variety of possible exposures this creates, but it’s hard for me to see how any these things make derivatives “evil.” Many derivatives were invented to hedge risks. I would love to hear why you think this is a bad thing. My favorite “toxic” derivative of choice, should you take the bait– CDS.

    Ironically, interest rate swaps are some of the tamest and most useful of derivatives.

  21. Obviously not engineering, where it’s a fundamental priciple of design to keep things as simple as possible.

  22. I don’t see where Fox-Penner is saying we need to ban derivatives. He does say we may need to live with a little less product complexity, but it’s a long way from there to banning interest-rate swaps. I think he’s just saying there are tradeoffs.

    If the problem is that current regulators cannot understand products that are complex but useful, then the ideal solution would be to get better regulators – perhaps by paying them more.

  23. I think a tax may be a good solution, but it can’t be on the notional amount of the derivatives. Say you have an interest-rate swap where one party pays 5% of $100 million and the other pays some floating rate on $100 million. The notional amount (the $600 trillion you refer to) is $100 million. But the amount changing hands each year is on the order of $500,000 (if the fixed and floating rates are 0.5 percentage points apart). So a 1% tax would be double the real size of the transaction.

  24. Johnson writes: “There is agreement that some kind of prudent regulation is needed as is investor and consumer protection, but that’s about it.”

    Well NO, I do not agree with that the focus of the regulatory reform should be more prudent regulation! In many ways I believe we need just the opposite.

    Though I am not “Fueled by billions of dollars of lobbying and purchased research” and I could use some funding I do indeed have my very own idea…. and it starts from the fact that our banks are not even supposed to be into AAA rated operations… that should be the exclusive territory of widows and orphans.

    Our banks should dedicate themselves to the much riskier operation rated BB+ and below, because it is right there that our future growth as well as our future AAAs normally operate, because it is there we need a true banker’s knowhow. Those BB+ and below clients were not the source of the current crisis, as the current crisis arose solely in the AAA sector, to which the banks were foolishly tempted to go when regulators offered them very low capital requirements.

    I have drafted my recommendations here http://bit.ly/1Xby8A and I sincerely appreciate any suggestions or editing help as well as passing on the ideas to as many as possible so that we get these reforms going in the right direction.

  25. CBS from the West

    Well, I am one of the people who has questioned whether mortgages are a good thing on this blog. My opinion is that they do more harm than good, make housing less affordable by inflating the prices as well as adding unnecessary transaction costs (interest, closing fees, etc.), and retard innovation in housing construction that would lower costs.

    I have a very open mind on the issue and I realize both that I lack expertise in the area and my view is unconventional. But it is interesting that nobody has ever said anything to refute my proposition. The _silence_ on the matter is deafening.

    Really, give some reasoning or evidence that mortgages are good for society. Then we can talk about what kind of other financial infrastructure might be needed to back them up.

  26. Jake! The devil is in the details.

    1%-2% tax on OTC derivitive transactions is a great idea.

    But how do you apply it retroactively to scores of trillion and counting, in dark pools that have no market, cannot be valued, are “toxic” and hidden in the shadow banking system?

    Moving forward yes! But how could you do it retroactively?

  27. Couldn’t you put a 1% tax on the original $100 million. (The difference between the fixed and floating rates could be 20% or more taking possible inflation into account.)

  28. A mortgage is just a certain type of loan against a certain type of collateral, but I agree. There should some basic level of housing that can be built and acquired without any financing. Many homes can be built by the future owners for the cost of a downpayment (circa 1990) on a house. They aren’t going to be particularly luxurious, but they would probably have more natural materials (less off-gassing of formaldehyde and other carcinogens and allergens), and more consideration paid to innovation (such as passive solar heating etc.).

  29. That’s only the real size until the risk is realized. Also, Jake seems to explain elsewhere (and apologies if I’m getting this wrong) that the point is to kill off nearly all derivative transactions.

  30. These folks tried to hedge risk with interest rate swaps. By attempting to reduce risk they only made it worse.

  31. “That’s only the real size until the risk is realized.”

    Don’t understand what you mean. $100 million has been put at risk. How much more than $100 million could you lose?

  32. Peter Fox-Penner writes: “As an industrial organization economist, I think this discussion would benefit greatly from a consensus on the role and goals of financial regulation.”

    So what are the “roles and goals” of financial regulation?

    Does anyone want to give this question a try?

  33. tippygolden: So what are the “roles and goals” of financial regulation? Does anyone want to give this question a try?

    Yes. Since the (long forgotten) role of our banks is to select and help out all of those entrepreneurs who normally do not live in AAA territory, until they can be taken care of by the capital markets, the roles and goals of bank regulation should be to help the banks to do just that, while minimizing the risks of the banks not having been able to pick out the right AAA candidates of tomorrow.

  34. Sure, I’ll take the bait… And let’s operate on your TURF – your derivative of choice, CDS.

    There are a number of issues that are immediately relevant. One is the issue of asymmetric risk in a highly volatile instrument. Recognize the following principle:

    If you face an asymmetric reward function, then in expectation you benefit from high risk (and, indeed, high volatility). Derivatives, by their very nature, _magnify_ risk.

    Consider the matter this way: Derivatives are inherently a form of leverage. With a few pennies, I can buy a call option on a stock. If the stock moves 20% upwards, ownership of the stock would have yielded 20%. Ownership of the derivative? Perhaps 500%. If it were an uncovered call, the counterpary has theoretically unlimited liability.

    The entire POINT of capital asset ratios is to ensure systemic stability AND to ensure that banks have enough capital to cover likely losses (because the reward structure is asymmetric – not just because of TBTF, but also because of simple bankruptcy).

    However, capital asset ratios are powerless to stop leverage from derivatives. Indeed, we don’t even have a good MEASURE for how much leverage is really endemic in a derivative, nor the effective cross-sector correlation in risk.

    The net-net creates the following situation:

    1) Other banks start generating massive profits by using huge (invisible) leverage – just like AIG did when selling CDS (effectively, a massive PUT option on mortgage-backed securities).

    2) You come under pressure from your board – why aren’t you earning the same profits? Does the board understand how much risk the competitor is taking? In all likelihood, you follow suit.

    3) Everyone is expanding leverage – a bubble emerges. All the typical dynamics kick in – optimism, anti-regulation rhetoric, theories as to why the underlying dynamics are really real.

    4) Bubble bursts, and so many financial institutions are threatened at once (regardless of whether you’ve prevented TBTF) that the financial sector presents the Fed with a fait accompli: bail us out, or all your planets are belong to us.

    Your presumption, Sam, is that derivatives were created to hedge risk. In practice, they are often used to _magnify_ risk. As Fox-Penner notes, if we cannot quantify and measure risk for all such instruments, we have to ask whether their advantage outweights their risks (given that we cannot effectively regulate those risks).

  35. If stability is the goal, it would help if the Fed converted the temporary liquidity it pumped into the economy into permanent liquidity, and took measures to keep velocity permanently lower (effectively shifting the economy more toward a cash-based, exogenous-money system rather than a credit-based, endogenous-money system).

  36. Because it would vaporize the money supply overnight.

    Your point about exposure is correct.

  37. They are not being used to create stability. They are being used to manufacture risk, which yields positive expected gains in the presence of an asymmetric reward function. As noted above, derivatives can serve as a form of leverage.

    Here’s a question – does anyone know a paper that answers it? – what percentage of derivatives are _actually_ used to hedge risk (which is what their defenders generally point to as a “good thing”)? What percentage is used to take big bets?

    Considering that the size of the derivative market dwarfs the size of the underlying securities, I suspect we know the answer.

  38. One quick note about overlapping agencies – often, Congress does this deliberately as a mechanism to assist with oversight. Think of it as a boss who assigns 2 or 3 employees (redundantly) to the same critical task, just to get different perpsectives on an answer and create competition.

  39. I should have been clearer. I was thinking in terms of the world of finance. Complex math has been used as a smokescreen in the valuation of financial instruments, portfolios, etc.

    There is no shortage of quants that are walking around feeling a little guilty or silly these days. We’ve even had a one or two share their come-to-jesus moments here and on similar blogs. The bottom line is that none of these things (that I know of) incorporate fraud, PR, and basic fear/greed psychology into their models, so they are worse than worthless, they are harmful.

  40. How do we measure the knowledge of regulators? That’s right, there is no way. I was thinking more of a financial patent system, but in retrospect that would probably just make layers even richer. Anyway a full disclosure would have the markets regulate themselves while bringing stability. As a bonus in engineering patents are notorious for stifling innovation so they could do the same for financial sector.

  41. to reduce the unsavoury decisions of RealPolitik regarding Nazi-war-criminals to a character flaw of John McCloy hints at a pretty romantic and very over-simplified Weltbild as well as a complete disregard for the Zeitgeist.

  42. You’re a fan of Kissinger?

  43. in my world “total quality management” was introduced after “to avoid the last 10 % of mistakes costs 70/80/90%? of the total” had been fully and meticulously implemented.

    If you chase paper-pushers through these kind of inanities you get what you plant.

    I find it hard to believe that finance should have been free of Mao’s “permanent revolution” is good for I forgot what.

    Maybe that the ideas of Mao’s Little Red Book fuelled a lot of this is not as absurd as it reads at first glance (today it is called innovation though and who dares to be against any kind of innovation is an enemy of the market – eerily reminding me of “Klassenfeind”)

    - look at the birth dates of the “deciders” in this mess – I’d bet that a lot of them have imbued this stuff at an age when they were most impressionable and most distanced from real life’s demands. Over here they jumped up and down the streets yelling Ho-Ho-Ho-Tchi-Minh and threw bricks if not worse trying to bring down the Schweine-System before deciding that the “march through the institutions” would pay for a nicer life-style.

    … and as to engineers being champions of keeping it simple …
    Yes, they do, quite often even admirably so, once the financial and marketing thumb screws have been adequately tightened.

  44. to answer the question why I already have the book by which I will start to read up on Kissinger you would have to be able to imagine the level of anxiety and inability to find out anything other than what our own mass media told us we lived in when the relief of Kissinger starting his shuttle diplomacy came.

    It looked to us as so much of something different and completely new and it raised high hopes in the young South American J..s who were in Germany for training purposes and I ran around with at the time also – there was movement some new idea in this all so entrenched and hopeless seeming situation with the atomic bomb looming large all the time – my South-American j…-friends all had their rucksacks packed to go to Israel in 1967 when fortunately the war ended after 6 days.

    I know nothing about the Chile-story except that I “administered” one employee who fled “Allende” with his savings invested in exportable ancient rugs because he didn’t want to end up in poverty and no he definitely didn’t pine for a return of the brown shirts.

    oh and as RealPolitik goes I don’t think anybody with a sense for “real” would have decided that a sorting of Europeans according to ethnicities resulting in lots of dislocated would do the trick of bringing peace to this forever threatening turmoil continent.

  45. while you keep talking about “banana republic” the French took to the street –
    http://timescorrespondents.typepad.com/charles_bremner/2009/10/how-we-helped-sarkozys-banana-moment-.html

    but of course “république bananière” sounds comparatively enticing – how to make use of the Banana watch at about 0:30

  46. Uncle Billy,
    how about publishing a list of operators (politics, finance, science you name it) of the past who comply with your standards of non-connectness and lily-whitness and who actually kept things moving or even accomplished anything?

    wreck your brain and let loose …
    and no I will not go into debunking your list of saints …
    I am not interested in saints I am interested in people who try to do their considerate best with what they know at the time of action

  47. Yes, I know. I live in a glass house.
    Don’t know of any public figures that would meet these criteria. A few my private life, but certainly no one that would want to assume an initially thankless position (as far as I know). This is why I’ve been advocating the education of a new class of administrators (I think I got this idea as a kid from Hesse’s “Glass Bead Game.) It sounds a little far-fetched, but I’ve seen children raised, and mature adults, that develop and maintain a razor sharp sense of duty and justice. Of course they can be corrupted too, but if we start with tougher nuts, to preserve their character won’t be as difficult. They would need to lead austere lives after completing their schooling — so maybe the would be required only to serve for 10 years or 20 years, and then would be afforded special privileges. It would all be voluntary: families could elect to have their children evaluated for suitability, and the children themselves could elect at any time to drop the program. (Though I’m sure our sophisticated psychologists could program in the proper inducements to stay).

  48. Bond Girl
    Interesting you talk about “platitudes” there. What specific answers have you ever offered on this site, other than insults to regulators who are never given the manpower or resources they need???

    Many people, including Warren Buffet and George Soros, (I suppose you would complain those two gentleman are ignorant to discuss the matter, since neither are currently employed by banks) have said credit default swaps (CDS) should be illegal. Many like Paul Volcker have said investment banks and commercial (retail) banks should be separated after all the damage Phil Gramm did to the regulatory framework. Is that also what you and the bankers refer to as a “platitude”???

    Please tell us which simple financial institutions were DOA in the 80′s???—you give no specific examples “Miss Platitudes”.

  49. Uncle Billy
    your scheme reminds me horribly of what monasteries wanted and probably still want to achieve …
    they most likely started with honestly best intentions and probably raised lots and lots who came up to the expectations but I can’t for the life of me remember anyone who did any good for the this world community

    - just look at the undoubtedly most saintly and leading a truly austere life operator of his time and the blood-shed he was able to help along due to the force of his oratory http://en.wikipedia.org/wiki/Bernard_of_Clairvaux

    I sincerely wonder if you’d compare the number of slaughtered due to his good intentions to the number of slaughtered due to Talleyrand’s maneuvers, Talleyrand a lapsed priest wouldn’t turn out to be the one truly deserving sainthood but that of course applies only if you consider the life lived here on earth to be the one to be cherished and protected

  50. Ted K
    listening to http://en.wikipedia.org/wiki/1812_Overture
    or something equally ear busting?

  51. If you want to reduce the incidence of x, tax it. “Why is no one suggesting such an obvious expedient?” Tax law is the playground of the Congress of the U. S. Proponents of your recommendation do not have the ear of Congress. To understand who does have their ear, please
    read opensecrets.org for 2007,2008, 2009 regarding lobbying expenditures.

    http://www.opensecrets.org/lobby/clientsum.php?year=2007&lname=Goldman+Sachs&id=

  52. I too would love to see more people with integrity in our government and in our regulatory bodies. (53 IRS agents took illegal First-time Home Buyer Tax Credits according to the Inspector General. Geithner failed to pay taxes on income over several years even though his employer reportedly paid him additional money to pay the taxes due. Congressmen of both stripes have failed to report income.)

    One other wild suggestion which is diametrically opposed to yours and far less high-minded: There are plenty of insiders from this crisis—some who tried to sound the alarm and were silenced—so why not hire them? Harry Marcopolos for one. Something akin to Internet security firms hiring high profile hackers.

  53. Uncle Billy one more on the possibility of the improved human being …

    peasants in Hessian “Siberia” used to counter any tale of a wonderful family life with the question “Haben sie schon geteilt?” (have they’d have to divide something up?) referring to a heritage having come their way

  54. Jessica
    not only hackers there are also lots of “depraved” but valuable “converts” once they can be convinced that daddy’s status and esteem will be good for the kids

    the record of rascals and even murderers starting to work for the side they have fleeced is probably a lot less bad than one cares to admit
    and if you read this only half satirical comment (second in the piece) on how far we have advanced in throwing insult at our public figures it seems high time to recalibrate out rightful and oh so satisfying to vent indignation http://www.timesonline.co.uk/tol/comment/columnists/rod_liddle/article6888851.ece

  55. Can anyone tell me, why there is a more permanent style link (on the Blogroll) on “Baselinescenario” that goes to the Wall Street Journal blog, when the Wall Street Journal has written a strongly worded editorial AGAINST the Consumer Financial Protection Agency (CFPA)???

  56. Many here talk about solutions to a problem and this all is starting to be very incoherent. Now from an engineering standing point, the first step would be to find more or less (preferably more) unambiguous definition of the problem(s). I haven’t seen a clear definition here so what is/are the problem(s) we are trying to solve?

  57. Have you read Alan Meltzer’s opinion piece in the WSJ on 10/22/09? How does the part about “idle reserves ” and the Fed buying “massive amounts of mortgages” as way of subsidizing bank profits and increasing their capital” jive with your view on converting temporary liquidity to permanent liquidity?

  58. Well, maybe it would help then to understand what he thinks “living with less product complexity” actually means. I was reading it to mean “what regulators understand,” which I daresay eliminates a lot of products.

    Even prior to them understanding these instruments is them wanting to understand these instruments. But that’s just me going off on capture again. Complexity is not our problem. We make complexity work in many other fields.

  59. Eurocitizen
    Dan Palanza
    Per Kurowski
    have both in their own way again and again and again defined the or one problem very neatly
    is their take too simple or too complicated from an engineering standing point?

    let me add from my own experience that problems in the paper pushing department are extremely hard to fix in an engineer’s way because whatever there is to be fixed it has metastasized in the most astonishing and unimaginable ways and if you do not catch those “subsidiaries” they may explode later on really badly. Complicating the procedure is that some of those subsidiaries may act in favour of well-being – that’s why I see any possiblity of hope in fixing basic basics ideas like Dan’s and Per’s

    as you like to point out that patents are an obstacle to innovation please remember that before patents there were officially granted monopolies – admitted patents need revising but without considering their once beneficial to innovation achievement “you talk, we protect you” the outcome will be crap

  60. We can get very academic about what the Fed should and should not do. (I’ve certainly done my share there.) But we all know there are political realities to what the Fed actually does.

    People who have money on the line need ways to stabilize their holdings from fluctuations in interest rates that inevitably occur outside the ivory tower.

    I find it ironic that so many people simultaneously argue for forcing the banks to have “some skin in the game” with respect to the loans they make, and then want to restrict their ability to manage that risk.

  61. So what is the definition of the problem?

    “let me add from my own experience that problems in the paper pushing department are extremely hard to fix in an engineer’s way because whatever there is to be fixed it has metastasized in the most astonishing and unimaginable ways and if you do not catch those “subsidiaries” they may explode later on really badly.”

    Then the problem definition was wrong and or the solution was wrong. That’s why engineering often is an iterative process.

    “as you like to point out that patents are an obstacle to innovation please remember that before patents there were officially granted monopolies”

    Patent system was created to get people disclose their inventions. Patent is an officially granted monopoly. As you mentioned the patent length should be significantly shorter as the world is moving a bit faster than it was in the 18th century.

  62. “As you mentioned the patent length should be significantly shorter as the world is moving a bit faster than it was in the 18th century.”

    I said no such thing, I am not the one who knows the easy fixes – and btw German patent law came into being in 1877 – that makes it the 19th century in my book – but never mind I am sure there are eminent historians who trace its origins back to the old Greeks or Sumerians

    “Then the problem definition was wrong and or the solution was wrong”

    you forget the cases where the subsidiaries aren’t even on the radar any more because they have made a life of their own but somewhere deep in their history is a foundational pillar that will be effected by changes somewhere else.

    River regulation comes to mind – beautiful idea, n’est-ce pas, did a lot of good except for some unforeseen side effects – too bad, now we are much more advanced, something like that would never ever occur today – If I had a penny for how often I’ve heard that song, I’d be richer than even today anybody can imagine

  63. Even if we assume the 19th century, you have to understand that this is the 21th century. Life has changed a bit. So should the patent system.

    I see you worry for subsidiaries, but if they are a part of the problem, then should we really protect them?

  64. OK, did some online reading on definition of “notional amount”. The $100 million is a notional amount.

    So as a “layperson” I have a very steep learning curve when it comes to understanding what derivative trading is about. Due to its complexity it might be akin to playing chess. But the information is asymetrical. Chess has rules / regulations. But its different in dark pools.

  65. It doesn’t really matter how much the tax is. What matters is complete disclosure and current value accounting. Your example suggests that an innocent little fixed-floating rate swap is at issue here. It isn’t. These derivative transactions are engineered to hide losses, create fictitious profits, gamble in currency markets, elevate short term returns while obscuring medium term risk. The only beneficiaries are the executives and traders who cash out at the expense of their companies. You have to understand the culture of derivatives better in order to write intelligently about it. Sorry. Incidentally, if these things can’t afford a 1% tax they are no different than workers who cannot afford at 15.3% social security tax on their earnings. The dealers should stop whining and just pay up.

  66. I wrote “subsidiaries” not subsidiaries and I think I mentioned metastasis somewhere
    you seem to be a great one for oh so slightly giving new meanings to my words
    thank you for that but in this case I prefer the accuracy of an engineer to the savvyness of a lawyer

    oh and btw if you can find all the metastasisses any given law, rule or regulation has become fertile ground for during its lifetime you are the most magnificant mind of all times

    as I consider the complete solution an impossibility I am for the minor tweek here and there observing the outcome – just imagine what happens if you wait a little bit after you have given one of two parallels an ever so slight push…
    (I know nothing in that vein is ever going to happen because it wouldn’t be stuff one could write headlines about, so it will be the world saving grand scheme/theory/plan once again)

  67. If a derivative transaction is outstanding it is no different than any other living thing. Parties are free to avoid the tax by collapsing the transaction before the trigger date. Perhaps I don’t understand the problem?

  68. Rules and goals of financial regulation are to keep five guys with money in Switzerland, the Bahamas and Lichtenstein from owning 98% of the Nation’s wealth, just like they already do in most of the emerging market countries.

  69. I’ll answer my own question.

    Rather than more regulation … it sounds like regulation itself needs to be reformed. Hence the need to agree on what the roles and goals of regulation are.

    This raises the question: What is the purpose of the financial system? And what role does government play in the financial system?

  70. Eurocitizen, you ask: “I haven’t seen a clear definition here so what is/are the problem(s) we are trying to solve?”

    My reply is more questions: What is the purpose of the financial system? And what role does government play in the financial system?

  71. Per,

    I read your proposal. It seems to me that ignoring OTC derivatives will permit the banks to simply ignore what you call productive lending and continue to game the system. Why would a bank make a productive loan rather than an easily hedged equity swap permitting a corporate insider to realize stock option gains without triggering either a taxable event or a violation of insider trading rules or even alerting the market he has dumped his position? How is the owner of a money market fund to determine that his above market return is hostage to the next blip in the mexican peso, thai bhat or russian ruble? Who knows whether GE is actually making light bulb profits or gambling on perpetual access to the commercial paper market? If you don’t tackle OTC derivatives the system will never work properly. No one’s investment will ever be safe and the financial plutocracy will continue absorbing public and private wealth until we end up like Mexico, Argentina or Malaysia.

  72. Only thing you didn’t answer was my original question, so I’ll ask once more: “What is the definition of the problem?”

    It doesn’t have to be and it can not be perfect even at the final stages. However, something is a start and better than nothing. Engineering principles are there to refine it continuously until further improvement is no longer feasible.

  73. Jake Chase “These derivative transactions are engineered to hide losses, create fictitious profits, gamble in currency markets, elevate short term returns while obscuring medium term risk. The only beneficiaries are the executives and traders who cash out at the expense of their companies.”

    Yes but the only reason they can do so is because they have a regulatory system they can arbitrate against. Let me explain it as simple as I can.

    If a bank has an exposure to a an A- client then it needs a 4 percent equity but if it bought a CDS from a AAA rated insurance company (AIG) then it can get away with only 1.6 percent of capital. How to split that saved difference of 2.4 percent of expensive bank equity was then negotiated between the bank and AIG.

    Eliminate the capital requirements for banks based on risk and you have eliminated the incentives for all of this. In all other CDS there are no artificial benefits to be split. For each seller taking the risk of being a seller there is a buyer taking the same risk as a buyer… and all they have to do is being sure that the counterpart has the means to pay out if he has to.

  74. Eurocitizen
    I am the wrong person to get enthusiastic about the “engineers lead the way” of fixing the world as I am not much of a lead follower in general

  75. Jake Chase “Why would a bank make a productive loan rather than an easily hedged equity swap permitting a corporate insider to realize stock option gains without triggering either a taxable event or a violation of insider trading rules or even alerting the market he has dumped his position?”

    Because if all the capital requirements for the banks are the same for all of their assets then there are no artificial arbitrage profits to be shared with someone and the bank would at that moment have to compete on equal grounds with the rest of the market and… that is no “fun” for a bank and so it would dedicate itself to its core business.

  76. Confused by my limited financial vocabulary. (I was opining while assuming a notional amount and a derivative transaction are the same thing.)

    You are saying tax the derivative transaction. This is interesting. In order to tax the derivative transaction there needs to be disclosure to the tax authorities.

  77. If stamp duty of house purchase didn’t exist but were introduced it would catch all future sale/purchase transactions. I don’t see any problem. The City of London in 2007 boasted derivatives trading of $600bn per DAY. Unlike those such as Willem Buiter who scoff at a so called Tobin tax, I just want the money (in the UK treasury). All other overdeveloped economies would follow because they too need revenue desperately. And incidentally, regulation that has parallel taxation is always more effective.

  78. @StatsGuy:

    first of all, you’ve mentioned nothing specific to CDS besides mentioning AIG.

    also, why do you think it’s just banks? that’s generally the object of discourse on this blog, but they are not the only players, and the largest leverage with respect to derivatives is certainly buy-side.

    back to CDS and AIG. AIG sold CDS assuming it was just an extension of the insurance business. This is clearly misguided, but if any insurance company concentrates on any one possible source of crisis (and therefore potential claims/payouts) it’s setting itself up for disaster. The problem is that AIG did very little to hedge any of the CDS contracts they were selling.

    Yes, it is certainly non-trivial to come up with a good estimate of liability on leveraged instruments. However, there are plenty of risk measures which are not very model independent and are used all the time (e.g. jump to default risk). For example, you could require a bank holding CDS (or other credit derivatives) to have reserves that cover some reasonable fraction of their JTD risk. If this kind of reserve had been part of the discourse, AIG would have looked very different.

    You are correct that derivatives are often used for leverage, but leveraged hedging makes perfect sense. If I buy cheap options to cover my main position, I’ve effectively hedged my risks. And plenty of banks and hedge funds do just that. Of course, if you’re using options ONLY as a source of leverage, it’s much harder to contain and even quantify the inherent risks.

    “if we cannot quantify and measure risk for all such instruments, we have to ask whether their advantage outweights their risks”

    Totally agreed, which basically goes to BondGirl’s original point.

  79. Well I do not like the tax on the derivatives… especially when they prime incentive for them is arbitrating different capital requirements because that would in essence make the State to have a vested interest in these derivatives.

    I prefer eliminating once and for all the differences in capital requirements based on risk because if it is not by derivatives these will be arbitrated by other means.

    In fact the biggest unrecorded loss of this crisis are the opportunity costs of our banks not having financed other more long term productive assets, just because they were given incentives to pursue AAA assets and where there is little to be gained for the society at large.

  80. I agree on the theory but would rather take the money. The banks are zombies anyway and will remain so for years.

  81. Sorry, Uncle Billy, they didn’t even have degrees in comp sci when or courses in systems theory when I went to school. My comments come from years of crisis managing complex 7×24 financial systems. If you want simplification include some of the folks who are experienced at cleaning up other people’s messes – it is in their rational best interest.

  82. So they paid a premium to transfer risk. Ie, to limit the downside risk to ideally zero.

    But the opposite happened! Many-many large investors who purchased AAA-rated products are much worse off for buying a premium against risk.

    Noting here, Taleb says complex derivatives are a cover for fraudulent activity.

  83. Mortgages are not just for consumers. It’s virtually impossible to do business without some sort of lending involved. Even if you eliminate all mortgages on homes, you’d still have a lot of lending to businesses.

    Conceptually, though, it sounds like you are making an argument against lending with interest; it’s not endemic to houses. Unless you want to do away with lending entirely, interest is an absolute must. No sane lender would ever not charge interest.

    Lending [in general] is good for society because it distributes money better than saving. Economies are driven by spending and it’s hard to spend if you can’t borrow. If it gets to a point where the average consumer has an unmanageable amount of debt, then yes, there’s a problem, but that doesn’t have to be the case.

    A consumer’s decisions aren’t all that different from a company’s. The basic logic is that if I need an instrument to do my job, but I don’t have enough money to buy it outright, I can borrow it and do my job. Otherwise, I can’t do my job at all and everyone loses. I can’t save enough money to buy the instrument because I can’t do my job. It’s a vicious cycle. Lending lubricates an economy.

    You could respond that with discretionary goods (and for argument’s sake, lets put a house in that category) your cashflow isn’t impaired if you just save for it. However, I think money is better distributed with lending here, too. If I want a big house and need to save for it, I have to either rent for the time being (this is clearly not as efficient) or buy a smaller house, save the difference and then eventually buy the bigger house. This would probably take at least 10-15 years, if not more. In this time, I’ve spent 10-15 years worth of maintenance costs on my smaller house, but most importantly, I’ve waited 10-15 years!

    This significantly dampens the housing industry. It’s hard to innovate in the housing industry when everyone is saving. If someone builds a house, lending makes it much easier for them to sell it.

    Also, I don’t see why mortgages retard housing innovation that lowers costs. If I can build a $100k house for $60k instead of $80k and still sell it for $100k because houses still cost my competitors $80 to build, you better believe I’ll do it. Lending accelerates this effect, not retards it.

  84. Probably not, however, I have always succeeded by understanding the desired outcomes, measuring (mostly counting, advanced mathematics are rarely needed) against those outcomes and tuning where necessary. Unfortunately since the M&A’s the only outcomes desired by the financial sector seem to be short term profits that support personal gains. Service levels are given lip service and the numbers are gamed.

  85. @Yakkis: I have an engineering background, actually. Fundamentally, I agree with you, but the key phrase is “as possible.” Would you say that an internal combustion engine is simple? Probably not, but one could argue it’s as simple as possible (or close to it).

    Financial complexity is the same way. There’s no reason to create complexity for complexity’s sake, since you have essentially no liquidity in those instruments. Standardization, to the extent possible, *is* generally sought.

  86. @Sam:

    “the largest leverage with respect to derivatives is certainly buy-side.”

    No, that’s not true. Or, more accurately, it’s only true if the seller of the derivative holds collateral to cover all possible obligations. (Of course, if this were to have occurred, we would never be in the situation we’re currently in.) If the seller is not forced to hold liquid collateral then the there can be huge implied leverage on both sides of the trade.

    The CDS that AIG sold were not covered. The implied leverage was massive. Huge. Astronomical. As history demonstrated.

    And you are right that many “non-financial” institutions can sell CDS, which is precisely why it’s important to separate banks for special regulation. The reason? Because banks can legitimately manufacture money and are critical to day-to-day business, and are thus _insured_ by the FDIC (and, apparently, and implied Fed/Treasury guarantee).

    “The problem is that AIG did very little to hedge any of the CDS contracts they were selling.”

    I politely disagree – the whole point of a company like AIG selling CDS was to allow _others_ to hedge. How long does the hedge-chain need to be before it’s deemed “Safe”? And how many financial services companies take their cuts along the chain?

    The real problem with AIG was that they used massive implied leverage, did so on a huge scale, were not properly collateralized for this level of leverage, and were fundamentally stupid or corrupt (or, alternatively, taken advantage of by slick city bankers… who were just down the street).

    I am not against CDS or derivatives. But…

    1) If we think the main benefits of derivatives are for hedging, then we should try to make sure that the main use of derivatives is for hedging – which would imply a HUGE reduction in the size of the derivatives market.

    2) I agree that measuring risk is critical – though I share BG’s skepticism about how we’ll ever do that given the speed of innovation.

    3) We can improve the situation through narrow banking or some similar option (so that only narrow banks get state backing and insurance). BUT, this does not fix the problem. Fundamentally, this rests on a primitive understanding of money. Money, at it’s core, represents a type of contractual obligation – an asset. This underlies the Fed’s 1995 observation that debt = money. In a “virtual” cash environment, the webwork of contractual obligations can rapidly dwarf the base money supply. This puts the Fed in the uncomfortable position that stabilizing the “real” global money supply requires stabilizing asset values (or at least paying attention to them). And if the Fed embarked on a policy of deliberately stabilizing asset values, using an inflation tax as needed, then how is that not creating an asymmetric risk function?

    I will be plain that I do not understand the full implications of what this type of implicit guarantee means for the global economy. There may very well be some positive benefits of such a guarantee – I really don’t know.

  87. But you have no issues with the present state of affars?

  88. Ok, problem no 1.

    It is not clear what the purpose of the financial system is and what is governments role in it.

    Anything else?

  89. “all they have to do is being sure that the counterpart has the means to pay out if he has to”

    The default counterpart being the taxpayer.

  90. all for going that way then please do not mix two problems at the beginning of the analysis.
    Answering even remotely
    “what is the purpose of the financial system?”
    and boiling it down to a memorable but still all comprising sentence should be a monumental task.

    how far is “standardizing exchanges of goods and services” covering it? and next question if that should be about it, can goods and services be lumped together?

  91. Well, there are actually two questions:

    (1) What is the purpose of the financial system?

    (2) What is the role of government in the financial system?

    There are competing claims over how these questions should be answers. Hence perhaps the “cacaphony” of debate over regulation.

  92. In fact, Eurocitizen, its ability to measure knowledge is why double-entry book-keeping has been the de facto control language for commercial trade for 670 years.

    The proper book-keeper measures value using a debit system and expresses right to ownership using a credit language. When the books are reconciled for a time period the quality of buy decisions is reconciled into a measurement of gain [losses] for buy|sell decisions in that time period.

    Profit [loss] is then a combined measure of cash trades in the production and sale of product, and the quality of capital exchange decisions on the other hand.

    The important point in today’s context is that nobody is doing an auditable book-keeping leaving us no way to know how intelligent the present state of business decisions are being made.

    Whether derivatives are sometimes good will not be known as fact until there is a proper, auditable book-keeping framework tracking the cash versus capital trade versus value of their exchange history.

  93. To the extent that fees are usually charged by someone to create any derivatives transaction, an “expense” should be visible to auditors. This maybe assumes that derivatives are traded on exchanges. Shares are also “derivatives” so no new complex tax collection system is needed. Such taxes could be collected daily at probably the lowest cost of any form of taxation.

  94. Yes now, after the fact, it was the taxpayer who ended up as the counterpart but, while it was going on, all this derivatives were bought from AIG because of their AAA status and which supposedly covered the risk of having AIG as a counterparty

  95. @StatsGuy:

    you are correct on AIG/leverage. My point was regarding intent to leverage.

    “the whole point of a company like AIG selling CDS was to allow _others_ to hedge. How long does the hedge-chain need to be before it’s deemed ‘Safe’? And how many financial services companies take their cuts along the chain?”

    That’s certainly how they viewed it and I do think they were taken advantage of. Hedging just by making offsetting investments is one thing, but diversification and collateral are certainly part of it too. That being said, part of what derivatives are about is to let different players take different risks that fit their business goals.

    AIG simply did not do that and there’s no reason they couldn’t have. Do you really think there’s nothing they could have done to better offset the risks of the CDS they were selling?

    How deep does the chain need to go? I don’t know. But there’s also no reason for one company to be the sink for all the risk in the system. That’s just dumb and bad for everyone. It’s the job of every company to manage their own risk. AIG didn’t do that. I don’t think they tried very hard, either.

    Beyond that I think we’re actually mostly in agreement.

    *stops to ponder that for a second*

  96. I take it you are not being entirely ironic here.

  97. I think the tax (aka stamp duty) has to be on the notional amount for simplicity. In some cases perverse effects may ensue, but life’s tough (or should be) for such traders. I doubt the tax will be introduced at 1% but more likely some small fraction thereof. Regulators / tax collectors should be, by law, given full details of each and every trade, counterparties etc., along with the due tax payment.

  98. Dan
    my bet on you rests on having lived through the discrediting of the accountant which probably started with the advent of the controller

    but I try and try and can’t learn your explanations so that I could repeat them in my own words, therefore

    couldn’t you put up a sample on my beloved T-accounts of how it is most commonly done today and how one of my old colleagues would have done it? – thank you !

  99. Well, at a certain level of generality, I can answer these questions with my own biased opinion in a few sentences. The purpose of a financial system is to help an overall economic distribute resources fairly and efficiently. Slavery and servitude used to be out of fashion in the last century for very good reasons in my opinion, so a financial system should be prevented from causing those things. (Democratic) government is supposed to help the majority not be run over by the minority, so regulation or structural features of the system preserved by government should be used for that purpose.
    Even at this very basic level, you can see the purposes being thwarted.

  100. To the extent that complexity as in derivatives are part of the problem you’d think that by now a way to regulate them would be well established.

    Early derivatives on the London stock market. Anne Murphy: “During the boom of the early 1690s, several thousand derivatives were transacted each year” http://premodeconhist.wordpress.com/

  101. Notional amount is not synonymous with exposure on account of offsetting trades. (Of course, there is still the problem of banks being intertwined together even if you net exposure.)

    There is also a world of difference in terms of exposure depending on whether one is a dealer or end-user.

  102. Tim, what a fantastic website you link to. And I like your mascot. :) There is a Canadian Magazine called The Walrus. It might be the only national independent magazine published in Canada.

  103. Ted,

    Before you cozy up to George Soros, please do a little research and get back to me. Google: Soros+Bank of England and Google:Soros+French Conviction. I wonder if Warren Buffet appreciates being mentioned in the same breath.

  104. Bond Girl: “I find it ironic that so many people simultaneously argue for forcing the banks to have “some skin in the game” with respect to the loans they make, and then want to restrict their ability to manage that risk.”

    It is consistent. The reason to have banks keep “skin in the game” is to make them retain risk, not to let them manage it. Not allowing them to pass so much risk on to others means reducing the amplification of risk down the line, thus reducing the systemic consequences of that risk. Not allowing them to pass on so much risk incentivizes them to be more prudential in the first place. As things have developed, it also increases transparency in the system, as pooling and securitization makes for opacity, either as a practical matter or as a contractual one, where information about the borrower may be confidential. It also retains some responsibility in the system. If the link between borrower and lender has become so attenuated as to be practically anonymous, what mutual responsibility do they have to each other? It is not often discussed, but the loss or attenuation of responsibility is one casualty of modern financial risk management.

  105. Silke, before book-keeping was revised into an industrial version somewhere in the 19th century, books were kept in the style documented by Pacioli in 1494. Many small businesses still use the Pacioli model.

    Pacioli style book-keeping used the T account as a tool to balance two sides of the general ledger, before posting transaction data into their journal book. This saved the book-keeper from getting errors in the trial balance.

    The trial balance is the posting of journal transactions into the general ledger as proof that the debtor|creditor relationship is in balance. “Balanced” means that for every posting of a debtor value on the left side of the ledger there is a corresponding posting of a creditor expression on the right side of the ledger.

    However, this level of book-keeping disappeared with the Industrial Framework, where ledger headings changed from Debtor|creditor to Assets|Liability.

    This switch automated the book-keeping process to facilitate a reconciliation of statements in shorter time periods –quarterly — than was normal in the Pacioli Model, which was once a year at best.

    With the Industrial Framework debtor values set equivalent to creditor expressions could appear on either side of the ledger. The T account was of little help here. When the Industrial Framework is coded into software, the change in book-keeping technology becomes even more automated and changes brought into play by the Industrial Framework are more clearly understood. (but too complex to explain here).

    However, I know that this little help to your experience with T accounts.

    My goal in communicating into these blog comments is to notify interested persons that book-keeping technology that was standard practice 50 years ago has been completely lost.

    It was not as noticeable for the first 20 years because book-keepers were still savvy and respectful of the old technology. But in about 1980, the microprocessor began to do away with languages such as Cobal that were designed exclusively to do book-keeping. Between that and programmers who never had a clue as to book-keeping’s technology and began writing record keeping code that is little more that a single entry system, from then on, all has been lost.

    What the economic community needs to understand is that trading of goods and services is a thermodynamic system. Debits versus credit are a direct analogy to work|heat in thermodynamics. Work and heat are always equivalent systems.

    What you are seeing today in financial markets is a distorted relationship between work’s value and the right’s to ownership in exchange.

    The analogy to thermodynamics would be a power company estimating the water behind the dam incorrectly, selling energy that is not going to be generated, getting the dollars, blowing them on bonuses and then saying “sorry” when they cannot deliver the electricity.

    You cannot cheat the thermodynamic system itself, whether you do the book-keeping or not.

    When the housing market collapsed the work had been done assuming that the dollars that were fed into the fiasco were worth $1.00 as rights to ownership. In fact those dollars, now sitting in bonds, are worth about $0.35.

    The houses, however, that people are trying to pay off mortgages for are carrying fake mortgage balances measured in the bloated bond dollars. Until the real value of the house and the bloated mortgage number come back into a semblance of balance the housing culture is going to remain stressed.

    If persons trained in economic theory, who populate this blog, understood the thermodynamics of double entry book-keeping issues, they would take a whole different attitude as to how to fix the present and the future crisis that we all know is coming.

  106. Dan
    thanks for your reply

    first I have never had a problem making myself understood or understand what was wanted of me when dealing with private auditors or auditors from the tax authorities using T-accounts for clarification

    Hence I insist strictly from the standpoint of a customer that everything concerning money that can’t be explained to me with their help or some even simpler scheme on a piece of paper makes me very very suspicious

    second I know nothing about the law of thermodynamics except that they exist so you lost me on that one too – what a pity and I had hoped to find in you a “comrade” for the resurrection of those maddeningly stubborn accountants of old

  107. Min,

    That applies only to credit risk.

  108. Silke, I understand that what I am bringing forward is difficult to understand until one has experience working with book-keeping as a real time modeling system.

    I do understand that using the T account is very helpful in the way that book-keeping is presently understood by accountants and auditors — a 500+ year old technology that could never have brought us the Industrial Revolution.

    But one to one resolutions with an auditor are quite different than a control language that must root out nasty, unethical usages as have been taking place over the past 30 years.

    I’m here to warn interesting persons that the problems are not going to go away until cultural leader understand the book-keeping framework. And, if the book-keeping framework is to be restored, leaders somewhere, Simon and James, for example, are going to have to take an interest in how the book-keeping framework can be restored.

    It was practiced successfully at GE 50 years ago with a paper driven system. Programming a software driven system can be done because I programmed a full prototype of the framework myself. So if today’s stagnant culture is still with us years from now perhaps someone reading these comments will give the history of double-entry book-keeping a second look.

    We need it today.

  109. CBS from the West

    @ Sam K:

    Thanks for responding. The topic is really a digression and I don’t want to waste to much of everyone else’s time on this. Let me just point out a couple of things and then I’ll be quiet.

    1. Your arguments presume that mortgages are in use. If there were no home mortgages, house prices would be substantially lower: I have personal experience with a situation where mortgages were originally banned and the introduced: prices jumped steeply. So, you wouldn’t have to save for 10-15 years for that house–not having to compete against other potential buyers with leverage, you would bid something you could afford from your savings, just as they would. Housing would be more affordable.

    2. If I need an instrument for work, borrowing is one option. But so is getting equity investment. When I was young, lots of small businesses were started with personal savings and with equity investments from others. My father, in particular, never borrowed a dime and built up a very successful business from his own savings, those of his primary partner, and small equity stakes purchased by a few friends (eventually bought back). He died a wealthy man and millions of people enjoyed the products he sold. His story is not unusual from that era. Now, this approach may not be workable at a very large scale, but I think it would go much further than it normally gets “credit” for if people didn’t resort to debt so quickly.

    3. Your arguments, if you read them carefully, say nothing about how credit benefits society as a whole: you make a strong case (which I accept) that it benefits _producers._ But producers are only a segment of society. Does credit really benefit consumers?

    OK. I’ll go away now and read all the interesting stuff that others are saying about the main points of this blog. But thanks again for at least engaging my argument.

  110. We do have a lot of cleaning up to do. Who are these folks you speak of experiencedgal?

  111. Tim, do you have any experience with dark pools? Do you know if they are trading plain vanilla equities here, or is it the whole alphabet soup of derivatives too?

  112. Oy, you’re worse than I am!

    Good outcomes, it seems at least to me, result far more from good intentions than bad intentions, so the logical course would be to at least start with good intentions and then to augment them with clear, forward thinking, and plenty of strategic savvy.

  113. Jessica: Sure, people like this can be very helpful, but accept no one at face value. Put them through a stringent background check / vetting process, and then watch them carefully. Especially the ones that look especially squeeky-clean.

  114. BG:

    The reason I so-muched liked your arguments in favor of “skin-in-the-game” is precisely because it is one of the major mechanisms we have to manage risk. But I can’t agree that we should rely on that mechanism alone. From that perspective, I don’t see any inconsistency.

  115. “Notional amount is not synonymous with exposure on account of offsetting trades.”

    Yes, and so far I haven’t found anything that estimates what % of the total market is real hedging (or offsetting trades), but the sheer size of the market compared to the size of the real world economy suggests that a lot (most?) of it is not hedging.

  116. Sam
    I am willing to listen to your case for derivatives except for one aspect that I don’t think you addressed – naked CDS.
    I can’t find a reasonable justification for naked CDS as a useful innovation, and I think they should be regulated heavily as the gambling instruments they are (regulation now prohibited by G-L-B).

  117. Peter, your post is so right. We need a long running consideration of regulation, effectiveness and impact, and it needs to be non-partisan and free from interference of “interested parties” (i.e. those to be regulated), and perhaps that should be a perminent part of the financial landscape, not just a commission, but a perminent, powerful, quasi-governmental organization. Call it the Council on Financial Activities. It needs to be populated by a variety of public and private experts, perhaps with two members each from the Senate and House, a member from Treasury and one from the Fed, and one from each of the major regulatory agencies. It needs to also have a strong set of economists, either as (semi) perminent members, or as consultants per topic. And it needs the authority to actually draft regulation to be endorsed by Congress.

    If we did this, as you suggest, then all of the noise that continuously inhabits the media and blogosphere should go away, because it will not have any real meaning once this powerful independent commission is formed. The commission not only should be perminent, but also shoudl keep its doings essentially secret. After all, this is about national security and safety vis a vis the world economy (this would avoid attempts to predict and negatively arbitrage its regulation.

    Good luck, This country tends toward superficiality, after all, advertising and lobbying would not work if that were not so.

  118. Silke:
    Law of Thermodynamics made really, really simple:
    Heat has to go/come from somewhere, so any change in the temperature of a system, from start to finish, must be accounted for.

    Gut genug?

  119. I can’t remember making that argument, not that I disagree with it.

    All I’m saying is that if you expect banks to keep loans on their books, you have to allow them ways to manage things like duration risk, and to some extent, credit risk. (And that is going to involve some complicated instruments.) That is not a bad thing and it is inconsistent to say otherwise (we do not want our banks to take risks, so we make them take risks). The problem is not the instruments or their complexity; their use just needs to channeled. We can’t do that in an environment where our regulators are captured and unsophisticated. And where our government enables this situation.

  120. It does not suggest anything.

  121. Doesn’t simplifying the regulatory system also simplify how one might compromise it?

  122. It is just the opposite in double-entry book-keeping. When the book-keeping framework is properly implemented it is a very simply control system that is very difficult to compromise. This is particularly true when the proper framework is programmed into software code.

  123. The closer a balanced processing of data is to real time, the closer the data comes to being impossible to compromise. Simplicity is data managements best friend.

  124. Bayard writes “Council on Financial Activities…If we did this, as you suggest, then all of the noise that continuously inhabits the media and blogosphere should go away, because it will not have any real meaning once this powerful independent commission is formed.”

    Do you mean something similar to The Basel Committee for bank regulations and which has operated as an incestuous mutual admiration club in almost splendid isolation?

    Let me be frank. The way most subordinated their thinking so completely to the truly absurd regulatory paradigms that the Basel Committee imposed, makes me suspect that you do not have the right people to populate that Council on Financial Activities or, if you had them, they would not be selected. And since it is an issue of national security as you rightly say, you would not want that over-powerful committee falling into the wrong hands.

    Simple objectives and simple and few regulations that minimize the interference of the regulation in the market and the possibilities of arbitrage and transparency and all in the open for everyone to see sounds to me like a healthier option.

  125. I completely understand simple data management is something to shoot for.
    However, I am referring to the regulators themselves. Wouldn’t it be easier to corrupt one regulating body than a dozen? Multiple overlapping regulatory agencies might not be the best way to manage things, but it does appear to offer a sort of enforcement redundancy that may be beneficial (e.g. Brooksley Born).

  126. Joskow seems to share your professional interests in energy and energy distribution. He’s a director at Exelon. Coincidence! Elizabeth Moler (see post above) is currently “Executive Vice President, Government Affairs and Public Policy, Exelon Corporation”

    Betsy Moler

    Does this mean that those dull dreambeats that we’ve been hearing, the ones that go BAN-KING AS UTIL-I-TY, BANK-ING AS UTIL-ITY, announce the birth of a new {cack} paradigm? The next big push to pervasive nuclear power?

  127. Chairman & CEO of Exelon is John W. Rowe. Not sure why, but this struck me as either funny or significant:

    “[Rowe] is the founder of the Rowe Professorship in Byzantine history.”

    http://phx.corporate-ir.net/phoenix.zhtml?c=124298&p=irol-govBio&ID=121588

    In any case, we’ve got the big ol’ energy establishment guest posting on Baseline now, speaking directly to the people. If they decide they need to take it up a notch, what are they going to do? Who are they going to have speak to us? Are the energy people asserting themselves and crowding out “those slimy wall street characters?”

    Simon, how did this post happen? Did Pete Peterson have a chat with Rowe, who dispatched Joskow to lean on Fox-Penner fire up the ol’ Wurlitzer?

  128. It is the regulators above all others that need the simplicity of data management. To make data management simple is not easy by any means. Book-keeping’s simplicity draws on 670 years of continuous refinement.

    The first order of business for book-keeping simplicity is data stored in reusable histories that enable the easy use of audit trails in order to know the material facts. Only a proper book-keeping would give the regulators that level of transparency that they need most.

    I agree that it is more difficult to corrupt multiple, overlapping regulators. In fact the real regulator of the past is the auditor. In today’s poorly implemented data management schemes the auditor’s job is a farce.

  129. “Simple objectives and simple and few regulations that minimize the interference of the regulation in the market and the possibilities of arbitrage and transparency and all in the open for everyone to see sounds to me like a healthier option.”

    Per, the only data management framework that is going to deliver these noble goals is the book-keeping framework of 50 years ago that has completely disappeared over the past 30 years.

  130. Yes so you have told us in about 50 comments, and still, at least I have not the faintest clue what you are talking about… the sliderule? that was like 30 years ago!!!

    Yes I remember now back around 1972 some accounting machines that looked somewhat like a telex and that you had to punch in cards for… great mechanical miracles, but I must confess I would run scared if I saw my bank using one of those today

  131. Perhaps I don’t understand your definition of the word “transparency” as you are using it in the statement of yours that I quoted. It may be helpful if you offered a definition.

  132. Redleg
    mehr als gut genug :-)

    and very helpful too because translated into what I call my kitchen language I will store it as

    “Von nix kommt nix”

    and hopefully will be able to remember this time around that the two belong together

  133. Redleg
    I’d first ask every work place which deemed to be old-fashioned rules had been done away with in her/his life-time and then consider re-installing them. Yes that will slow-down paper-pushing but it will revive a sense for the seriousness of handling other people’s money and it will get the population on the side of the counterinsurgency*) team because probably most of the cubicle population still feels very uneasy with the “non-bureaucratic” laid-back ways imposed on them and they’ll be the first to know where fraud or rip-off is brewing.

    Second I would get at the fancy language by decreeing that any such creation has to be translated into plain housewife’s language (like the French try to do with English)
    Maybe the most ominous example is when Germany got on the merger-bandwagon it was proclaimed all over the place that this was a great chance to “Synergien heben” (lift synergies) – anybody who dared to translate it into personnel reduction would be treated like a know-nothing apostate

    *)assuming that the banksters and their colleagues in corporations are the equivalent of insurgents/war lords of course shows my total ignorance of everything

  134. There are 4 laws of thermodynamics, including the “zeroth” law.

    http://en.wikipedia.org/wiki/Laws_of_thermodynamics

    (just in case anyone else was having this issue)

  135. ” Nonetheless, today’s airwaves are filled with arguments that regulatory reform will stifle financial product innovation and attending benefits.”

    I listened to that arguement, and I accepted it – not that everything has all gone to sh*t, I no longer accept it.

  136. They are evil because they make ‘investment’ decisions impossible. Neither you nor anyone else has any idea of the risk of any investment in today’s financial markets. Numbers on financial statements mean nothing. This is the effect of financial innovation. It is also the substantial purpose of financial innovation: allowing market participants to make any claim that suits their fancy.

    And the benefit is what, exactly, that somebody, somewhere, is going to get a lower rate on a mortgage he will never be able to pay off?

  137. Financial regulation as currently practiced is a confidence game in which the appearance of knowledge substitutes for actual knowledge so long as the insider fraud stays within reasonable bounds. This explains the career of Greenspan, who was an idiot masquerading as a genius. Does anyone remember Jersey Kosinski’s book, Being There (or perhaps the movie)?

    Any system of specific rules will be gamed and only complete disclosure will tell us who is gaming them.

  138. Perhaps you have eliminated the bank incentive. I wouldn’t know about that. But you forget the incentive on the other side of the deal- to manufacture fictitious profits, avoid taxes and regulatory restrictions, place bets on perceived sure things, etc.

    The one thing we know about banks is they are absurdly undercapitalized. Allowing them to place bets with the money they don’t have is idiocy. Allowing them to keep the bets secret is beyond idiocy. Allowing them to keep all the profits and transfer the costs to one hundred fifty million people who actually perform productive work is criminal. No one who has not experienced Wall Street close up has any idea how criminal the culture is. It has swallowed up forty percent of US corporate profits and still manages to bankrupt the government. Do you really think a small coterie of Basel gnomes can fix this?

  139. Yeah, sure, everything will be okay if they just tell Tim Geithner. No, they should have to tell everybody.

  140. data stored in reusable histories

    Dan
    maybe in accounting it is possible to get the histories straight again or do you propose to start from scratch?

    Everywhere else where record keeping of entitlements/rights was going on clerks scrambled and fought often without success to keep the “narratives” of transfers uninterrupted. During the heyday of the merger craze companies/departments/groups were renamed, split up and re-assembled several times a year and no extra personnel allowed to assist those stupid useless paper pushers keeping the records in shape because of course the computer would do it all said the smart kids from the software companies :-(((
    I am holding my breath when all that mess created then and there will start to bubble up – maybe if one looked way down in the hierarchy this messing up the clerical part was not as insignifant as one might think when one focuses on the big profiteers of the mess.

  141. The purpose of a sane financial system is to lubricate a real economy which produces what living people need and creates opportunity for them to earn the money with which to buy it.

    The purpose of our existing financial system is to enable a small handful of rogues to grab everything by hook or crook and finance a continuing stream of payoffs to the politicians who are unaccountably trusted by a bare majority of voters who fail to notice that regardless of whom they elect nothing changes except for the worse.

    Ironically, this is very easy to fix without introducing Marx or Lenin or Mao or any other demagogue of the left. You fix it by introducing rules that apply to everyone and enforcing them uniformly. The basic rule is protect the value of money, because once money becomes dishonest the only regulatory mechanism is armed force. We now have a totally dishonest financial system and we ought to try to make it honest while we still can.

  142. I think he means like the Warren Commission.

  143. That is not an argument; it is an assertion. You have to understand the difference.

  144. Jake,
    “Basel gnomes” couldn’t quick fix it “once and for all” but just as they, if Per is right, did a lot to unfix it, they could probably do a lot to set a path to something less mind-boggling or even reasonable.

    In paper pushing I have often seen that a little push originates in all kinds of often unforeseen changes in very remote and unconnected areas.

    The image I use to keep that fact always in mind is not the famous butterfly wings but parallels, if you give one just a little push so it isn’t quite parallel anymore lots and lots of things will be different a few miles and days on – for example no train will be able to blaze through anymore …

  145. Simplicity vs. Complexity

    One single capital requirement for all… everyone knows the rule there is no space for individual lobbying.

    Many different capital requirements based on risk, like now, total confusion and everyone is out there trying to push their particular risk segment a lot of individual lobbying.

  146. OK, I see what you are saying. If we could – long term – separate the _uses_ of these instruments that are beneficial (e.g. true hedging) from the uses that are detrimental (e.g. manufacturing beta, or claiming to reduce beta without really changing it), then yes.

    One of the main reasons I’m skeptical is that it’s very hard to imagine a public regulator – subject to public pressure – having the autonomy and capacity to truly execute nuanced regulation, when the regulatees can make (well funded) arguments that the state is disrupting the free market.

    Bright lines are rarely efficient (and they are not here), but they are easier to sustain politically.

  147. Jessica:

    Recognize that Meltzer has an agenda, and is generally a strong dollar advocate/anti-inflationista.

    Meltzer’s argument is weak for the following reasons: The Fed has thrown liquidity into the system, but CLEARLY signalled that it will withdraw the liquidity. That does not create a permanent expectation of stable inflation (any real monetarist should know this); what it creates is an expectation of a moving “wall of liquidity”, and by telling people the wall will be torn down in the near future, it creates an incentive to avoid TRUE long term investments and to arbitrage away the temporarily “low” rates (which are only not low in real terms).

    It’s like saying “We’re going to try to fight deflation by creating a little bit of inflation, but we don’t _really_ mean it. We just want you to think we mean it. (But, really, we don’t.)”

    Meanwhile, while trying to keep expectations of long term low level money, there are huge dynamics that are suppressing velocity – and some of those dynamics are a GOOD thing. The problem is there is not enough real cash in the system (or perceived to be in the system long term) to support higher price levels given the deleveraging. (Hence, if we succeed at re-regulating and forcing de-leveraging, but do not supply the base liquidity to the system, the inevitable result will be lower prices.)

    And the only reason the Fed even budged at all on printing any money seems to be because the precious banking system was threatened – so what we have is a huge invisible subsidy to banks (via spreads, payment of interest on reserves, etc.)

    The Fed has implemented this policy because of its ridiculous belief that this crisis was never real – that it was a simply liquidity crisis (not a solvency crisis or an aggregate demand crisis).

    Here is another WSJ article that expresses the belief that the real problem was “unlocking credit channels”. The authors call the source of the problem the “credit channel blob”, and if it sounds absurd that’s because it is.

    http://online.wsj.com/article/SB10001424052748704471504574438650557408142.html

  148. Naked CDS is a tough one indeed. The way I see it, if you don’t hold the underlying debt, you might still have exposure related to various highly correlated events (i.e. the health of the company). A simple example is if you have LCDS and want to hedge the default risk but *not* the prepay risk (i.e. not buy LCDS), you would technically be buying naked CDS but I don’t really see any problems with this situations since it’s essentially identical.

    You’d probably respond that this should be acceptable (since you still have a large stake in the company’s debt), but I guess I don’t fundamentally see a difference between this and other stakes in the company. It’s true that naked CDS can drive a company under due to speculation, but there’s also plenty of naked CDS investors who aren’t speculating–just genuinely hedging, which I don’t really see as a problem. It’s really just insurance at that point.

    Unfortunately, in order for the “insurance” to be liquid, speculators sort of come with the turf. I share your skepticism, but it’s hard for me to entirely write off the value of naked CDS either. I’m just not sure overall.

  149. Yes, gem of a site run by very professional journalists. The Walrus theme comes from where? I feel I should know but can’t recall it? Lewsis Caroll?

    The Walrus and the Carpenter
    Were walking close at hand;
    They wept like anything to see
    Such quantities of sand:
    “If this were only cleared away,”
    They said, “it would be grand!”

    Sounds like a theme for this blog too. Too much sand in many eyes.

    I had an aunt in Vancouver who claims she was the first female PI in the locality (Canada?). Keep up your inquisitive tendencies, maybe something in the water:-)

  150. I guess this goes to the question (and worry of capture) of whether it is possible to regulate derivatives to maximize their use for hedging and not the suite of other detrimental pursuits.

  151. I guess this goes to the question (and worry of capture) of whether it is possible to regulate derivatives to maximize their use for hedging and not the suite of other detrimental pursuits. Sam K

    Sam K., Correct but while we decide how to regulate why not tax the lot of them? The exercise of writing the tax law may reveal many of the issues inherent in tackling future regulation. Call it a “temporary tax” if it makes everyone feel better. (Income tax was partly sold that way too:-) I’m sure no-one will say that our governments have plenty of tax revenues, low deficits etc. It’s cash flow that kills enterprises, some governments too.

  152. I do not know why the above came out as anonymous but I guess most of you recognized me anyhow.

  153. Silke: “maybe in accounting it is possible to get the histories straight again or do you propose to start from scratch?”

    Silke the problem is in the book-keeping software. One has to understand the difference between a framework of rules and an accounting strategy. A framework of rules is typical of a constitution that sets the rules for governing a nation.

    Today’s book-keeping software does not follow the framework of rules that were refined into practice 670 years ago, and further refined as commercial cultures became more complex. That framework of rules, to my knowledge, has been never been programmed into software.

    I know it can be done because I programmed a prototype version that does work, but surely not on the scale needed today. So, yes, it can be done, and yes it is a large, complex programming task.

    However, the state of the financial system tells that the challenge has no alternative. Book-keeping is a social science language, that is just as important to social harmony as mathematics is to the physical sciences. We would not get far in space travel if NASA suddenly decided to abandon mathematics.

    We are where we are today because the software community has never been schooled in the science of the double method of balancing books. The big thing with book-keeping is that it records a reusable history.

    Every time you hear the word “opaque,” or experience it as you have, relative to accounting data, you are hearing the complaint that the history of book-keeping transactions were not properly recorded according to the rules of double-entry.

    I say that with confidence because a software driven accounting will have many magnitudes of greater potential than any we have ever know, relative to transparency, when accounting data is recorded in a proper software driven framework.

  154. Jack Chase,

    I appreciate you sharing first hand experience as a trader.

    Taxing the notional amount or the derivative transaction! It is a good start. It would force transparency to rein in the wreckless gambling that is destroying our economies.

    Here in Canada with 33 million people, the federal and provincial deficits combined is $90 billion, with budget deficits forecast for another 5 years. A man who stocks the shelves at my local grocer told me, after a decade of employment, his hourly wage was cut by $7 an hour. It’s all very alarming if not frightening.

  155. After seeing what the consequences of innovation are, maybe its best that the innovative products are not allowed to see the light of day until they can be comprehended on a systemic scale (if ever).

    And mathematical models of risk assessment should not count as “comprehend”ing anything…

  156. Sure, why not. Taxation was mentioned in another comment and unless you’re trying to kill them entirely (I’m assuming that’s not generally the goal of a tax), *what* exactly does one tax (the point in the other comment thread was that you can’t tax the notional). I guess you could tax a percentage of the cashflow, but that has plenty of problems of its own. I would love to hear suggestions.

  157. @ Sam K, Stamp duty was first levied in the UK in 1694 to pay for the war with France. Although initially only planned for four years, it proved such a good earner for the government that it was never repealed.

    At first the tax covered “vellum, parchment and paper”, but this was extended during the 18th and 19th centuries to cover a range of goods, including newspapers, insurance policies, gold and silver plate and even hair powder. The tax was extended to property sales in 1808.

    In 1765, the attempted enforcement of stamp duty in English colonies in America led to protestor’s demands of “no taxation without representation” – and ultimately to the Boston Tea Party and the outbreak of the American War of Independence.

    In 1797, William Pitt the Younger described stamp duty as “easily raised, pressing little on any particular class, especially the lower orders of society, and producing a revenue safely and expeditiously collected at small expense.” He virtually doubled the tax that year.

    I see no real problem with the tax being levied on the notional amount. It’s only a question of how much. Maybe different rates for different categories would be appropriate like VAT (another European tax that will rear its head in the USA soon enough and cause much more outcry:-)

  158. Guys, I think what we are missing here, and maybe someone already said it, but the problem was with the people in these jobs, the politicians giving them leadership (lacking). We had a people failure. Instead of “regulators” saying things were wrong, we had our leadership saying “no nothing’s wrong, keep on destroying your company, don’t worry about tomorrow or the next generation, get all you can get now and forget everyone else”. Until that mindset changes, we will continue to have these problems. Everyone seems to forget the past.

  159. I think I see what you mean – the regulator might not want to admit they don’t understand the “product” that they regulate and become a sycophant to avoid embarrassment.

  160. Not true. From the proceedings of the Basel Committee it was clear that the regulators had taken over the whole regulatory process without any political supervision, and that is how they were able to implement their very narrow agenda of a world with no bank failures, no matter anything else. That this later backfired on them, because they were so naïve and gullible as to believe they could empower the credit rating agencies to decide so much about the capital requirements without these either making human mistakes or being captured, that is a totally different issue.

  161. That has indeed a lot to do with it

  162. “What the economic community needs to understand is that trading of goods and services is a thermodynamic system.”

    Interesting analogy. The main difference is that while the trading is, the consumption is not a closed system in the sense that people have diminishing marginal returns to utility. Thus, gains from trade.

    Financial engineers simply extended the notion of “gains to trade” to risk. So that by trading risk, everyone is happier, which they would argue increases overall willingness to invest (and hence economic prosperity).

    To a point, we know historically that this is true.

    The question is, what is that point, and how far past it have we gone?

  163. I would look for folks who have real world experience with systems in a variety of disciplines. Some familiarization with economics and finance is needed by acolytes of any particular school of economic thought should be avoided (although these folks are valuable as knowledge experts and validators). IBM and GE have some excellent folks, there were some excellent folks who bailed out of BofA and Wells after the mergers, I would look at Google (they seem to have solid system concepts and creative problem solvers), among others.

  164. Per,

    To describe the central bankers that are responsible for Basel II as “naive and gullible” is incredulus. Perhaps “intellectual capture” might be a better description.

    Perhaps Alan Greenspan — with his libertarian free-market ideology, with his long tenure as the chair of the US Fed, with the United States being the richest on the planet — influenced the timbre of Basel II.

    Below is a list of the central bankers who are now responsible for Basel II. These are among the most powerful people in the world. People who are “naive and gullible” do not rise to such positions. It is utterly baffling that you should make this claim.

    Board of directors at the Bank of International Settlement:

    * Guillermo Ortiz Martínez, Mexico City
    * Hans Tietmeyer, Frankfurt am Main
    * Ben Bernanke, Washington, DC;
    * Mark Carney, Ottawa;
    * Mario Draghi, Rome;
    * William Dudley, New York;
    * Stefan Ingves, Stockholm;
    * Mervyn King, London;
    * Jean-Pierre Landau, Paris:
    * Christian Noyer, Paris;
    * Guy Quaden, Brussels;
    * Jean-Pierre Roth, Zürich;
    * Masaaki Shirakawa, Tokyo;
    * Jean-Claude Trichet, Frankfurt am Main;
    * Paul Tucker, London;
    * Alfons Vicomte Verplaetse, Brussels;
    * Axel Weber, Frankfurt am Main;
    * Nout Wellink, Amsterdam;
    * Zhou Xiaochuan, Beijing

  165. Indeed tippygolden, it is “utterly baffling” for me too to have to use those words.

    But, if I wanted to describe a host who nominates his butler (a great sommelier) to decide who of his guest have the taste-buds worthy of receiving the finest French champagne and who are only going to be served white wine from a long-life box, and then believes his butler will not be the subject of undue influences by his very honorable guests, in order to convince the taste-bud-rater that they indeed have the taste-buds that merits the best, and that his butler will not, sooner or later, fall for their arguments, what other words other than naïve or gullible would you suggest I use to describe the host? “Intellectually captured” by his butler does not really seem to sum it all up.

  166. StatsGuy: “The question is, what is that point, and how far past it have we gone?”

    If we had been using our computers to keep proper books for the past 30 years, we could have used the S&L Crisis example to gauge the high tech bubble. We then could use both to study the mortgage bubble. This would give us an idea of the melting point we can expect from a derivatives bubble.

    Book-keeping is experiential learning that builds real time, reusable models, which stats guys can use to establish reasonable conjectures as to the degree to which a healthy bubble can be safely inflated and deflated. This, I believe, is the only answer to your question.

    I repeat (Sorry Per) book-keeping has the potential to make speculation a great deal more fun than it is now. We need to learn more about the physical facts upon which safe speculation rests.

  167. Maybe, finally, the “too big to fail” = “too big to exist” idea is gathering momentum.

    * As a proud dutchman, I’m saddened to see ING be split up, but hey, it’s a start. And Ms. Kroes wanted, I guess, to show she wasn’t afraid to start at home.

    * Even Larry Kudlow & Charlie Gasparino are behind Volcker. (I turned off CNBC months ago, but caught a few minutes today in the gym…).

  168. redleg
    you got it,
    it should be considered highly impolite to even imply disdain/ridicule in certain situations and which those are, all of us still know and try to observe meticulously in our private life

    but it’s not only the regulators who have the dirty little secret that they do not really understand it. My bet is that it is the bosses too and they too hide it or at least make sure it isn’t mentioned. They probably have the same relation to their models I have to my car … if I put the foot down it either accelerates or slows down

    also he/she doesn’t even have to become a sycophant, just embarrassed enough, shy to get ridiculed, in order to try to avoid it happening again. It is just too painful, somewhere in the category of discrimination i.e. being object of the intimating wink wink between those “in the know” – or think of being wrongfully accused

    - of course the solution on the part of the laughed at is to become extra-simple in his/her demands for explanation, which might, if he/she is allowed to go through with it, easily get her/him exluded from further get-togethers or if they can’t do that then they clamp up whenever he’s present.

    And maybe, just like all or almost all of us here on the blog, a regulator might believe that if there is shady stuff going on, it is not on the surface and he needs his “context”, the chats on the office floors, to unearth bad stuff. In my book up-to-no-goods more often than not publish to wide circulation what they are up to. (the shady stuff arrives only later when the S begins to HTF and that’s maybe where witch-hunting begins to make sense.)

    But the seeding, the preparation of the fertile ground, is done publicly.
    The language maybe confusing but it most likely will be there – that is one of the reasons I am at least as allergic to jargon and obfuscating language as Orwell was.

    As to any hope of the super-regulation-rules that will fix it once and for all, forget it. Even the most sophisticated and sensible regulation will due to changes in the conditions on which it was based eventually show a fissure here a fissure there, will get patched here, will get patched there and one day a smart gambler will see a loophole.

    My pet dream to fix this is empowerment of the clerical level paper pushers.

    As turning whistle blower is a lousy job which probably only the independently rich can afford, one has to create somebody the clerk can brief with the full knowledge and (grudging) approval of its employer (employer and employee must continue to be able to work together with an assumption of mutual trust).

    Some decades ago a system like that has been established in German corporations. There is a job called SicherheitsBeauftragter=in charge of safety. When it was first established manufacturing foresaw its immediate demise and Germany becoming impoverished etc. but it was probably the Berufsgenossenschaft maybe via threatening higher premiums which put its foot down and it worked and it probably saved lots of lifes and healths.

    Now how to create and EMPOWER a paper pusher equivalent to the technical supervisor of safety with an equally strong and feared back-up like the Berufsgenossenschaft is still beyond my imagination. (seems to be one of those uniquely German institutions, but it is the only one all bosses I have ever met feared and respected, i.e. a lot more than the tax man – the Berufsgenossenschaft seems to be the only outfit you seriously try not to monkey around with http://de.wikipedia.org/wiki/Berufsgenossenschaft)

    btw the paper pushers who could brief the FinanceSafetyAttorney do not need to understand the fancy models, they are not macro-managing, they see the models’ consequences in real time just like a housewife doesn’t have to know how to read a thermometer to realize that the oil in the pot might soon flame up.

  169. tippy
    those in high positions are not super-human they are just like the rest of us, intelligent in one situation and naive and gullible in the next
    - to equip them with anything out of the ordinary

    makes them look more invulnerable than they deserve to be

    - they have one or several special talents, so do I and so do you, if we dare to include ALL our talents not just those which we are taught to rever as higher talents.
    - come to think of it they probably have better family connections than most of us do (Tietmeyer for example is said to be the Pope’s ideal banker)

    - and falling for utopian world views (like that there may exist infallible rating/vetting processes) is a favourite past time for whole masses of people and those who fell for it were not the top people but high ranking clerks who hatched those stinking eggs

    Whenever I read about one of the high and mighty I remind myself that I also may be “klug” (a mixture between intelligent and wise) on one point and criminally stupid on another and that often less than a minute apart

  170. I’m with you oldgal

    when it was still done by hand I saw quite a lot of what was then called NetzwerkAnalyse (net work analysis) – I am not quite sure but I think its English name was SystemsAnalysis (in our computer age the SystemAnalytiker is a totally different job).

    Anyway these guys had these huge papers on their walls with lines running from A to B, C, D and from there on to some, a bit like this only a lot more complex http://upload.wikimedia.org/wikipedia/commons/thumb/0/00/Netzwerkanalyse_beispiel.svg/400px-Netzwerkanalyse_beispiel.svg.png

    the purpose of that department was to keep an eye on the logistics of the construction of an industrial plant wherever, i.e. from personnel to material to local hires to housing to malaria prophylaxis etc.
    They sounded the alarm when the time schedule was in jeopardy. They must have worked together with the controllers who kept an eye on the cost but I only remember that there never seemed to be a friction between the two.

    the Netzwerker were all of technical origin and their boss once complained to me that he had a hard time to get them to do the thinking backward which seemed to come to us paper pushers quite naturally, i.e. you say day X this and that has to be ready you count back on your fingers all the workdays you need to get everything in place in time – it seems that to think these chain of events from the end to the beginning is not the natural way for all

  171. Per,
    how dare you even dreaming a doubt of the integrity of butlers ;-))))))

  172. “stats guys can use to establish reasonable conjectures as to the degree to which a healthy bubble can be safely inflated and deflated”

    oh no – please!!! not again, not another promise of salvation

    shouldn’t “experiential learning” have taught us by now that “safe” is a forever luring fata morgana http://en.wikipedia.org/wiki/Fata_Morgana_(mirage)

  173. “the Netzwerker were all of technical origin and their boss once complained to me that he had a hard time to get them to do the thinking backward which seemed to come to us paper pushers quite naturally, i.e. you say day X this and that has to be ready you count back on your fingers all the workdays you need to get everything in place in time – it seems that to think these chain of events from the end to the beginning is not the natural way for all”

    Silke, for me your phrase, “thinking backwards” is key to much of the conversation on this thread. When I worked at GE in the late 1950s and early 1960s in a division that built steam turbines and ship propulsion systems, Netzverkers were the “production control team.” There were no charts on the wall because the story was duly recorded in control cards (3 X 8 mimeograph) that consisted of the book-keeper’s journal anticipating the recording of the history of goods and services being traded as the turbines were being built.

    The thinking backwards was built into the data on the cards. I was also there at GE when the electronic data processing machines began to take control of the 3X8 card system, and replace them with punch cards. The first thing that was lost in the transition was the backwards thinking: because the IBM system was not yet ready to handle recursive structures. A recursive system is when an assembly is built within another assembly (a complex turbine rotor inside of the turbine casing, and a bucket system with the rotor etc).

    I watched as a dispatcher on the production control team nearly went blue in the face trying to explain to the central data processing manager (a position that came with the IBM control cards) the importance of sorting cards that would preserve the recursive structure in his card files. Central data could not see it because their processing machines at the time could not do recursive sorting.

    Ironically, to this day, the reason we do not have a slick double-entry book-keeping system, typical of the one at GE before central processing took control, is because central data (today’s software developers) still do not understand the method by which one builds a harmonious network by doing the backwards thinking in the control system itself. But to do that the computer Netzverkers need to understand recursive structures. For the most part software developers still do not understand recursive structures.

  174. Dan,
    the thread is getting too long I am starting a new one here

    just to be clear that I get the thing with the recursive structures connected correctly to my personal experiences

    once I “unlocked” the data in an undocumented data bank through trial and error and checking the results against the paper records using Microsoft access. While doing that I learned that I had to keep the two things separate, i.e. the way the data was stored (which fortunately for me had been done in a very well structured way with no redundancies) and the surface I worked with i.e. a kind of clawing/fishing tool.

    After this here is my question: I can’t imagine recursive structures would belong in the “background” data storage part but would all have to be part of the clawing/fishing tool part of the whole software system. (problem for the user: he/she never sees the back-part and therefore tends to believe the surface and it are one and who’s left in today’s paper-pushing world who has ever been allowed to design his/her own clawing no matter how primitive)

    btw in my case the storage part was kept in a long forgotten ancient program which nevertheless willingly delivered its results to Access which had no data content itself only know-how about clawing.

  175. Complex rules on complex facts gives you complexity squared. Enforced by a complex web of agencies it easily ends up with complexity cubed. Efficient enforcement relies on simplicity.

    I find that Peter Fox-Penner highlights a very important side of the regulation problem. We need enforcable regulation, and it will only come by making the rules and organisation simple. The facts of the financial world will never be simple.

    The easiest solution to TBTF and to the problem of unwinding financial institutions is to abandon the strict divide between debt and equity we have choosen to establish by law.

    Make a simple rule that automatically converts debt of financial institutions to equity in the form of ordinary shares. Link the convertion to a given spread on the debt of the institution over treasuries. If the spread is higher than x bp when the market close for the day, the convertion will take place overnight and the market will open next morning with let say 5% of the debt converted into equity.

    Institutions with low transparancy, high leverage, high risk or bad management would have a much higher funding cost.

    If you want to protect the original owners position, the could be given the right to buy back the converted shares within one year at the current market price.

    The need for regulation is in large part created by our own choosing of how the virtual concepts of equity and debt are constructed. If we are not able to regulate and enforce this concept in an effective way, we must abandon the existing concept and formulate a new one that is enforcable.

  176. Simon Johnson and James Kwak. You would not like for any of your loyal blog followers to remain with an unsolved issue that might disturb his peace… would you?

    I have perhaps too daringly placed the words of naïve and gullible on the table to describe the extent to how the bank regulators in Basel relied on the credit rating agencies, but why do you not suggest some other words so that tippygolden could feel more at peace? At least you, James Kwak, since I believe you have no ground on which to appeal to any Fifth Amendment right, of not having to declare on something that could incriminate you.

  177. It is a good question

  178. Silke it depends upon how the term “experiential” is defined. In book-keeping “experience” is the real production and trading of goods and services. The rest is conjecture based upon real experience’s data.

    Stats guys are making conjectures on conjectures. Book-keeping is going to come to their aid. As a book-keeping I have reasons to dislike stats guys, but i don’t because what they will do when the system is in order is just as important as the real-time physical model that the true book-keeper ought to be supplying.

    So, yes, it is another promise of a solution.

  179. Alan Greenspan, chairman of the US Federal Reserve, 1987-2006. He was the most powerful central banker in the world and he held office for nearly 20 years. Greenspan was a “naive and gullible” man?

    Sugggest there was a — failure in leadership — at the US Federal Reserve and the Bank of International Settlement (the “parent” of Basel II).

  180. What are the role and goals of financial regulation?

    According to PBS Frontline, Alan Greenspan did not believe financial regulation had a role in fraud prevention. Greenspan thought there was a rational market mechanism to deal with fraud. In October 2008, it would have been to let the TBTF banks fail.

    Suggest — fraud prevention — should be among the roles and goals of financial regulation.

  181. I agree, the naïve and gullible, usually do not make for good leadership

  182. Alan Greenspan

    has his relation with or his take on Ayn Rand already been evaluated with a focus on “naive and gullible”?

    and I mean ALL of the relationship, irrational attractions and revulsions included – isn’t it common amongst us normal human beings that close relationships are shot through with lots of “naive and gullible”? (this golden guy is forever going to protect me from all evil?)

    and let’s assume it was a meaningful relationship are we then to believe that his judgement was not nudged ever so slightly in a certain direction by it?

    if we want to make ourselves believe that than we might as well subscribe to the view that those on top are equipped with more than ordinary human possibilities

  183. I agree but, careful, first, do no harm… avoiding fraud provocation should come before fraud prevention.

  184. Silke said: “After this here is my question: I can’t imagine recursive structures would belong in the “background” data storage part but would all have to be part of the clawing/fishing tool part of the whole software system. (problem for the user: he/she never sees the back-part and therefore tends to believe the surface and it are one and who’s left in today’s paper-pushing world who has ever been allowed to design his/her own clawing no matter how primitive)”

    Silke, you are totally correct. You have me laughing hysterically. Let give you a quick over view.

    The important point here is that you are correctly distinguishing two categories of structure that universally occur in data histories. Because the two have unique arithmetics the book-keepers enters them once for each category — hence the “double-entry.”

    The existence of two structures in building and working with reusable histories is classic book-keeping. What makes the two categories different is that one is a network of physical facts and the other is a hierarchy of controls.

    When you are doing the clawing you are playing the role of the hierarchical control language, because only you in the context that you describe know what you need to know from the network of physical data. You are the analyst — the hierarchical controller — deciding what to claw and what not to claw.

    A proper book-keeping would provide that work for you simply by coding data, as it is being recorded in the first place, in a way that lets you automate the grouping process that tells what a user like you may want to claw back later on in your build process.

    In book-keeping we would say that when clawing you are creating a subsidiary ledger, where a ledger is a story told by the relevant physical facts.

    You want only a small portion of facts at a time. The proper book-keeping would filter a huge body of journal entries to give you the small group that you need at a particular point in time. You and your data would work together by talking in a coded language.

    All of the commercial book-keeping systems I have studied have stopped posting transactions into a journal|ledger relationship. They post to relational databases.

    In building their RDBMS structure they have to guess what you would need in the future and structure their RDBMS accordingly. The book-keeper’s journal stores material facts; the relational databases store facts as graphic images as information about material facts.

    In other words, the RDBMS is not a physical model of material facts and that is the rub in most of today’s data mismanagement.

    To build a recursive data structure one must store the data in a network architecture because the control language cannot know, for example, how deep the recursive process will be in each context of the work. That is precisely the problem that was glossed over 50 years ago at GE. And here you are wrestling with it today.

    Silke said: “btw in my case the storage part was kept in a long forgotten ancient program which nevertheless willingly delivered its results to Access which had no data content itself only know-how about clawing.”

    I wonder if the long forgotten ancient program is a book-keeping system journal that may be very helpful to you if you were able to gain an understanding of its original data structure?

  185. Per
    nobody is “naive and gullible” thru and thru
    as nobody is free from “naive and gullible” thru and thru

    that either of the two is at all possible is one of the illusions we cherish each of us about ourselves

    i.e. all of us have areas where we are clear headed and impossible to cheat and others where we are easy prey for the skilled trickster, whether it is one with benevolent and evil goals doesn’t matter in this

  186. What should be the role of government in financial regulation?

    America is dealing with is Alan Greenspan’s legacy. The most powerful central banker in the world believed that — government had no role — in regulating the financial system. While Hank Pauleson organized the $700 billion bailout, a most extreme form of government regulation in the financial system.

    Bond Girl has no faith in the regulators due to capture. Sorry to be blunt. It seems to me the way to restore faith and enforce compliance is by — investigating allegations of fraud and prosecuting charges of financial crimes — (a Baseline theme).

  187. Silke, absolutely and thank God for that. If we were not naïve and gullible it would indeed be hard to step out of the bed each morning.

    But in our field of responsibilities we are supposed not to be too naïve or too gullible and in my mind these regulators were.

    I just know that in May 2003 in a risk management workshop for regulators at teh World Bank, I ended a brief formal intervention as an Executive Director with the following words:

    “Finally, just some words about the role of the Credit Rating Agencies. I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.”

    And I ask, should not the regulators have known that?

  188. Dan
    you lost me almost completely on that – though we seem to be talking about the same things I can’t visualize what you try to tell me
    the only thing I can relate to is creating ledgers – sometimes if a “claw” got too complicated for me to formulate I would extract data and create a temporary data bank on my local PC with it from which I then clawed the information I needed – later on of course a programmer took over and made it look all slick and nice and operable with very simple and self-explanatory entries

    but the important thing was that by the time the (wonderful) professional came in my two like-minded colleagues and I knew exactly how our now invisible to us data looked like and behaved when clawed at (invisible because it was no longer on the index cards and we didn’t do any collating of data by hand from the anymore)

    Do you realize that the big difference between the paper times and now is that soon there will be no persons left who have ever seen and worked with a literally “graspable” (begreifbar) paper card index box? (I sometimes wonder whether the change will be as big as after gutenberg when learning by heart went down)

    as to the long forgotten ancient program
    - I am retired since 2004 and that program was something that would only run on one left-over server and was not compatible with our printing system etc. but it presented its content to me in Access in little boxes that looked to me deceivingly like paper index card boxes and so I played around with them as if they were exactly that and hurrah it worked.

  189. Edit required,

    Sorry to be blunt. It seems to me the way to restore faith in regulation and enforce compliance is by investigating allegations of fraud and prosecuting those accused of financial crimes (a Baseline theme).

  190. And I ask, should not the regulators have known that?

    definitely yes and if they didn’t they should still CLAIM responsibility for it – in my book professional honor should require that of them – after having done that they should inform us in detail how they think it came about that they fell for it and we should as a payment for acquiring that knowledge refrain from bashing them

    After you said that at the World Bank you still felt safe walking on dark streets?
    or,
    due to the fact you are 3rd world country, you had a kind of jester’s freedom?

    (how this strange not-knowing comes about is something I have been baffled and intrigued by all my life – as you know I am from the country of “that we didn’t know” and I find it hard to believe that all who said that were consciously lying. We took the accusing stance and so never got to hear about the process. I have inklings how it works but I would love to have detailed tellings.)

  191. Suggest a failure in leadership (clearly not limited to BIS) that caused a systemic failure in the world financial system.

    According to Baseline the remedies so far for systemic failure have been “fingers in the dike” and “patchworks” applied to regulation.

  192. Yes it is said that Greenspan “believed that — government had no role — in regulating the financial system”

    But how does this square with that then they regulated to such an extent that the capital of the banks was to be based on arbitrary definitions and measurement of risks, whereby they intervened like never ever before, and sent trillions of dollars over the precipice of the subprime AAAs. Had they not regulated, had capital requirements remained the same for any asset, this would not have happened.

    But I sort of understand him. If I had to confess to having been naïve and gullible I would also much prefer to accept that I trusted too much a supra worldly entity like the market than that I trusted too much the capacity of some very human credit raters. To be wrong on your philosophical outlook looks like sort of less bad than to be unglamorous wrong when using your calculator.

  193. Absolutely! But this includes sending away the regulators to at least do some community work, a couple of weekends.

  194. Silke: “Do you realize that the big difference between the paper times and now is that soon there will be no persons left who have ever seen and worked with a literally “graspable” (begreifbar) paper card index box? (I sometimes wonder whether the change will be as big as after gutenberg when learning by heart went down)”

    You make a fascinating point. If I were to assess the culture the is in the new paradigm, I would say that it has a tendency to ignore history. That to me is dangerous part.

    But whether the new culture will handle data that is abstractly stored in computer memory I know from my small town experience that young persons can be as handy with data stored electronically as you are I were working with control cards.

    The important factor asks whether the young members of the culture will be taught about the things that do not change as the methods of handling data change.

    Clearly the culture’s financial woes tell that how we learn processes that do not change is in trouble. For me, that is the scary part.

    I live in a small town. I watched as banks that could only loan in their own county supported the local business community. The laws changed and the capital city banks bought the local banks. Weeks later the city banks stopped loaning to local businesses and began loaning to countries in South America, where they lost their shirt.

    Locals had to find other ways to finance their own businesses. Where they once borrow on 90 day notes to buy inventory, more often they paid a longer price to suppliers who used 5% factors to fund the sale. Stuff of that nature happened in increasingly greater proportions until the local culture is now paying nothing but interest and penalties to factors of one sort or another.

    Nothing of value is being produced locally. Persons are hunkering down to bear essentials. Monetary schemes are ignoring how culture works.This to me is the same as ignoring how your homemade file system worked so far as the data it managed is concerned.

    The principles of book-keeping have not changed in 670 years. Those principles are completely opaque to today’s software developers, economists, even accountants and auditors do not know these ancient data storage methods. Those methods do not change as the technology changes. I suppose that that is what you are referring to.

    I agree that it is a serious problem. That is why I am contributing to this group. Financial services have to have a book-keeping system that works, or we are all going off the cliff.

  195. There was a $700 billion bank bailout in America. One also needs to consider the cost TBTF-bailouts in other countries. A few trillion of taxpayer money hedged on future ability to pay?

    Utterly baffling.

  196. Silke “you still felt safe walking on dark streets? Yes, did I not recently concede we all have our side of naïve and gullible? Just joking! I am sure there was no reason I should have felt unsafe… even if I had been seen as a threath.

    Silke “the fact you are 3rd world country, you had a kind of jester’s freedom?” Who knows but what mostly drove my questioning was not 3rd world country instincts but more private sector instincts. You see I saw the credit rating agencies as what they were, outsourced public bureaucrats and I shivered at the sole thought of having some bureaucrats to decide what is too risky to be financed and what is not.

  197. young persons can be as handy with data stored electronically as you are I were working with control cards.

    definitely yes, I am not into bashing youngsters just the opposite I got always accused of getting along too well with them by others in my age group (it’s probably due to that I love to giggle)

    I was aiming at the abilities of the “big ones” to manipulate and keep in line the “little ones”. “they” have always done that and I assume they must have changed their ways when news could be distributed by pamphlets as opposed to only by word of mouth and/or royal messenger.

    so now that “they” have the possiblity to define data access in much more selective and authoritarian ways than they could in paper times it might happen that they may want to individualize the amount of trust/knowledge “they” accord to their underlings.

    And no matter how savvy those clerks are as long as they do not even know the information exists and serendipity is largely prevented how will they manage to get an overall general larger picture. Then put on top of it that they may not work all in one big place anymore where they meet in the canteen at lunch and chat to strange colleagues and voilà you have one of my better nightmares.

    (after all the sheer man power, needed for keeping paper cards, limited how many systems for how many groups you could maintain – that of course had its severe drawbacks also)

  198. Dan Palanza: “Ironically, to this day, the reason we do not have a slick double-entry book-keeping system, typical of the one at GE before central processing took control, is because central data (today’s software developers) still do not understand the method by which one builds a harmonious network by doing the backwards thinking in the control system itself. But to do that the computer Netzverkers need to understand recursive structures. For the most part software developers still do not understand recursive structures.”

    It’s not so bad, Dan. Nearly every modern computer language has recursive structures, and college students in computer science learn about them. Why, I learned how to make them in assembly language back in the 1970s.

    This is not to say that programmers understand double entry bookkeeping, but it is easy for them to build recursive structures.

  199. Here is an idea that I ran across recently, that could be applied to OTC derivatives. File copies of the derivative contracts with the regulators. They could be kept confidential. Ordinarily nothing will happen, but if something goes wrong, they could be examined, and if determined to be gambling bets, they would be deemed unenforceable.

  200. So what is the purpose of the economy?

    Suspect a massive case of corporate welfare to very-wealthy people who promote the ideology that it is — not the role of government — to provide public goods like universal health care, education and (for some be-nighted third world countries) even water.

  201. Okay. You and I are in the same boat.

    Once a book-keeping framework is properly coded the opposite happens: the power goes back to the end user where it belongs. Book-keeping is a framework of rules that administrator cannot change to their advantage.

    That was the pattern 50 years ago at GE. Marketing, Engineers, and designers did their thing and the data went into book-keeping’s control framework that the workers not only understood, they created the cards, filed and used them. Instead of creating cards they will be creating work-roles that run subject to the book-keeping framework.

    I’m sure this is what you are looking for, and my point is that the full technology was there 50 years ago, but never got programmed into software and so the administrator that would be King took control

    There is a direct analogy to banking, where the bankers took control when they realized that there was to accountable way to stop them from sticking there fingers in the till.

    Ne need a proper book-keeping framework. Nothing will be regulated no matter how hard a government tries until the book-keeping framework is in place.

  202. Hi Min, I did not expect to hear from a technical person.

    In book-keeping there are two categories of data that involve two types of recursive structure. The debit system tracks a network of physical states, while the complementary credit language is a hierarchy of intellectual controls. It is that combination and how the book-keeping pattern holds them in a natural balance that occurs in book-keeping that I have never seen elseware.

    Thank you for picking that up. Yes, of course, recursive structures are everywhere, including the computer’s file system.

  203. Dan
    in the same boat are many many people but when has it ever happened that when the cash flow to the “big ones” is in good shape that they were willing to listen to calls for sanity?

    didn’t even the prophets of the old testament warn in vain?
    poor sane Kassandra got even slain … http://en.wikipedia.org/wiki/Cassandra

    probably the only way to get a handle on it is to outmaneuver them through some kind of back entrance.

  204. I don’t believe they can be out maneuvered. Normally I don’t even comment in forums like this one. But a friend and my daughter both encouraged me to do so because they see in Simon a person on the correct side of today’s crisis. But even Simon falls short of what I believe will reverse the madness.

    There needs to be more than a break up of big banks, and there needs to be more than a split between commercial and investment banks. Culture’s, like trees, grow from the ground up. Prior to 1980 we had commercial banks that could only lend in their own county. We need to have that level of banking back.

    Local cultures are where the creatively hungry people are. For me things have to go back to that structure. The runaway system that is now in place is hopelessly dumbing down the local cultures. The lack of local banks is robbing us of our creative spirit.

    Within book-keeping there are two structures, the network of contributors, as work. And the hierarchy of controls as ownership. As a building contractor I have always been interested in developing the network of contributors. However, I have not seen a way to bring that idea forward in this forum.

    I’m also interested in the connection between double-entry book-keeping and science. Western Science has ignored book-keeping, leaving it to become a folk-science. However, many of science’s unsolved questions have clear solutions in book-keeping. I spend most of my time on that effort.

  205. Dan… when you start with your double entry steps you lose me but when you argue that “The lack of local banks is robbing us of our creative spirit” then you are entering a terrain where I can agree.

    Back in 2000 in an article published in Venezuela titled “Kafka and Global Banking” I wrote the following.

    “… I remember thinking “thank God we still have several banks to work with”. Imagine if we would have had to discuss the issue with an official of the One and Only World Bank (OOWB). Without a doubt this would present us with a future full of horrendous Kafkaesque possibilities.

    This leads me to think about the consolidation currently going on among banks. With every day that passes we have fewer and fewer banking institutions worldwide with which to work. This trend has been marketed as one of the seven wonders of globalization.

    I believe the trend introduces other risks which have either not been sufficiently commented on or which have simply been ignored. Among these I can identify the following:

    A diminished diversification of risk. No matter what bank regulators can invent to guarantee the diversification of risks in each individual bank, there is no doubt in my mind that less institutions means less baskets in which to put one’s eggs. One often reads that during the first four years of the 1930’s decade in the U.S.A., a total of 9,000 banks went under. One can easily ask what would have happened to the U.S.A. if there had been only one big bank at that time.

    The risk of regulation. In the past there were many countries and many forms of regulation. Today, norms and regulation are haughtily put into place that transcend borders and are applicable worldwide without considering that the after effects of any mistake could be explosive.

    Excessive similitude. By trying to insure that all banks adopt the same rules and norms as established in Basle, we are also pushing them into coming ever closer and closer to each other in their way of conducting business. Unfortunately, however, nor are all countries the same, nor are all economies alike. This means that some countries and economies necessarily will end up with banking systems that do not adapt to their individual needs.

    I remember that John K. Galbraith once wrote that the economic development of the west of USA was helped by the fact that in the eastern part of the United States, banks were big and solid but that in the west, banks tended to work with much greater flexibility. The fact that some of these banks went bankrupt from time to time was simply taken as a normal cost inherent in development. Today, Venezuela’s economy might be in dire need of some Wild West banks.”

  206. It seems to me that if the regulator doesn’t understand it, it should not be allowed.

    The problem is that admitting one doesn’t understand something is not something that just anyone can do. Doing this requires intelligence and confidence, which vary in any individual over the course of a week not to mention how this varies in the population at large…

    Maybe I’m thinking too hard about this, but for what should be a simple solution it really gets psychologically complicated. I know there is a reasonable person standard in law, but I’m not a lawyer so I don’t know whether or not it could apply to finance.

  207. Per, there were several national banks in my town. I knew half the directors on all of them. A national bank could borrow from the Fed. And so they regularly lent money on 60 or 90 day notes where the interest was a fraction of the money one could earn with that money. This was commercial banking in the sense that it enabled a small business great leverage, because they could get a sum of money right when they needed it.

    A store, for example,that turned over inventory regularly could buy that inventory for a favorable cash price and take a 90 day note to pay for it.

    When I built houses I liked to put everything underground before I put up the frame. Construction mortgage payouts to the builder were 10% when the foundation was in and 40% when the roof was shingle.

    10% was not enough to get everything underground in place so builders would build the frame to get the roof on with mounds of dirt in the way.

    I would take a 60 day note and put everything underground and put up the frame in comfort. Later, when I worked with a finance person who owned a lumber yard I would take a short term loan put the foundation and underground in, wait till then to put the construction mortgage on the house, and have the house completed in the 8 more weeks and only pay 2 months of construction finance.

    All sorts of opportunities like the above disappeared in weeks after the law was changed and Boston banks could buy the local banks. And what did the Boston banks do with the deposits they were now grabbing from the people in my town whose savings and checking accounts were in the local banks? They loaned huge sums of money to South America. You may recall the great losses they suffered in the early 1980s.

    They were getting warmed up for the S&L fiasco.

    So when Volcker talks about splitting commercial from investing, he needs to also include a return to local banking. There are about 370 cities and towns doing this same scenario as above with their their local banks. Imagine how much creative spirit was wiped out when this loss of local banking came to an end all across America.

    I could go on and list the loss of small factories where an “investor” bought the factory, dismantled it and sold everything off just to get the manufacturer’s name to place on inferior products manufactured in the far East. It goes on and on.

  208. t seems to me that if the regulator doesn’t understand it, it should not be allowed.

    that seems to me a wonderful idea

    lets make freely admitting one doesn’t get it the new cool ;-)
    no, seriously taking the humiliation out of the “confession” one doesn’t get it, even if one is in a job, where one is supposed to get it might change a lot

  209. You are absolutely right. What you describe belongs to the first obligations of the banking sector but most of them have gone elsewhere to do something else.

    And as I write in my proposal http://bit.ly/1Xby8A, to complicate all matters the banks are now busy rebuilding capital shortages that occurred because regulators allowed them extremely low capital requirements to finance what most often had a lower priority for the society or financing the AAAs who should not even have needed the banks

    And so meanwhile I suspect that many of these unrated entrepreneurs are bleeding to death and with them so many possibilities of the jobs that are needed; and the re-regulators are busy with credit rating agencies, “too big to fails”, derivatives and other less important issues, including perhaps checking out Baseline. Sincerely, as an outside observer, this is looking more and more to me like a financial Katrina. If they are not very careful the whole stimulus package will go wasted… and then you sit there with the public debt and nothing to show for it. But as ususal it is the political agenda that is important!!!

    But please keep me out of your double-entry bookkeeping file-management discussion… that I don’t see here.

  210. Per,

    Rather than “naive and gullible” — ideological bias — might be more accurate.

    Basel II could be an expression of what Michael Sandel calls free-market triumphalism. Basel II sanctions capital ratios as high as 1:52. Perhaps that is the point. A deliberate touch of regulation to free money, that would otherwise be held in reserve, for investment.

    That said I will concede “naive and gullible” might well describe some people who place their faith in “free-market triumphalism.” (Eg, people who rely on Fox-TV and Rush Limbaugh, seniors who want the government to stay out of Medicare.)

  211. tippigolden. You really have difficulty in accepting that the regulators were naïve and gullible… because you so absolutely want to use this crisis to totally discredit your obnoxious free-marketers. You are doing yourself a huge disfavor.

    Let us suppose the regulators had authorized the 1:52 you mention, for all (actually when AAAs are involved, 1.6 percent capital they authorized 1:62). Well yes, in that case, I would agree it could have been the result of pure free-market craziness… but that is NOT what they did.

    Much the contrary the regulators showed utmost “distrust” of the markets when they imposed the credit rating agencies on the banks and, for instance, if a bank is lending to an unrated client and therefore only using their own criteria then it needs 8 percent in capital, which results in a 1:12 leverage.

    And so again I repeat I cannot find better words that naïve and gullible to describe how the regulators trusted those risk-commissars they appointed. But again I am open to accept any other words but… where are the suggestions?

  212. “Skin in the game”
    If you don’t have the money to cover your losses, you can’t place the bet.
    Why does it have to be any more f#%king complicated than that?
    Let’s try treating the players like they do at casinos.. can’t cover your losses? We break your legs (or worse). Watch how fast things clean up.
    You can have all the complexity you want, as long as when you lose, YOU LOSE.

  213. Yep, that should discourage unwise leveraging too. And incidentally I suspect that bean counters at casinos, bookies and the like have zero problems with double entry accounting. As the Australian expression goes “they know who is up who”.

  214. Per, I know very little about free-market ideology. Although, I found this Michael Sandel lecture series thought provoking.

    You say Basel II “imposed the credit rating agencies on the banks”. Perhaps Basel needed to do this because it had opened a floodgate (the 1:62 ratio) of capital reserve into the market.

    The American credit rating agencies are unregulated for an ideological reason.

    According to this PBS documentary, Alan Greenspan did not believe fraud should be regulated. His ideological claim was markets are self-correcting and have internal mechanisms to deal with financial abuse.

  215. Per, took a quick look at this link. (lol) Frankly, I’m not entirely sure what the point is to argue over whether the central bankers at BIS are “naive and gullible” or otherwise.

  216. “Perhaps Basel needed to do this because it had opened a floodgate (the 1:62 ratio) of capital reserve into the market.”

    On the contrary Basel said if you follow these credit rating agencies into AAA land then, and only then, are you allowed to go to 1:62

  217. I am not arguing over it. I just say they were.
    Cheers

  218. The regulators told the banks

    “If you follow the credit rating agencies to AAA land then you only need to put 1.6 percent skin in the game, but if you go on your own, into unrated land, then you need to put 8 percent skin in the game.”

  219. Per Kurowski,

    You are the only commentator on this blog that I know of with experience as a banker. (In your case you are a former World Bank official.)

    If I understand you correctly you are saying: the purpose of a banking system is to provide credit to borrowers who are building a genuine economy for themselves, their communities and society.

    I am reminded of micro-lending developed by Muhammed Yunis where borrowers are charged about 10% interest and the default rate is somewhere in the 1% range.

    Moreover, you are calling for the abolition of the Basel risk rating and capital ratio system because you consider this system entirely flawed. You call for a light hand to regulation. Banks should be well-capitalized, on their own initiative, while lending to entrepreneurs who are building a genuine economy in their communities and society.

    It interesting here (if I’ve got it right) in that you are advocating for a — social reform — of the banking system.

    Investment banking most likely has little or nothing to do with making the lives of poor people and societies better. Wall Street and The City occupy an entirely different universe from the kind of social reform you may be advocating.

    But one should never consider a noble cause hopeless.

  220. Bankers are those who find a good prospect and lead him little by little to where he can fend for himself in the capital markets…. Is this a romantic vision? So be it!

  221. Per
    there is a guy named Gunnar Heinsohn http://en.wikipedia.org/wiki/Gunnar_Heinsohn#Sacrifice
    who without mentioning Basel*) seemed to me to say about risk the same stuff you say albeit from another angle

    *) it was a show called Philosophical Quartet (I don’t think he’ll draw much of an audience in mainstream media, though firmly to the left he is void of touchy-feely) http://www.zdf.de/ZDFmediathek/content/865252?inPopup=true