Proof That the Banking System in its Present Format Cannot be Regulated

Consider two points:

  • Last Week Mervyn King said in a now famous speech in Manhattan that of all the banking systems it is possible to have, our present system is the worst.
  • In 2002 Warren Buffet coined the phrase “Derivatives are the Financial Weapons of Mass Destruction”.

I am not sure if the Sage of Omaha was conversant with all the regulatory aspects of derivatives, but I choose this enormous component of the international banking system to explain that our system is incapable of regulation and certain to fail again.

In principle, there is no difference between the regulatory capital charge applied to a risk held by a bank in derivative format from any other format, for example, loan format.  Where the system has failed the taxpayer is in the accounting and regulatory treatment of risks that are bought and sold by a bank for profit on its trading book.

Let me draw a parallel with the business of my local second hand car dealer, Barnet Motors.   The car dealer’s very simple business model is to buy a second hand Ford Mondeo from Peter for, say, £10,000 and sell it on to Paul for say £11,000, recording in its accounts the £1000 gross profit (before expenses) of the trade.

Consider how banks record purchases and sales of many kinds of risks in derivative format. Banks operate two books, a banking book and a trading book.  The destructive arbitrage I am about to outline occurs entirely within the bank’s trading book.

Let us take a simple example of something that went very publicly wrong in the bubble leading to the crash of 2008 – banks buying and selling sub-prime mortgage risk in derivative format.

The parallel with the car dealer is on its face reasonable.  The bank buys the asset (writes protection on a portfolio of sub-prime mortgages) in credit derivative format.  Step 2, it sells the asset by purchasing a matching credit derivative from, say, AIG’s bank.

The accountants and regulators treat the asset as bought and sold and the margin in the middle is treated as profit earned today by the bank.

However there is a crucial difference between the derivative trade and the second hand car trade: nobody has paid for the derivative.  There are indeed flows of annual premium income in favour of each writer of protection, but the recognition of the sale on trading book enables essentially all of the buy/ sell premium differential to be recognised by the bank as profit up front.    But tinkering with this rule would not prevent the derivative asteroid about to hit the banking system.  The problem is far greater, as we noted in 2008.  When the bank was called to pay out on its derivative by the protection buyer, it discovered that AIG had assumed so much of this risk that the counterparty to whom our bank had “sold” the risk was insolvent.

This explains why banks choose to put so much business through their derivative trading books. They did not need to trade in the derivative, they could have bought and sold the underlying sub-prime bonds.  The reason for the volume of business being put through the derivative trading book is primarily the “easy ride” of this unreasonably soft treatment of a matching derivative as equivalent to a sale, which in turn implies bank profits which subsequently prove to be illusory.

And therein we can see the absolute impossibility of regulating derivatives – the rules assume no linkage, no correlation between the probability of a default of the underlying assets (the mortgages) and the probability of default of the counterparty to whom the risk of default has been supposedly sold, but who has not paid for or collateralised the exposure.

As ever, this is a simplification of complex rules and hair splitters will point to commercial future collateralisation requirements, but as we saw in 2008 and in the other major banking crises throughout my career, these tweaks never protect the banks and their prime stakeholders, depositors and taxpayers.

What, you might ask, if our regulators asked how much of various risks AIG held?  In practice it is impossible for regulators to monitor such matters and the trend towards confidentiality is on the increase, not the decrease.  There will never be global banking regulation; there will always be a regime that allows AIG to operate in the future in precisely the way it did in the past.  The only solution is a fundamental reform of the present banking system.

And so we have proved that the banking system in its present format is incapable of regulation.