“It's a Wonderful Life” On Regulatory Policy: Focus

Focusing on the wrong organizations

Let's start with the waste inherent in focusing on the wrong institutions.  The WALL STREET JOURNAL had an article entitled “Probe of Big Bank Widens: SEC, Others ExaminingWhether Regions Financial Improperly Classified Bad Loans” As it reports, “Federal agencies are examining allegations that Regions Financial Corp. (RF) improperly classified loans that went bad during the financial crisis, according to depositions filed as part of a civil lawsuit against the large southeastern U.S. bank.”

One shouldn't misinterpret the focus of these comments.  As pointed out in the last posting (“It's a Wonderful Life’ is truly a gift that doesn't stop giving”), the accounting practices of financial institutions present a serious problem to investors.  As the WALL STREET JOURNAL article puts it, “transparency of accounting decisions at major banks became a major concern for investors...”  There is nothing wrong with that statement.  Also, this posting does not imply any judgment about Region’s accounting practices.  The issue is whether the resources could be used in other ways that would provide greater benefit. One does not need to judge Region’s accounting to see some policy folly. 

What is curious and shows a short sightedness of much of our policy is the timeframe the article seeks to establish for the need for transparency.  They go on to say that the concern arises as “questions on the subject continue to bubble as financial firms' crisis-related cases wind their way through the courts,” and the article treats the issue of transparency as if it only relates to practices that occurred “during the financial crisis.”  As any investor knows, that is pure hogwash.

The problem is that it is not just the reporter who gets this wrong.  Consider the reported origins of the investigation.  The article reports “The Regions depositions emerged as part of a lawsuit brought in 2010 by two pension funds that own Regions stock. The funds allege that Regions hid problems by moving loans out of nonaccrual status, which means interest payments were overdue and collection of the principal unlikely. Rising nonaccruals typically force banks to increase reserves for loan losses, a move that eats into profits. A lawyer for the funds declined to comment.”

Is it any wonder that “a lawyer for the funds declined to comment?”  Pensions have a fiduciary responsibility, and one has to wonder where was the pension manager’s due diligence if they only noticed accounting irregularities during the financial crisis.  If accounting irregularities were there, they didn't start with the financial crisis.  Further, it seems to me that an objective analysis of the practices used to establish reserves would not flag pensions as particularly good judges.  For the lawyer to have commented might have presented a real case of the pot calling the kettle black. 

As the article reports, the investigation reflects a “widening U.S. scrutiny of the lender as regulators and federal investigators step up their surveillance of the methods banks use to classify loans or reserve for losses.”  What policy wonk or bureaucrat came up with the notion that bank reserves at large regional banks are the highest priority for scrutiny?  Although not the purview of bank regulators, from a policy perspective, it would make more sense to focus on pension funds, especially public sector pension funds.  Many pensions, especially those in the public sector, have been deceiving pensioners regarding reserves for years.  It would have been nice if the article had reported whether there was any evidence that pensions’ lawsuit reflects an effort by the pensions to compensate for previous failures in the pension funds’ reserve policies.

Focusing just on banks, large regional banks hardly seem to be highest priority.  One should recall from previous postings that TARP repayments would indicate that it was smaller banks, not large regionals, that proved to be insolvent during the financial crisis.  So, based upon the TARP experience, when the issue is solvency, the bank regulators may be focusing on the wrong banks.

The folly of the regulatory practice was illustrated again in another article on December 27, 2012 in a WALL STREET JOURNAL article entitled “Whale' Capsized Banks' Rule Effort."  It focused on the J.P. Morgan Chase (JPM) trade that resulted in extensive press coverage.  The first thing to note is that the J.P. Morgan Chase trade involved significantly less money than the article on TARP indicates that smaller banks have cost the federal government.  Second, it should be noted that the J.P. Morgan Chase trade cost the bank profitability, but cost the federal government nothing.  That outcome appears, at least to this analyst, to be totally appropriate.

The more important point that many of those framing policy do not seem to understand was highlighted by Julie Williams, The Chief Counsel for the OCC at the time.  As she put it, “such trades were likely part of the bank's regular course of business….  They were likely hedges….”  If that is true, then much of a critique of the trade, and citing it as justification for the Volcker-rule is totally misguided. 

It is unfortunate that many people reach the conclusion that the fact that traders lost money “demonstrated the risks posed by proprietary trading at large banks.”  Quite to the contrary, the conclusion that people are reaching demonstrates, not risk to the bank, but naivety on the part of the person reaching the conclusion.  Put simply, not every trade is designed to make money.  The people who think they have to make money on every trade are incredibly naïve.  They seem to totally lack any understanding of the purpose of a hedge or the reality of investing.  Unfortunately such nonsense seems to be guiding many of the people formulating policy.

As the article points out, portfolio hedging is often designed to protect against losses across an entire portfolio.  J.P. Morgan Chase’s loss on the “whale trade” may have allowed it to hold other investments that resulted in a much greater profit.  The first obligation of anybody who wants to reach a policy conclusion from the “whale trade” is to show that it was not intended to hedge other portfolio risks.  That is far more difficult than just determining J.P. Morgan Chase’s aggregate profitability or loss during the quarter.  There is no reason to assume that J.P. Morgan Chase was not hedging other investments that will yield a return in another period.   Maturity mismatches are extremely common in banking.

It is possible that the loss represented a miscalculation of the extent or timing of the hedge.  It is important to keep in mind that when a bank’s investments are not hedged, also involves a maturity mismatch.  So, a miscalculation on timing, or even on the extent of the hedge, may have been less damaging to the bank than if it had left its investments unhedged. 

Regulators seem to be chasing headlines in stead of trying to facilitate a functioning financial system.