I reviewed the following report from the Federal Reserve to Congress today, and found it disappointing.? From my prior experience as an actuary, and the time that I spent on the asset-liability committee of a small bank, I know that? the banking industry is far behind the life insurance industry on risk control.? The Fed would have done far better to have studied the works of the Society of Actuaries and the National Association of Insurance Commissioners, and learned from their efforts.
Now, I know that the contingencies of banks are far less predictable then those of life insurers.? Further, life insurers have long liabilities, whereas the liabilities of banks are short, and thus, they are more subject to runs.? But liquidity risk management does not play a large role in their document — and this is a severe defect in what they write.? Almost all failures of financial firms are due to loss of liquidity.? The word liquidity only appears once in the document, on page 15.? This shows the amateurish work of the writers.
The Fed focuses on a lot of process issues that don’t matter as much as the substantive issues of discovering forward-looking measures of risk, and changing business processes to reflect those risks.
Here are some examples:
1) Internal controls matter, but it is a rare internal control auditor that can truly analyze a complex mathematical process.? They don’t have the capacity to review those processes, or they would be doing it and earning far more.
2) Risk identification is important, but the Fed document would have not helped in 2007-2009.? How do you detect risks that have (seemingly) never happened before?? Further, if you do detect a major problem that has happened before, and it would impair some very profitable businesses, why do you think management will kill profits to appease your lunacy?
3) Governance is important, but the board gets data so late that it is useless.? This is not worth bothering with.? Management has to do the job here.
4) The language on capital targets is weak, and allows the banks way too much latitude in performing their own calculations.? The Fed needs to be far more specific, and prescribe the scenarios that need to be tested.? It need to prescribe the loss severities, asset class by asset class.? It needs to prescribe the correlations, if any, that can be used in the models.
5) The document does not speak of ethics.? Valuation Actuaries do the same work on a higher level, and they have an ethics code.? That may occasionally make them oppose the management team that pays them, but it is a necessary check against managements trying to manipulate results.
6)? The piece spends too much time on the dividend policies of bank holding companies, and no significant time on the abilities of the subsidiaries ability to dividend to the bank holding companies.? The proper focus of a bank regulator is on the health of the operating subsidiaries.? Who care if the holding company goes broke?? Big deal, at least we protected depositors.
Banking regulators should adopt the same policy as insurance regulators.? Outside of ordinary limits, they can deny any special dividends from subsidiaries to the holding company.
7) The piece does not get forward-looking estimates of risk.? On new classes of assets, you don’t have historical data to aid in estimates of risk.? At such a point, one must look at similar businesses that have gone through a failure cycle, or do something even more difficult: do a cash flow model to estimate where losses will fall if asset values decline for an unspecified reason (okay, no more ability to buy…)
8 ) Macroeconomic factors rarely correlate well with the factors that lead to losses on assets.? Most of that effort is a waste.
9) As Buffett said (something like): “We’re paid to think about things that can’t happen.”? This is why the Fed has to specify scenarios, and be definite.? The mealy-mouthed language of the document can be gainsayed.? Life Actuaries have better guidance.
10) So all of the banks did not pass the mark.? With the vagueness of the guidelines, no surprise.? Let the Fed put forth real guidelines for bank stress tests, and let the banks scream when they get them.? Better to have slow growth in the banking sector than another crisis.
2) Risk identification is important, but the Fed document would have not helped in 2007-2009. How do you detect risks that have (seemingly) never happened before?
Bit of an absurd statement, David. Many people did, with considerable accuracy. Here’s one example (publication date: 4 March, 2008):
http://www.amazon.com/The-Trillion-Dollar-Meltdown-Rollers/dp/1586485636
I agree that some did, but few of the regulators did. I wrote a detailed piece at RealMoney that did in June 2005, with many follow-ups. I got ridiculed for it. That’s my point, and I did not want to toot my horn in the article.
David, I think you know I admire and appreciate your blog — but I have to agree with Crocodile Chuck. Suggesting that the 2007-2008 collapse couldn’t be detected well in advance is absurd. Worse, you are playing into the bank CEO lie (and yes, they are liars and cowards).
For openers, Bernanke made the assinine comment during Congressional testimony in March 2007 that the subprime contagion appeared well contained. He was responding to wide-spread criticism that subprime losses were going to cripple the banking system.
Hundreds upon hundreds of journalists had already published articles about the housing bubble. Most of these journalists do not have a PhD or MBA or CFA designation. Heck, many of them barely managed to squeeze through a bachelors in communication. They saw the problem coming, and they reported on it — the stories are all over the place in pretty much every US publication.
If a bunch of communication majors could and did see the problem coming, why are you still buying into the political cover story?
Any bank CEO that didn’t know this problem was coming well in advance was not qualified to be a bank officer at all. Yes, I am saying every CEO at every major money center bank was and is unqualified to serve.
I detailed (two or three posts ago) how in 2005-2006, every single bank on Wall Street was asked by FNMA and FHLMC for desperate help in hedging the GSE’s out of control negative gamma. No bank CEO needed to connect the dots, they just had to pull their head out of their $20,000 private toilet.
Bernanke insisted (he LIED) as late as July 2008 (three years after FNMA’s insolvency was common knowledge at every major bank) — that somehow FNMA was “adequately capitalized”.
bernanke is an idiot. It is insulting that the media still expects the public to pretend like Bernanke is even an average economist.
Before the economy can turn around, the lying needs to stop. There is no way to spin this story and still sound intelligent — not even you, David, can pull it off.
These so called “leaders” — in Washington DC and in the bank boardrooms — are nothing but cowards. They guaranteed themselves tens of millions in payouts, pensions for life, etc. They get unlimited health care for life, while the people they were supposed to lead get ObamaCare.
These people are COWARDS. They knew years in advance that their was a massive problem — and they just stuck their heads in the sand, knowing that their bonuses were secure even if everyone else ended up on food stamps.
When the Captain of the cruise ship Costa Concordia left his ship while hundreds of passengers were still on board, he was branded a coward. He also faces criminal charges.
People in leadership positions get the corner office and the pretty secretary — or the captain’s private quarters right off the bridge. In return, they are responsible for all the people in their company / passengers on their ship. The captain is the last guy to leave the ship — only after all passengers and all crew are safe. Otherwise, the captain goes down with the ship. Especially when the Captain sees the iceberg coming years in advance, as is the case with bank CEOs.
Stop making excuses for the cowards David. You are better than that.
Could it be that insurance companies are more about funding liabilities and banks more about making a profit or being rewarded for it. The goals and incentives are different in the two industries.