Vericool Finance

After a difficult gestation, the Government’s blueprint for regulating the City finally emerged blinking into the cold light of day. Observers anticipated few surprises in the White Paper, much of which is based on the relatively uncontroversial proposal put forward by Lord Turner, chairman of the FSA, in March.

As expected, the Chancellor made clear that he did not favour splitting up big and complex global banks, dubbing such proposals “simplistic”.  Instead, they will be forced to hold more capital to absorb losses and to have greater liquid assets to guard against a run on deposits.  The riskier a bank’s operations are deemed to be, the more capital they will have to hold. There will also be a new “backstop” power to prevent them borrowing too much.

The initial reaction from the City was broadly positive.  As well it might be. Investment banks, including Barclays Capital, are already inventing schemes to reduce the capital cost of risky assets on balance sheets to a practice BarCap calls smart securitisation.  Some will see this as a sign that financial boffins have already found a way to run rings around rules on capital designed to make banks safer.

Certainly signs of life in the securitisations market should serve as a warning to regulators: the plan to impose higher capital thresholds will only succeed if the riskiness of the derivative products can be accurately monitored. What does the White Paper say on that?  Not much. Little detail was given on how macro-prudential oversight is to work, or who will be in charge. As such, the Chancellor’s proposals are a wholly inadequate response to the banking crisis.

The bottom line is that Alistair Darling has plumped for fudge. Perhaps the biggest dollop is the new Council for Financial Stability, which is actually just a rechristened version of the old tripartite system, comprising the Treasury, the FSA and the Bank of England. The old trio failed miserably, largely because they couldn’t communicate effectively and things fell through the cracks.

In future, both the bank and the FSA will have slightly broader powers and the Council - chaired by the Chancellor - will be more transparent.  But these are mere tweaks.  The Chancellor has also deferred the important questions of exactly how counter-cyclical measures, such as jacking up capital ratios, will be applied.

Getting the details right is clearly important, but so is getting things done.  There is some good stuff in this White Paper, but unless momentum is maintained, the Government could end up wasting a good crisis.

There’s a new buzzword doing the rounds in the born again City – BAB.  It stands for Bonuses are Back and its arrival in the lexicon is evidence that bankers are once again looking forward to bumper payouts, just eight months after the sector faces meltdown.

Goldman Sachs staff are now looking forward to the biggest payout in the bank’s 140-year history.  Many other investment banks are anticipating stellar profits in no small part as a result of the chaos caused by their previous activities.  Bond markets are hectic as a result of governments’ needs to finance their deficits, while economic problems have created (profitable) volatility in foreign exchange markets.

When even majority government-owned banks, like RBS, join the party, you know the system is rotten. RBS chief Stephen Hester’s £9.6m bonus shows that bankers haven’t changed.  Indeed, there is growing suspicion that this lethal breed is going back to business as usual, although the financial crisis remains unresolved – frightening prospect for taxpayers everywhere.

Fading political will to secure a strong regulatory response – and a good deal of sustained lobbying – would appear to have let banks off the hook.  That is dangerous, particularly against a background of unresolved global imbalances.  There must be a possibility that, with bankers once again at play, the financial system will return to chaos in the not too distant future.

What should be done?  Bank of England Governor, Mervyn King, argues that investment and retail banking should be separated, along the lines of the old US Glass-Steagall act. His reasoning is that it is too risky for high street banks to continue playing in the casino of investment banking.  The problem, though, is that shrinking banks so dramatically would generate a big chill just as the markets are beginning to unfreeze.

Without its investment banking division, Barclays would have joined RBS and Lloyds as a burden on the taxpayer.  It would be better to follow the FSA’s strategy of making banks reserve more capital the banks warn that even a tamer crackdown could stifle recovery, because the more capital and liquidity a bank has to hold, the less they are able to lend.

That’s a valid point.  The crucial thing now is to get enough money into the system to get the taxpayer off the hook, keep good businesses alive, and convince jittery foreigners to find the Government’s truly extraordinary borrowing requirements.  The niceties of financial regulation can wait.

Ever since the fall of Northern Rock, a cold war has been waged between the Treasury and the Bank of England.  Last week we witnessed the equivalent of the Cuban Missile Crisis.  The setting was the gilded banqueting hall of mansion house, and the level of brinkmanship and tensions, as Alistair Darling and Mervyn King faced each other down, was palpable.

Darling delivered a lacklustre speech on regulation, setting things up nicely for the Governor’s putsch.  King is making a power grab:  not only does he want to put the Bank in charge of spotting squelching future threats to financial stability; given the chance, he’d break up Britain’s biggest banks, too.  The Treasury is opposed to both measures; the Tories broadly sympathetic.

The financial crisis has descended into a tedious soap opera.  Alistair and Mervyn have fallen out again.  The guv’nor is getting matier with David and George… It’s all so trivial.  Instead of arguing about who should be sheriff, we should begin with the broader question of what sort of financial system we actually want.

Yet the sheriff question is key.  The tripartite system of joint regulation (between the Bank, the FSA and the Treasury) which Darling defends in such lukewarm fashion clearly hasn’t worked.  The tatters of the British financial system are testament to its failures. Indeed, in continuing to champion it, Darling has cast himself outside consensus.

A key measure of President Obama’s regulatory blueprint is to put the US FED into the cockpit.  King’s wise proposal echoes that.  The FSA should be left to deal with consumer protection and the solvency of individual banks, leaving the Bank to safeguard against systemic risk.

There are regulatory battles everywhere.  This week’s tussle between Gordon Brown and Brussels over fiscal independence was a more significant encounter than the Darling-King scrap.  Who would you prefer to, make judgements about the UK banking system, Mervyn King or the European Central Bank? The PM, fortunately, secured an opt-out.

Clearly, the posse of global regulators is breaking up as national interests assert themselves, and, given the confusions, that’s all the more reasons why Darling is right not to rush reform.  The FSA chairman, Lord Turned, fears that the will to reform… could weaken as recovery takes hold.  Perhaps, but until you know what new levers you want to give the regulators, you can’t really decide who should pull them.  Darling is right to take his time.  We need to get this one right.

There is a distinct whiff of cordite in the air.  Investors at this year’s AGMs have been expressing rage at the wholesale destruction of value.  Eggs were thrown at the directors of Allied Irish Bank; protestors singing the Marseillaise stormed the stage at Belgian bank Fortis; and there have been confrontations over pay at BP, Provident Financial and Amec.

This has been the biggest backlash yet.  In one of the most significant investor rebellions in years, 59% of Royal Dutch Shell shareholders voted to reject the company’s executive pay plan – evidence of the mounting anger over remuneration and bonuses.

Shell had it coming:  the behaviour of the non-executive directors on the company’s remuneration committee was outrageous.  According to their own rules, bonuses would be due if Shell came third or better in a league of five oil majors ranked by total shareholder return.  When the company finished fourth, directors brazenly declared that the race was so close that fourth was as good as third. Shell moved the goalposts.  But there are plenty of other cases where the goalposts were simply set in the wrong place, with shareholders’ approval, making it ridiculously easy for executives to claim huge payouts for mediocre performances.

That fact, one suspects, partly explains the sudden outbreak of rebellion.  Investors are finally realising that the wool has been pulled over their eyes for years. Stock markets are back where they were a decade ago, dividends are being slashed, but boardroom pay has gone to the moon.

In boardrooms, in clubs – and at certain flower shows one might mention – you will hear much huffing and puffing from some directors about having their hands tied.  Others will feel they can shrug off shareholder votes, which are non-binding, even when they’re made on the scale we saw at Shell.  But Shell’s remuneration committee, led by Sir Peter Job, has taken shareholders for granted for the last time.

Other directors take note:  next time, the protest could get personal. If that is what it takes to remind self-interested executives who really owns their firms, so be it.  The crunch has highlighted a crisis of ownership.

Supine institutional shareholders, such as pension funds, were the handmaidens of recklessness, greed, corruption and destruction- and they allowed it to happen with our money.  Regulation is only part of the answer:  we need to move from a culture of entitlement to a culture of responsible ownership.  Executives, like politicians, must be forced to realise that they work for us.

Swine flu, a major bankruptcy, rumours of big holes in US bank balance sheets… last week looked like “yet another shocker” to add to all the others that have roiled the financial system.

Not so long ago, any one of these events would have wiped billions off stock markets; together they would have caused catastrophe. But something has changes.  Traders seem bent on shrugging off the bad news and continuing a winning streak that has lasted almost two months. As Richard Dunbar of Scottish Widows observed on the BBC Radio 4 Today programme, “the market has moved from 100% fear to 100% greed” in six weeks flat.

This feels like a pivotal moment in 2009’s titanic battle between bulls and bears, and the bulls would appear to be in the ascendancy.  Equity markets across the developed world have jumped by a third; emerging stocks are on fire; and risk indicators are retreating.  Three-month Libor (the inter-bank lending rate) dropped below 1% this week, reflecting banks’ willingness to trust each other again.

Meanwhile the big guns are out in force, reiterating their conviction that the good times are rolling again.  Hedge fund manager Crispin Odey, who made a fortune shorting bank shares on their way down, has reportedly made another mint after buying them at the bottom, and he’s convinced the rally has only just begun.

Investors, like policy-makers, are betting that optimism will prove self-fulfilling. Clouds become mere appendages to big silver linings. As for unequivocally bad news – a huge increase, or confirmation that UK house prices are still falling – it is simply ignored.  Investors seem to be on a mood-enhancing drug.  And, in a sense, they are.  Governments and central banks have been issuing vast quantities of a stimulant (cheap money) that gets markets high.  But the drug is still in trials, and may yet have adverse side-effects.  Try soaring inflation, for starters.

There’s now a risk of a massive trap for unwary investors. Having preserved their money after the first big crash, they are now being set up to lose it in the next one. The economy is still in deep trouble and markets cannot ignore that fact forever. The most that can be said at this point is that financial Armageddon is no longer looming. If that’s true, it may well be worth 20% on share prices, but is can’t create a sustained bull market.  For that to happen, more good news is required.  Recoveries in the real economy tend to require something more substantial than a handful of semi-cheery surveys.

Spring has come to Washington and, with it, the sickly sweet smell of scandal.  Or was that the smell of blood?  The public outcry over the sickening $165m in bonuses paid to AIG executives is certainly justified:  some of the recipients – particularly those working in the specialised London unit whose creative gimmickry effectively sank the company – are more worthy of jail cells… than new vacation homes.

At $182bn and counting, they’ve cost the US taxpayer dearly.  Yet the tabloid-fuelled outrage came dangerously close to becoming the lynch mob.  Several executives reported death threats (one involving piano wire), and the mood was scarcely less violent in Congress, where one senator said he hoped executives would follow the Japanese example and “go commit suicide”.

That remark was later laughed off as rhetoric, but Congress was deadly serious in its quest for revenge.  In its bipartisan rage, the House saw fit not merely to punish the employees of AIG’s financial products unit, but to vote in a 90% tax on the bonuses of anyone at every bank receiving $5bn in taxpayers money who earns more than $250,000 a year.

A draft Senate version of the bill is even broader.  Never mind if the bonus was earned last year or earlier, or under a legally binding employment contract.  The confiscatory tax will apply ex post facto. It is certainly one of the more amazing and senseless acts of political retribution in American history.  Few stopped to debate the potentially ruinous effect this might have on the financial system, let alone the rule of law.  Obama needs to face down the AIG mob, or his presidency may become the next victim.

Obama is clearly uncomfortable with the legislation, but he should do more, and actively oppose it:  not least because his Treasury Secretary, Timothy Geithner, desperately needs the private sector to support his new bank rescue plan.  What’s the incentive for private investors to risk buying toxic assets if any gains are later confiscated?

The situation was partly defused when AIG reported that most executives had handed back their bonuses.  But the stakes remain high.  The Treasury plan assumes that the basic problem is one of liquidity: it aims to create a market for securities that are currently not trading.  But if the problem is really one of solvency – that these assets are worthless after all – all bets are off.  Emotion is high on both sides.

Wall Street is raging against the dying of the light and Congress is responding to populist rage.  Those emotions could yet derail this plan.