Mr. Diamond Was Correct

Mea Culpa, Mea Culpa, Mea Maxima Culpa

Dear Bob, I confess that I allowed my heart to overwhelm my visionary gift and chose not to foretell that your Red Sox would make it to, much less win, the World Series. I was wrong and you were right. Congratulations on their second Championship in the 21st Century. Now, they just have to win another 20 and they will be equal with the Bronx Bombers!

All the best,

Cassandra

Dr. Matt Ridley Does The Right Thing

But, Did The Northern Rock Board?

Northern Rock Chairman Resigns After Lawmaker Attack
By Sebastian Boyd Oct. 19 (Bloomberg) --

Northern Rock Plc replaced Matt Ridley three days after lawmakers asked the chairman why he was "clinging to office'' following the first run on a U.K. bank in more than a century.

Bryan Sanderson, CBE, a former chairman at London-based Standard Chartered Plc, will replace Ridley, who offered to resign in September when the bank was forced to seek emergency funding from the Bank of England, Northern Rock in a statement today. Sanderson, 67, was chairman of Standard Chartered until November 2006.

On Oct. 16, members of parliament blamed Ridley and other directors of Newcastle, England-based Northern Rock for failing to recognize the risks of the bank's strategy, in particular their over-reliance on debt markets to fund mortgage lending.

"You're chairman of the bank that ran out of money; caused the first bank run in this country for 150 years; you've had to borrow billions of public money from the Bank of England; you've damaged the name, the good name, of British banking,'' Conservative Party member of parliament Michael Fallon told Ridley on Oct. 16. "Why are you still clinging to office?''

Ridley told lawmakers his resignation was available if demanded. Northern Rock said it asked Ridley, 49, to stay on until he had appeared before the committee of U.K. lawmakers.
....
Sanderson spent most of his career at BP Plc, where he was CEO of its chemicals unit. He was chairman of Standard Chartered for three years to 2006 and is chairman of health insurer BUPA.
___________________________________________________________
Friday's action by the Northern Rock Board begs two questions and a comment:

First, where is Sir Derek Wanless' resignation?
Given the negotiations on the sale of Northern Rock, one can understand why Adam Applegarth cannot resign, at this moment, but is there any reason that can be given for keeping Sir Derek on the Board? Given his testimony, on 16 October, before the Select Treasury Committee where he proved, beyond a reasonable doubt, that he did not have a clue about modern Risk Management ("We were stress testing plausible scenarios."), Sir Derek lost any credibility to stay in the post of chairman of the Northern Rock Risk Committee. If he will not, "do the honourable thing" and resign, he should be removed immediately.

Second, why did the Board chose Mr. Sanderson?
Whilst we cannot be certain, it is unlikely that there was a very long list of the willing, much less the willing and the able. In Bryan Sanderson's own words, he agreed to it because "It is important for both the reputation of the City of London and for the north-east, where I was raised. I think it's a job that has to be done, and it's an important one." A prosaic answer, but not a bad start; unfortunately, Mr. Sanderson kept on speaking - "If this had been Cornish Rock, I would not have done it."

As reported in the Financial Times, "Mr Sanderson’s move into such a high-profile situation is a surprise, given his age. He stepped down from his role at Standard Chartered last year because he was tired of the incessant travel and official functions."

In a bio-piece, entitled, Bryan Sanderson's Working Day, printed in The Sunday Times of October 17 2004, we were provided with some further insight into the new Northern Rock chairman:

"The Standard Chartered chairman wakes at 5.30am in his north London home and starts the day listening to the BBC World Service, making a cup of tea.

“I start slowly,” says Bryan Sanderson. “I think about what I am going to do during the day.” He is collected by a driver at 7.20am and is at work before 8am, unless he has a breakfast meeting.

His schedule is plotted out for up to nine months in advance. An average day at Standard Chartered will involve meetings on forthcoming deals, relations with governments or internal issues. Every day will also involve a work lunch of some sort. More meetings will follow and evening events. “If there is something later, then I will sneak off from the office at 4pm, and have a two or three-hour break,” says Sanderson."
____________________________________________________________
With all due respect to Mr. Sanderson, is a 67-year-old, over-tired, chemical expert, whose apparent major claim to the position is not his three years as the chairman of Standard Chartered, but rather his "northern roots," the right man for this demanding job?

Perhaps I should give him his due: if he can apply those same masterly diplomatic skills that he invoked in his acceptance interview to gratuitously insult the people of Cornwall to pound some sense into the skulls of his fellow board members and his management team, he may prove his value to the employees and customers of Northern Rock.

We will watch and wait.

Cassandra

What Is To Be Done? Proposition One - A Reprise

I have received a number of pointed responses from the readership on my piece regarding the Tripartite Authority and the role of The Bank of England, most of which have suggested that I am either naive or just daft in my conclusion. Yes, sadly, they believe that this benighted commentator seemingly strayed into the regions of Cloud Cuckcoo Land and posited the absurd, the impossible, the outré - what a silly notion - to propose that the Bank of England be the focal point of the Tripartite Authority!!

Attendez mes amis et mes amies, you can let Cassandra alone and start aiming your slings & arrows at the editors of

That's correct THE ECONOMIST! It appears that in this week's edition* that they have chosen to go the route of the absurd, the impossible, the outré, and propose the very same solution, in a piece entitled:

Northern Rock, Lessons of the Fall -

How a financial darling fell from grace,
and why regulators didn't catch it.

I will leave it you to read the whole article but would like to draw your attention to the concluding paragraphs:

Brickbats All Round - And One Lesson

No one emerges well from this tale. Northern Rock pushed an aggressive business model to the limit, crossing its fingers and hoping that liquidity would always be there. The FSA failed to spot the danger. The Bank of England worried too much about forgiving over-risky behaviour and too little about shoring up a stressed financial system. Mr Darling failed to reassure depositors when he eventually got round to it, then arguably reassured them too much when it no longer mattered.

But the biggest failure was the “tripartite” system, and its unreadiness in a crisis. Undoing the reform of 1997 that divested the central bank of supervision would be hugely disruptive; and other countries have divided central banks from banking supervision without seeing financial institutions go to the wall. But if Britain is to learn one lesson from the Northern Rock saga, it may be that a single outfit needs to be in overall charge of financial stability, the bedrock on which economies are built. Only a central bank can provide the liquidity needed in times of crisis. So whatever its failings this time, it is the Bank of England that should take responsibility and call the shots.

May I simply add, HEAR, HEAR!


Cassandra

PS May I direct you to Matthew 13:57 and/or Mark 6:4? Either will do, but preferably from the King's James Version.

________________________________________________________________
* Oct 18th 2007 from The Economist print edition. For the full article please go to
http://www.economist.com/displaystory.cfm?story_id=9988865

WE INTERRUPT “What Is To Be Done?”

TO BRING YOU THIS NEWS BULLETIN ---

Crock Spokesmen Strain The Nation’s Incredulity

I have decided not to use this space to initiate a discussion of all the inanities that were uttered yesterday before the House of Commons Treasury Select Committee by the Northern Rock Board Chairman, Dr. Matt Ridley; the CEO, Adam Applegarth and the “independent” Board Member, Sir Derek Wanless. (Blessedly, the other independent member, Sir Ian Gibson, kept to platitudes and words of commiseration for employees and depositors.)

This decision is partially in keeping with my desire to continue on the positive track of my “What Is To Be Done?” series. It is also because even I, in my most cynical and satirical frame of mind, could not replicate the farce that was played out in the committee room at Portcullis House.

Instead, I wish to make reference to only one point put most eloquently by Dr. Ridley and repeated ad nauseum by Mr. Applegarth and Sir Derek Wanless that “We were hit by an unexpected and unpredictable concatenation* of events.” As lyrical and melodic as the phrase may be and, as brilliant a zoologist as Dr. Ridley is, he and his colleagues were speaking, I regret to say, balderdash, claptrap, drivel, hogwash, idiocy, lunacy, poppycock, rot, rubbish, tosh, twaddle; i.e., all around nonsense. Let us take the quote one claim at a time:

First, it was not “unexpected.”
Many commentators and market watchers were positing, even as early as the fourth quarter of 2006, the potential for a severe and long-lasting disruption in the credit markets. The very committee that had called the Northern Rock management to testify had discussed the possibilities in open session in the spring of this year. The housing market in the US (something one would expect mortgage bankers in the UK to follow rather carefully) had been exhibiting difficulty since autumn 2006 and went into a free-fall in spring 2007. Whilst no one was placing a date and time on when and by whom the shot would be fired, we all knew that the gun was loaded and that it had a hair trigger.

Second, it was not “unpredictable.”
The FSA had warned Northern Rock in April that its stress testing regimen, built for the regulatory reforms of Basel II, was not thorough enough. Indeed, Mr. Applegarth admitted today that the bank hadn't run tests to see how it would cope with a "rapid, long-lasting closure of the financial markets."

When asked by Committee Chairman, John McFall, why such a scenario had not been run,the head of Northern Rock’s Risk Committee, Sir Derek Wanless, failed to follow the party-line (enunciated just minutes before by Mr. Applegarth) saying, “Our stress tests at the time were sufficient.” An incredulous Chairman McFall parried by asking, “Why are you here alone, out of all banks? Why are you an orphan in the banking sector?" Sir Derek, threw all caution, as well as logic, to the wind and responded, “The position is not that at all. We were stress testing plausible scenarios.” When I read this quote, I must admit words failed me. Fortunately, they did not fail MP McFall who, shaking his head, hit back with, “This is unreal! This is unreal!...You don't know how you got here? You as head of the risk committee didn't do your job."

Third, “concatenation of events” are anything but rare.
A review of the most severe market disruptions/dysfunctions (which were accompanied by rapid rises in interest rates and/or inflation) over the last three plus decades include the following events:

The Russian collapse/LTCM failure starting August/September 1998
The East Asian Financial crisis starting in July, 1997
The Market Crash of October 19,1987 – Black Monday
The US Recession of 1980-1983
The Second Oil Shock of 1978
The First Oil Shock of 1973

Add to these:
The Enron/Worldcom/Quest/Adelphia, etc. collapses of 2002 - 2004,
The Dot.Com bubble burst of 2000-2001,
The UK Housing Market collapse of 1991 -1993
The US Housing Market collapse of 1989 -1992,
The Junk Bond (LBO) market collapse of 1989 -1990
(including the liquidation of Drexel Burnham Lambert)

and you can see that concatenation is not a “remote” event. Rather, it is something that we have experienced repeatedly in the markets over our lifetime. For the principal players at Northern Rock not to have known of these past events and the probability of a future catastrophic event occurring that could cause massive market disruption is not only highly implausible, it borders on the impossible.

Taking a Look Back
To illustrate what went wrong, in part, at Northern Rock, I went in search of two articles I had read many years ago regarding another financial institution (let us call it "XYZ Company" ) and fortunately, for once, found them quickly. The first is from the financial writer, Joe Kolman, in 1999:

Like most players in the market, “XYZ Company” used a variety of risk management techniques, including value-at-risk, stress testing and scenario analysis. VAR analysis estimates the maximum loss that can be suffered at a certain level of confidence, often 95 percent or 99 percent. VAR numbers are estimated using historical information about volatility and correlation. The assumption is that the future will be approximately like the past.

“XYZ's” firm-wide VAR analysis analyzed the thousands of positions it held and generated predictions about the daily profit-and-loss volatility it was likely to face. ... (At the beginning of what would be its last year in business) “XYZ” managers say they carefully geared their portfolios so that the daily firm-wide P&L volatility remained at about $45 million.

Risk managers were comforted by other statistics. According to “XYZ’s” models discussed in the road-show, a 10 percent loss in its portfolio was judged to be a three-standard-deviation event—an event that would occur once in a thousand or so trading periods. A loss of 50 percent of its portfolio was unthinkably high. According to one of its estimates, the firm would have had to wait 10-to-the-30th days—several billion times the life of the universe—to experience that kind of loss. By massaging the data, and applying other, more conservative econometric techniques, it would have had to wait 10-to-the-ninth days (1 billion days or approximately 2.7 million years).

“XYZ” used industry-standard risk management methodologies, but put undue reliance on value-at-risk numbers at the expense of stress testing. ”XYZ’s” executives also admit the firm badly misjudged market dynamics and liquidity issues, and failed to reduce the firm’s risk in the wake of losses."

The second quote comes from an article written in 1998 by Bonnie Loopesko, a former senior staffer at the Federal Reserve Bank of New York:

“People focus a lot on whether volatility should be scaled up to two, three or five standard deviations. But stressing correlation assumptions is as important as stressing the size of shocks in volatility assumptions. In some cases, recent correlations between markets have turned out to be dramatically different from anything we’ve seen before.

One of the most difficult things in stress testing is getting people to suspend incredulity. If you come up with a scenario that’s relatively extreme, senior managers can say: “We can run that scenario but it won’t happen.” As a result, you attach such a low probability to it that you discount it & don’t take any action. So it becomes a meaningless exercise. You don’t reduce positions, you don’t hedge; you just run this scenario because somebody told you to.

You can believe that spreads will converge over a longer time frame, but if that’s outside the time frame of market patience, it doesn’t do you any good. “XYZ” thought it had taken care of that because it had locked in its investors. But it couldn’t lock in its creditors. One could argue that even Drexel Burnham was a viable concern when it went under. If creditors aren’t going to be patient, the liquidity issue bites with a vengeance.”

In case you are still wondering, for “XYZ Company” read Long-Term Capital Management.

So what lesson can we draw from these two seemingly disparate, yet astoundingly similar, failures? Simply, while market upheavals cannot be timed, we know that they are out there waiting for us. Prudence dictates not just that we use models and stress tests, but that we use our experience of past events to prepare for future events, which will undoubtedly not play out as they had in the past. It is imperative that we use our brains, not just computer programmes. Why? To quote Benoit Mandelbrot because, "Clouds are not spheres; mountains are not cones; coastlines are not circles; bark is not smooth; nor does lightning travel in a straight line. Being a language, mathematics may be used not only to inform but also, among other things, to seduce.”

To summarise:
The central question which the Treasury Select Committee asked yesterday, “Could Northern Rock’s Board and Management have foreseen the events that transpired in the markets and, having foreseen them, could they have forestalled the damage to themselves, their debtors, depositors, staff and the British taxpayer?” has only one honest answer, “Yes.”

The leaders of Northern Rock chose to bury their heads in the sand. They low-balled their stress tests by removing what they thought were improbable, but what we know to have been very possible, scenarios. Today, they tried to "pass the buck” to the BBC, the Bank of England, the FSA, to the US, to everyone and anyone, save themselves. They could not admit that they had fallen victim to their own hyperbole, to their own narrow view of the greater world, and worst of all, to their own hubristic belief that their business strategy was foolproof. It turned out instead to be a proof for fools.


Cassandra

________________________________________________________________________________________
* Concatenation is the linking of things together or the state of being interconnected and/or interdependent.

What Is To Be Done? Proposition One

Towards a Truly Independent Bank of England

The recent Labour Conference was abuzz with rumours as to the fate of Mervyn King and the "independence" of the Bank of England. The betting line, by many members, was that the good old days of "Old Labour" would be back 'ere long. "All we need is for the PM to cut rates before the election and the housing market will be right as rain." "Inflation isn't as much a worry as building a solid majority." "With five more years in Number 10, we can wait out this cycle." The rumours were wild then, and are still continuing, that a reform of the Tripartite Authority was in the offing. Labour stalwarts want the Chancellor and Treasury to come out on top; they would handle any "future crisis" with the Bank of England handling monetary matters and the FSA regulatory ones and both doing what they are told when it came to "matters of national (for national, read party political) interest."

As Anatoly Kaletsky wrote in The Times, "Labour backbenchers sounded like liberated religious cultists, suddenly freed to return to the old patterns of thought that were brainwashed out of them ten years ago."

Less you think I am overlooking them, the Tories have also added their bit of non-sense to the present arguments. At their party conference the Shadow Chancellor, George Osborne, posited his party's solution to keeping the Bank of England independent: replace the Governor every five years! What a novel idea; let's throw the baby out with the bathwater. George, just to make absolutely sure that we've gotten rid of the baby, why not throw out the bath, too? With ideas like that, Mr. Osborne should stay in the shadows.

This is all too reminiscent of the chatter at the Republican Party convention in 1972 when delegates praised Richard Nixon's ability to lead and for Arthur Burns, then chairman of The Federal Reserve Bank, to follow.

I know there are those who will argue with me, but it is my belief that the damage caused by this surrender of monetary independence was far greater than the damage caused by the cover-up of the Watergate break-in. From the time he took the Fed Chairmanship, Dr. Burns pursued an expansionist monetary policy. This strategy, coupled with wage and price controls, that he agreed to at Mr. Nixon’s behest, led to inflation soaring from 5.4% in 1970 to 11% in 1974, when Mr. Nixon resigned. In point of fact, during his tenure as Fed chairman, Dr. Burns presided over a 78% increase in the consumer price index. Although part of this can be laid at the door of the two oil shocks that occurred in the period, the majority of the effect was due to a Fed policy aimed at keeping unemployment to 4% and interest rates low.

The parallel continues when one examines the source of Mr. Nixon's motivation -- his loss in the presidential election of 1960. In his book, The Six Crises, Mr. Nixon laid the blame for this loss on the recession that started in April 1960 which he believed was brought about by the tightening monetary policy (aimed at curbing inflation) put in place by then Fed Chairman William McChesney Martin in 1959. After Mr. Nixon won the presidency in 1968, he appointed Mr. Burns chairman with the proviso that the Fed would ensure a plentiful credit supply prior to his re-election.

It took the chairmanship of Paul Volcker and the presidency of Ronald Reagan to bring the era of stagflation to an end by targeting inflation, rather than interest rates and unemployment. Whilst this resulted in a major recession in the US from 1981 to 1983, with unemployment rates higher than at any time since the Great Depression, the long-term results of this strategy -- low inflation and a moderate but over-all growing economy -- are still with us today. A key element in this recovery was the decision by Mr. Reagan to give Mr. Volcker his pledge of neutrality. President Reagan allowed Chairman Volcker to set the target for inflation and to use the means necessary to bring about the resurrection of the American economy.*

History’s views, or at least current researchers' views, of the two men are as different as their methods and the outcomes that followed.

Dr. Burns is in the odd position of being viewed as a lamb led to the slaughter whilst being at the same time one of the slaughterers of the lambs. That is, he was a chairman who was overly influenced by political pressure in his monetary policy decisions and who thus left the national economy in a nightmarish state.

I would argue that this is less a than a fair assessment of Dr. Burns' entire career and his body of works, which have influenced the likes of Milton Friedman, George Stigler, Anna Schwartz and others. Nonetheless, it is his current epitaph.

Mr. Volcker is viewed as a hard-nosed leader with the tenacity to hold fast to his beliefs despite political and media pressure and who, ultimately, turned around the US economy.

As an avid fellow fly-fisherman I would say of Mr. Volcker that he made the prize catch of the day while Mr. Burns missed his cast; Mr. Reagan got to ride off into the sunset

To return to the present, I do agree that the Tripartite Authority needs to be reformed, but not in the way that the politicos and bureaucrats wish it to be. I believe that what the UK needs is a truly independent Central Bank that not only handles issues of the monetary supply but is also, once again, an integral part of the regulatory process.

Why take such a step you ask? My answer, like Gaul, is divided into three parts. First, to quote The Captain,

"What we've got here is failure to communicate."

Whilst the jury is still out as to where responsibility lies, it is abundantly clear that something failed in the regulatory due-diligence process with regard to Northern Rock. The first jury, a political one, namely the Treasury Select Committee of the House of Commons, will determine if, in their view, the FSA fell short in its duty to the people of this nation to provide proper oversight. Whilst the issues at Northern Rock were made known in mid-August by the FSA Chairman to the Chancellor of the Exchequer, the Treasury Permanent Secretary and the Bank of England Governor, my sources tell me that they were told that the FSA did not consider the situation to be "dire." Indeed, even up to the morning of Wednesday 12 September, the day that Governor King sent his letter on "moral hazard" to the Treasury Select Committee, he received assurances that a direct intervention would not be necessary. It is becoming clear as well that the situation at Northern Rock over the prior 7 months was not communicated, without varnish, to the Governor of the Bank of England.

The main communication from the FSA on Northern Rock, in particular, and on the credit crisis in general, from mid-August to mid-September, was an incessant call for Mr. King to liberalise the BoE rules and accept mortgages and other less-than-gilt assets as collateral for short-term lending. Not winning him over, his "colleagues" in the Tripartite Authority used the media to launch a campaign against Mr. King. They touted the policy of Fed Chairman Ben Bernanke “to accept a broad range of collateral for discount window loans, including home mortgages and related assets," and pushed aside Mr. King's concerns with the moral hazard of bailing out the perpetrators of this crisis. The fact that the Fed had long-accepted a mixture of assets for discount, whilst the BoE had not, was of little matter. Why let the facts get in the way of an effective tool, pressure in the press, which could be picked up by MPs and used to hammer on Mr. King?

Yet Mr. King stood firm. As he said in his letter to the Treasury Select Committee, "this was no time to compensate banks that had accepted too many risks too cheaply. If a central bank provided implicit insurance to lenders the next period of turmoil will be on an even bigger scale." What he did not know was that he was about to be mugged on his own doorstep by the Chancellor, the Treasury and the FSA. The very next day he was handed an ultimatum to change or be damned in the form of the virtual collapse of Northern Rock. The Chancellor, like a good marionette with his strings controlled by the Puppet Master (PM), reminded Mr. King of the Mephistophelian bargain that had been made in 1997: the BoE was free to be an "independent monetary authority" except when called upon to be the "lender of last resort" (a phrase soon to be changed by Treasury in its frantic attempt to show that the Northern Rock panic needn't have been a panic at all, at least not outside the stately rooms of Whitehall). With his back against the wall, and with as much pride as he could muster, Mr. King succumbed.

Mr. King’s first face-saving effort, his testimony before the Treasury Select Committee on 20 September, was fascinating to watch as he so very carefully led the MPs away from himself, like hounds following a drag, and towards his opponents in Treasury, the FSA and inside his very “house.” The truly remarkable fact is that Mr. King was damaged not only by the actions and words of Sir Callum McCarthy, Chancellor Darling and Chief Secretary of the Treasury, Andy Burnham, but also by the inaction of Sir John Gieve, Deputy Governor of the Bank of England. Sir John admitted that he had neither read the Northern Rock’s interim financial statement of July 25 nor communicated its details to Mr. King. As John McFall, MP, chairman of the Treasury Select Committee, asked Sir John, "So, were you having a sleep in the back of the shop while a mugging was taking place?" Poor Sir John could only reply that, no, in August he had gone off to a funeral and then on his annual 'hols' to the South of France.

Many will remember Sir John, the former Treasury mandarin and Permanent Secretary at the Home Office, from the David Blunkett "give a visa to my mistress' nanny" scandal, as well as being the person who failed to have 1,000 illegal alien former-felons deported under Charles Clarke. He culminated his career in the Home Office under Jack Straw by failing to obtain the National Audit Office’s sign-off of his department's financials due to irregularities (which he dismissed as "niggling"). He also ran the Chancellor's private office for Nigel Lawson, John Major and Norman Lamont, and was responsible for the first two Labour spending reviews under Gordon Brown. Whilst he served these masters well and remained, in Gordon Brown's words, "well respected in the civil service," it was clear that because of his cock-ups he would be given neither the job of cabinet secretary nor the top job at the Treasury; so he walked the well-trodden path to the Bank of England.

This takes us to the second part of my answer, which is best illustrated by quoting Oscar Wilde on puppets,

"There are many advantages in puppets.
They never argue.
They have no views about their art.
They have no lives, only those of their masters."

For the record, it is not my intention to pillory Sir John Gieve as an individual, but rather who and what he represents. Whilst he was reputed, at one stage, to be an excellent economist, his latter years in Government have been noted for a plethora of poorly thought out, poorly handled and poorly explained decisions and policies that have rendered him unfit for the position of Deputy Governor. He simply does not have the attention to detail and the facility for analysis and action that this post requires. What he does have, in the words of one of his colleagues, is “the ability to withstand the withering fire of a parliamentary committee.” That may play well in the labyrinths of Westminster but that alone is not enough to merit his position.

Now, I am fully aware that the norm in all Governments is to pass out political plums to the "boys" and even, on very rare occasions, to the "girls," as it is all too often not what you know, but who you know that matters most. However, if this crisis teaches us anything, it teaches us that we need to place our Central Bank in the hands of professionals who owe their positions to merit and not in the hands of cast-off career bureaucrats or recipients of political patronage.

This brings us to the third and final part of my answer. To quote Sophocles,

“What you cannot enforce, you do not command.”

The plain truth is that the Tripartite structure has failed for the same reason many committee forms of governance fail: the lack of a leader who is accountable for the decisions and actions taken or not taken by his or her organisation. In the world of monetary and regulatory control, which is the essence of a Central Bank, such a leader cannot be beholden to a political regime (Dr. Arthur Burns) or be the erstwhile stalking horse for a political/bureaucratic regime (Sir John Gieve) or receive the office as the reward for faithful service to any and all of the above (Sir Callum McCarthy), without creating an inherent weakness in the very structure they pledge to run. No, an independent Central Bank must have an independent head who is focused on the task at hand and can actually deliver what is required, as St. Paul said, “in season and out of season.”

For whilst one of the Bank of England's two core purposes is monetary stability (meaning stable prices, low inflation and confidence in the currency, which the Bank seeks to meet through the decisions on interest rates), the other core purpose is to maintain the stability of the financial system. The BoE states on its own website, “The Bank has to make sure the overall system is safe and secure and that threats to financial stability are detected and reduced. By monitoring and analysing the behaviour of participants in the financial system and the wider financial and economic environment, the Bank aims to identify potential vulnerabilities and risks, with a view to making the system stronger.”

The question we need to ask is, “How well has this been accomplished under the Tripartite structure?” As Mr King testified, the BoE has had difficult obtaining critical information on this country’s banks. It has had to rely either on its own ability to scout out matters in the market or on information passed to it by the FSA. We now know that this information has been subject to the judgement of political appointees "having a sleep in the back.” This situation is untenable.

Primus Inter Pares **

I checked “Google Map,” and they calculate the distance between Threadneedle Street and Number 25 The North Colonnade to be 3.5 miles. In reality, the distance is measured in light years, political light years. Whilst the arguments, the lack of unity of purpose and the failure to maintain authentic channels of communication (the real distance) may be papered over in the forthcoming “reforms” from Treasury, they will still remain unless a fundamental step is taken to overcome them. That step must be radical, in the real sense of the word, a return to basics, to the roots. In order to meet their requirement “to maintain the stability of the financial system,” all regulatory controls, including the FSA, must be brought under the aegis of the Bank of England.

This is not to say that the FSA must be subsumed into the BoE, but rather that the FSA must look to the BoE for guidance on policy, for sponsorship of its regulatory due-diligence and as importantly, for protection from political manipulation. Failing this, the BoE will need to replicate internally the regulatory structure of the FSA so as to re-build the credibility that once was their hallmark and by which they were viewed as the banker’s bank, an institution truly knowledgeable of each bank as well as of the senior bankers who ran them.

Whilst this level of duplication is common in the US, with the Fed, the Comptroller of the Currency, the FDIC, the SEC and the individual state regulatory bodies having joint and several responsibilities for different aspects of the regulatory regime, it is not the norm in the UK. Rather than duplicate bodies, the better route is to declare the BoE to be at the head of the Tripartite Authority.

The Governor, rather than the Chancellor or the Treasury Secretary or the Chairman of the FSA, must be recognised as the accountable leader thus removing the inherent weakness of the present Tripartite structure. At the end of the day, the hand at the tiller in a serious financial crisis cannot be that of a career politician or bureaucrat, whose motivations may be various and sundry.

No, in order to inspire and maintain confidence in the roiling seas of the financial markets, the leader must be the country’s most senior, independent, public financial official -- the head of the nation’s central bank.

We can argue long and hard about whether the incumbent is the right man for the job, but that is not the point. The issue is where is the right place to invest these powers in the UK and, in my opinion that can only be in the office of Governor of the Bank of England. The Tripartite structure needs to be revised to guarantee the independence and the primacy of the Bank of England in all matters monetary and regulatory, with said independence to be guaranteed by all parliamentary parties and to be deemed part of the Constitutional fabric. My first proposition to prevent a replay of the present crisis is as follows:

Resolved
That the Bank of England is, and of right ought to be, free and independent and that all political and bureaucratic manipulation by this or any future, Government of Great Britain is, and ought to be, totally proscribed.

The Old Lady of Threadneedle Street needs to change her emblem –

Britannia must give way to Bodicea

Cassandra


* Volcker always commended Reagan for his taking the politics out of the Fed, saying “People in the White House and Treasury put pressure on Reagan, but they could never get Reagan to criticize me.” “The president,” Volcker said, “had this visceral feeling that fighting inflation was a good thing. … He also believed that politicians come and go but economies endure. … He had an innate trust in an independent Fed with an independent chairman.”
Paul Volcker: The Making of a Financial Legend, Joseph B. Treaster,
New York: Wiley, 2004.

President Reagan wrote down a quote of Chairman Volcker on the cost of inflation in his daily journal that the President also used in defending the Chairman, "Inflation is thought of as a cruel and maybe the cruellest tax, because it hits in an unexpected way, in an unplanned way, and it hits the people on a fixed income hardest. And there's quite a lot of evidence, contrary to some earlier thinking, that it hits poorer people more than richer people."


** Primus inter pares, which translates as first among equals is, a phrase indicating that a person is the most senior of a group of people sharing the same rank or office. When not used in reference to a specific title, it may indicate that the person so described is technically equal, but looked upon as an authority of special importance by his peers. In some cases it may also be used to indicate that while the person described appears to be an equal, he actually is the group's unofficial or hidden leader.

What Is To Be Done? - A Prologue

A very good friend of mine, Pliny the Younger, wrote me after my last posting:

“This is all very good, entertaining reading. I enjoyed this last one particularly. I know no one would question your authority on the fact that things have been handled incorrectly. But, and there is a but, Can't you be more constructive?

I suggest this as your friend. I respect you too much and I know you have too many great solutions inside you to risk becoming labelled as someone who only sees the problems. What about proposing and lobbying for a particular solution to these issues? What should the FSA, Treasury, BoE, CEBS, European Commission, SEC, etc., actually do differently (rather than 'have done differently'?) After all, they seem to need some fresh ideas!

Someone once told me that the safest car to drive would be one with a large steel spike protruding from steering column towards the driver's chest. Not sure what the banking equivalent of that would be, but whilst it would be safe no one would want one.”

Pliny’s point was not only heart-felt (it was he who said, “It is difficult to retain what you have learned unless you practice it” *), it was also very timely. I received his note whilst I was in the midst of researching the next several postings in which I will lay out my suggestions as to how the banks, their depositors and borrowers, their regulators, the markets, etc., indeed all of us, can benefit from the crisis we are now experiencing.

Whilst I have made it a point, from the very first posting, of staking out the role of being a Socratic “gadfly,” I, too, had come to the conclusion that I needed to offer alternatives, not just point out deficiencies. Unlike Pliny, I am not so sure that my solutions are all that “fresh” or that they will fall any more kindly on the ears of some than has my criticism, but nonetheless I will give it a serious effort.

My first foray into the role of advocate follows.


Cassandra

______________________________________________
* Difficile est tenere quae acceperis nisi exerceas.

A Modern Modest Proposal

For Preventing UK Regulators from Being Burdens to the Nation & for Making Them of Use to the Public.

The late, great, American bank robber Willie Sutton, when asked, late in life, why he carried a Thompson submachine gun on his heists, observed, “You can't rob a bank on charm and personality.”* Well Mr. Sutton, you were wrong; you can rob a bank on charm and personality, but only if you are a banker.

Witness the charm and personality that has besotted the FSA supervisory staff who reviewed Northern Rock. Was it the gleaming, youthful smile of Adam Applegarth or the toothy grin of David Baker or just that they were mesmerised by the financial sleight of hand that Northern Rock exercised so well?

Actually, it matters little, as we have just discovered that the FSA could not have done anything even if they knew all and knew it well in advance.

Why? Because they have no power!

That’s right, the poor FSA has no power to intervene because the structure of the Tripartite Authorities prevents them. According to the Financial Times of 20 September,

“FSA executives privately say the regulatory regime does not give them the power to interfere in the running of a bank, as long as it meets the regulatory capital requirements. Northern Rock met regulatory capital requirements and satisfied all solvency requirements.

FSA insiders also point out that the regulator insists on regular stress tests. It also stepped up monitoring, recently asking Northern Rock whether it was prudent to fund itself on such a short-term basis.”

Hello? Have I been living in a parallel universe where an alternate FSA rules?

The last time, in fact, every time I have had dealings with the old boys and girls of Number 25 The North Colonnade they were not so hands-off or so constrained by the UK’s “regulatory regime.” In all of the High Street banks I have been involved with over the last 10 years (I have worked or advised at 4 of the top 6), I have had direct contact with senior FSA supervisors and their teams. I can tell you that none of them were shrinking violets that blanched at the thought of telling us brutal, barbaric, bankers to behave and not to loot and pillage. No, they “offered” advice just the way you were “volunteered” in the military, "You, you and you come here!" On numerous occasions we, the banks, have been told in no uncertain terms by the regulator to fix or change very particular structures, including business plans and products. It would be laughable, if it weren’t so poor a porky pie, to have “FSA executives” claim that “they were only following orders", pardon, "principles-based regulations." I doubt that there is a single senior banker on this island who has not had to choke back a chortle when they heard the FSA Executive's latest rendition of the Whiffenpoof song.**

We're poor supervisors who can’t have our way,
Baa, baa, baa!
Our Tripartite Agreement has led us astray,
Baa, baa, baa!

Regulators watch bankers off on a spree,
Doomed to stand by to eternity.
Lord have mercy on such as we,
Baa, baa, baa!

But what a convenient "out" the mandarins have in the Tripartite Authority – the BoE can point to the FSA who can point to the Chancellor who can point at the BoE, and round and round it goes, where it stops nobody knows - the perfect Catch 22.

I was going to write, “Please, don’t treat us as idiots; there are all too many of us who have had dealings with the FSA and BoE, and we know when you are engaged in a CYA exercise,” but I have thought better of it.

Why not just take the Tripartite's position at face value? Maybe they weren’t asleep at the wheel or thoroughly incompetent; maybe they are telling the truth and there was nothing they could do except sit on the sidelines and wait for such a disaster to occur. After all, the same-said “FSA executives” stated, “This is a one-in-a-million event; nobody expected interbank funding to dry up.” After all, other regulators across the globe, not just the FSA, had failed to predict a total drying up of liquidity in the money markets; none of them had prepared banks for such an eventuality.

Maybe, this is the best we can expect from them; to quote Jack Nicholson as Melvin Udall, "What if this is as good as it gets?"

Don't Quail in Fear, for Here's an Idea,
Let’s Buy a Bank in L'Angleterre!

Instead of looking at this as a negative, why not look on the bright side of life? This crisis reveals a structural weakness that is a godsend for those wanting to make a profit. The stuffy old banking world of Mervyn King's 12 September warning note is dead. With no more silly worries about moral hazard and fiduciary responsibility, with regulatory bodies with self-inflicted wounds having neatly tied their own hands behind their backs, the UK is now a perfect place to buy up a bank!

Just sit back, close your eyes and dream of this possibility. A band of brilliant bankers backed by intrepid international investors enter the UK market with the view of creating a new financial entity, let's call it ÜberBank, following this plan:

• Do a leveraged buyout of a small building society and de-mutualise it. Using the benevolent UK tax code’s treatment of leveraged buyouts, gain "taper relief" so that one need only hold investments for 2 years and are required to pay only 10% tax on dividends.

• Start buying mortgages from other building societies, many of which are looking for liquidity and new funding, at present discounted “market” prices. This will build up the balance sheet rapidly and provide critical mass.

• Use the increased mass to issue mortgage-backed "covered bonds" - Pfandbriefe look-a-likes *** - into the emerging markets of China and India which have already turned to these vehicles due to their perceived increased security and tradability. Given the lack of alternative available investment vehicles, prices on this class have fallen thus increasing ÜberBank's profits.

• Start a major campaign to draw in depositors by paying above-market rates on smaller deposits, between £2500 and £5000, locking them in for 12 to 24 months. (Any number of UK banks are already doing this in the £1000 to £2000 range.)
  

• The “covered bonds” and new deposits become the base for further acquisition of discounted mortgages. Continue to grow the balance sheet without the need for direct lending.

• Onward and upward -- until the bubble bursts - and then go knocking on the Tripartite Authorities door!
  

What a concept! No penny-ante operations! This will be a truly dynamic, no-holds-barred, rapidly growing entity that can generate large profits for its senior executives and shareholders, who, of course, will be one and the same. Thanks to HM Government ÜberBank will have no worry about niggling things like depositors clamouring for their money back in the event that it is caught out, ahem, pardon, in the event that there is a disruption in the markets. That will be the province of the Chancellor and the Treasury who will act as the backstop for the pence and pounds of the hoi poloi, with the insurance costs being borne by the taxpayer. After all, is it not a small price to pay to ensure that London remains the financial capital of the world? ÜberBank will not be bothered by these worries as it builds the next generation of risk-less products selling them far and wide to Chinese and Indian “dentists” and their ilk across the globe. If things go pear-shaped, they will simply apply for "rescue" from the BoE. Of course, The "Old Man" of Threadneedle Street will start by huffing and puffing and pontificating but, in the end, he will see the light - the one that shines from Number 10 - and suck it up and do as he is told. VOX GORBI, VOX DEI.

And this scheme does not forget our friends at the FSA, those poor little lambs who are powerless to help the banking public. Given their sad lot in life, they will be offered a new opportunity to be of service to the people of Great Britain, as the staff of ÜberBank branches. Who better to deal with the public, and explain why they cannot help them, than the very people who wrote the principles-based regulations and were trained to quote them in such ponderous voices?

Can you imagine a certain Knight Bachelor standing at the till and explaining to an angry, frightened and bewildered group of depositors to please remember that "the wider economic background remains benign" and that "as an industry" we "have capital ratios which remain significantly higher than regulation requires" and our "return on equity is at levels which many competitors envy" and while we "may be subject to liquidity pressures," we "have, with a single notable exception, coped well with these pressures to date."

For those of you who didn't have the pleasure of attending, these remarks are taken verbatim, with the exception of the change from they to we, from those given by Sir Callum McCarthy at Mansion House on Thursday, 20 September.

I am sure that one of two things would happen if this flight of the imagination where to transpire: either the depositors would be swayed by the Knight's dulcet tones or he would say good-night and hie off to some QUANGO or other where he is safe from public, as well as Parliamentary, gaze.

Granted, my prose does not have quite the elegance found in the original Modest Proposal of Dean Swift, but at least it has no cannibalism, or rather only that related to financial institutions.

Finally, I want to go on the record that it is not my intent to disparage any of our regulators, whether they be individuals or institutions; I know it may be thought of as a cliché, but it is true nonetheless -- I am honoured to number among my friends several of the senior supervisors and their team members, past and present; they are not just adept risk practitioners, they are good and wise men and women. Rather, mine is a call for a return to sanity and consistency; to responsibility and accountability; to truth and away from "spin." We are told that financial institutions and markets need to be more transparent; so too do our regulators.

To those who think this "over the top," I leave you with the words of Prospero:

If you were dismay'd: be cheerful:
Our revels now are ended. These our actors,
As I foretold you, were all spirits and
Are melted into air, into thin air:
And, like the baseless fabric of this vision,
The cloud-capp'd towers, the gorgeous palaces,
The solemn temples, the great globe itself,
Yea, all which it inherit, shall dissolve
And, like this insubstantial pageant faded,
Leave not a rock behind. We are such stuff
As dreams are made on, and our little life
Is rounded with a sleep.
-- I am vex'd:
Bear with my weakness;
my old brain is troubled.
Be not disturb'd with my infirmity.
If you be pleas'd, retire into my cell
And there repose:
a turn or two I'll walk,
To still my beating mind.

Cassandra

* It is an urban legend that Willie Sutton said, in answer to the question, "Why did you rob banks?' “Because that is where the money is.” However, the above quote is actually his own words, as recorded in an interview he gave to The Reader’s Digest in September 1980.

** The Yale University Whiffenpoofs are the oldest collegiate a cappella group in the US, established in 1909. Best known for "The Whiffenpoof Song," the group is comprised of senior men who compete in the spring of their junior year for 14 spots.

The ending of the Whiffenpoof Song is as follows:

We're poor little lambs who have lost our way,
Baa, baa, baa!
We're little black sheep who have gone astray,
Baa, baa, baa!

Gentleman songsters off on a spree
Doomed from here to eternity
Lord have mercy on such as we
Baa, baa, baa!


*** The key difference between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make loans and package them into Pfandbriefe keep such loans on their books. This means that when a company with mortgage assets on its books issues the covered bond, its balance sheet grows, which it wouldn't do if it issued an MBS, although it may still guarantee the securities payments. This action of maintaining the mortgages on one’s books provides investors, or so they believe, with a seemingly better position than if the mortgages had been sold off into the market. At the time of their introduction in the UK market they were deemed to be in accordance with UK contractual law and thus no new regulatory law needed to be passed. “The Treasury and the Bank of England were happy that we could do something without primary legislation,” said Bill Young, managing director at Goldman Sachs.