Fed Capital Requirements: Bearing the Cost that Failure Would Impose on Others

Too big to fail is a narrowing option. And running with riskier assets is going to be costly for larger banking institutions, according to new rules by Federal Reserve as noted in the Wall Street Journal:

The Fed completed one rule stating that the eight largest banks in the country should maintain an additional layer of capital to protect against losses, its plainest effort yet to encourage them to shrink. At the same time, it offered a reprieve to General Electric Co.’s finance unit from more-intensive regulation, after the company promised to cut its assets by more than half.

…Regulators have pushed big banks to expand their capital buffers to better absorb losses, reduce their reliance on volatile forms of funding, improve their risk management and cut back on risky assets. So-called stress tests measure banks’ resilience each year and can restrict shareholder payouts at firms that don’t pass.

For Wall Street banks and their investors, the emerging regime presents a series of choices: specifically whether to pay the cost of new regulation, which will fall to the bottom line, or change their business models by shedding businesses or withdrawing from certain markets, such as owning commodities.

In a quote that I think is one of the best commentaries on the subject,

Fed Chairwoman Janet Yellen, before voting to approve the new measure, said financial firms must “bear the costs that their failure would impose on others.” She offered banks the choice of maintaining more capital to reduce the chance they would fail, or get smaller and reduce the harm their failure would have on the financial system.

The big banks of course object to the action stating that it will remove billions from the economy. Below is a graph of the big 8 that will be hit with he most significant requirements (click for larger image):

Bigger Buffer

But it is not size along that determines how each bank will be assessed, “the size of each bank’s additional capital requirement is tailored to the firm’s relative riskiness, as measured by the Fed’s formula, which considers factors such as size, entanglements with other firms and internal complexity. As those factors shrink or grow, so will a bank’s surcharge.”

Washington Super Sizing Bank Boards Oversight

In yesterday’s Wall Street Journal, Regulators Intensify Scrutiny of Bank Boards outlined many of the problems inherent in bank boards, especially in the wake of the great crash of 2008 when the banking industry was exposed for just how risky and reckless a business it always has been, versus the illusion of prudence, conservatism and moderation. The result has been increased layers of oversight, now with final authority in Washington:

The Federal Reserve and other bank regulators are holding frequent, in some cases monthly, meetings with individual directors at the nation’s biggest banks, demanding detailed minutes and other documentation of board meetings and singling out boards in internal regulatory critiques of bank operations and oversight. In some instances, Fed supervisors meet more often with directors than the directors meet formally as a full board. Boards at small banks are also getting new attention from regulators.

But while the “2008 crisis showed regulators that some boards—and senior management—didn’t understand the risks firms were taking or didn’t exercise appropriate oversight,” additional problems may not be where you expect them:

In some cases, board members weren’t experienced enough or were too closely tied to the bank to perform their duties. Studies since the financial crisis—for example, the International Monetary Fund’s October 2014 Global Financial Stability report— have shown banks with independent directors are less likely to take on risk, while boards chaired by the bank’s CEOs take more risk.

As a result, the Office of the Comptroller of the Currency has turned its attention to bank boards and their activities as they specifically address risk, as well as their understanding of the activity their institutions are engaged in, resulting in “more supervisory contact with the boards than ever before.” According to the head of bank supervision at the Federal Reserve Bank of New York, “while the level of engagement varies across firms, in general, we are seeing boards being more active in asking questions, providing oversight of management and engaging with supervisors.”

Will it work? See two articles in the Financial Times from last year that may suggest otherwise: A reckless banking industry is a drag on the economy and Financial reforms will make the next crisis even messier.

CYNK: The “NINJA Loan” of the Capital Market

Do we remember the NINJA loans? Or has it been too long – six or seven years? You know, loans made to folks with no income, job or assets for that matter. Does THAT sound familiar, and for that matter completely insane? Investopedia explains just why such loans are so risky,

While the specifics of any NINJA loan can change, most offer the lender a low initial rate, which is then increased after a few periods of payment. The borrower is hoping for the value of their property to appreciate significantly, allowing them to repay the loan with the newly found equity. However, when the property doesn’t appreciate, many borrowers cannot make the repayment.

This of course explains the full implications on the CDO market as outlined in an IMF paper which, oddly enough, seems less filtered by hindsight as it was written in 2008, so close to the mayhem and actually written in June of that year preceding the Lehman bankruptcy:

The damage was propagated at each stage of the complicated process in which a risky home loan was originated, then became an asset-backed security that then formed part of a collateralized debt obligation (CDO) that was rated and sold to investors.

The paper is worth a re-read as it underscores the fundamentals of the madness of the crowds, the reckless history of much lending activity (not the first time there has been a banking crash), followed by an absence of liquidity, panic, crash and finally, a backstopping by the government.

Of course the case of CYNK is quite different from the CDO market crisis mentioned above. But there are similarities of behavior, especially as they relate to knowingly engaging in fraudulent behavior, and the predictable irrationality of the crowd. And unfortunately, in the case of a pump and dump (or whatever this is), no backstopping is on the way.

Outside of those flipping round turns based on oscillators, algorithms and signals – the assumption is that this crowd knows what they’re doing – does anyone ostensibly investing in a security like this actually read, or even glance at the financial statements? And what about the qualitative data that should accompany the quarterly and annual reports, such as an absence of filing? No, unfortunately, all of the handwringing and analysis is pretty much foolishness. All you needed to know was the basic ‘NINJA’ equivalent found right there in the SEC filings:

No Income:

CYNK No Income

No Assets:

CYNK No Assets

No filing.

No dice.

And finally, this, the footnote on going concern (emphasis mine):

The ability of the Company to continue as a going concern is dependent on the Company obtaining adequate capital to fund operating losses until it becomes profitable. If the Company is unable to obtain adequate capital, it could be forced to cease operations. These factors raise substantial doubt about its ability to continue as a going concern. In order to continue as a going concern, the Company will need, among other things, additional capital resources. Management’s plan to obtain such resources for the Company include: sales of equity instruments; traditional financing, such as loans; and obtaining capital from management and significant stockholders sufficient to meet its minimal operating expenses. However, management cannot provide any assurance that the Company will be successful in accomplishing any of its plans.

Enough said. All the other anecdotes and, “meet the mysterious executives” behind the mythical unicorn, is just noise.

I’ll bet you didn’t guess this strategy…

I’ll bet you didn’t see this one coming? According to today’s WSJ headline, Stocks Biggest Gains Are and Inside Job. It’s one thing to shop for the date of record, even if you do not plan to hold. But a strategy of looking those subject to a buyback? Not a likely strategy. When prompted with the question, “Quick, what is the stock market’s biggest driver today? Corporate earnings? Interest rates? The Federal Reserve?” My immediate response is, perception of all the above. But some have suggested another possibility:

Some say the correct answer is something people rarely discuss: companies buying back their own stock. Companies purchasing their own shares represent the single biggest category of stock buyers today, according to a study this month by Jeffrey Kleintop, chief market strategist at brokerage firm LPL Financial.

In a remarkable statement from the LPL strategist,  “only one other major group, individuals, is a net stock buyer now and individuals are buying less than corporations,” and this includes major groups of investors: “hedge funds, foreigners, insiders and investment institutions such as pension funds and insurance companies all are net sellers.”

But such a practice is quite subject to criticism, and for what seems to be somewhat self obviating reasons. Some of the first terms we learned in second semester accounting was, dilutive and antidilutive, as noted on Investopedia, “the effects of securities retirement…on earnings per common share (EPS), where EPS is increased for shareholders…[i.e.] by lowering the share count or increasing earnings.“ And the article goes on to speculate that, “some critics go so far as to say executives use buybacks to manipulate share prices, which helps them hit earnings targets, please investors, receive bonuses and avoid scrutiny from shareholders and boards.”

While the argument can be made for the tax benefits to the investor for such an action versus dividends, actions such as those by IBM are questionable. Specifically, on the face of it, there is nothing unusual about IBM using $8.3 billion of pent-up cash from the sidelines for a stock buyback. But it was quickly noted that Big Blue’s balance sheet reflected higher liabilities rising alongside the stock buyback and thus, debt fueling EPS. This actually comes down to the argument of intrinsic value and understanding all of the financial statements and how they tend to tell a more complete story, when taken together, rather than the obsession and fixation on the one, the income statement and earnings-per-share.

Innovation and Finance – Making the Connection Part 2

In the first post on this topic I cited a recent article in Strategic Finance titled, Innovation is for CFOs, Too, and I’ll use that article to highlight what I believe to be some very relevant points to the operational aspects of financial reporting. The article begins with the comment that financial reporting is grounded in a 500 year-old system, and that is remarkable. It actually gives pause to the effectiveness of such a system. After all, how many of us could codify a system that would remain a functional model for centuries? I don’t know if introductory accounting texts still include this history but I was fascinated with it when I first read it twenty years ago. But the trade-off for a system that works well in times of stability is its inverse relationship to innovation and forward movement. This is a well-known topic of strategic planning. That is, a highly systematized organizational model that follows a highly structured hierarchy worked well in a marketplace where change was gradual, incremental and even somewhat predictable at times. But in a global market with an avalanche of information available to many, the model simply does not facilitate the rapid response that is needed in a post-industrial era. So while many of the processes involved in financial reporting have been accelerated and automated as a result of technology, this is really is only part of the solution. The goal, as outlined as a major premise of the article is for senior finance executives to “drive improved results by making significant innovations in the finance function.” The challenge for leadership is that most financial staff do not think in these terms. This is likely due to the detail oriented nature of the average functional operational area within finance. So how can details translate into value?

Although geared toward a for-profit model, the authors cite principles than are applicable to any organization, with their first suggestion under the broad heading of change to the business model. That seems simple enough, and it is with the right mindset. It is suggested that leadership should consider what is being currently offered to customers, yet emphasize those things that are “critical in the value they currently offer customers and consider how they can enhance that value by offering it in a different or a better manner.” This may take the form of expanding product or service offerings, or as is the case with  many successful models, reducing them in order to deliver exceptional performance. I recently spoke with a software provider who was recounting the history of their success as a firm, and what I was struck by was how many things they decided against pursuing, in order to produce an exceptional core business that is unique to their industry. Another interesting modification is to the target customer. Specificity in customer base has been a topic for decades, but from the perspective of innovation, this may be a moving or changing target. This is frequently seen in the re-branding of products that historically appeal to one gender over another, but are then flipped with little more than a change in emphasis. But integral to the previous two are changes in technology. Breakthrough or significant changes in technology can offer the benefit of an immediate pop that can be leveraged, but many other times, existing technology available to an organization can be used by simply changing the approach, mindset and culture of an organization. I have experienced this firsthand with the conversion to paperless reporting using technology that was already in place.

But most significantly for financial leadership are changes that are often the least noticeable to those outside the organization, “enabling technologies, such as information technologies, can be very important because such changes help ensure better decision making and financial management.” I have frequently cited the tension between time that is chewed up looking for the right data, rather than its ready access resulting in thinking and influence for the organization and its strategy. I think this is the most significant contribution of technology and innovation for financial managers as their roles interface with the operational leaders. This changes the financial reporting functions from an inherently backward looking exercise, to energy that is spent engaging in the ongoing process of innovation.

Reference:

Davila, T., Epstein, M. & Shelton, R. (2013). Innovation is for CFOs, Too. Strategic Finance. http://www.imanet.org/PDFs/Public/SF/2013_07/07_2013_davila.pdf

Innovation and Finance – Making the Connection

A number of white papers on the topics of service and operational innovation have caught my attention, and I wrote an overview of one recently here. While many of the ideas regarding innovation are similar, the number of perspectives and expanded applications to operational innovation is impressive. As a proposed subspecies of organizational innovation, operational innovation has particular application for accounting and finance. And as such, it seems natural that information technology functions (up to a certain sized organization) commonly fall within the scope of the chief financial officer within the organizational structure. Why does this matter? Because what begins with a mindset toward innovation often requires the necessary bandwidth made available through technology.

In other words, technology in and of itself is NOT the answer. I cannot count the number of times I have seen an expensive system that was purchased in the absence of an organizational mindset that embraces and encourages innovation, and the inevitable happens: it lies dormant or is abandoned altogether. This is a particular shame because not only are resources wasted in the process, but it reinforces the mindset of those who are looking for an example of failure in order to resist change, as if change were being implemented for the sake of itself, rather than a desperately needed implementation that will move an organization forward. So the process begins with a mindset that permeates an organization, encouraging a culture of continuous learning. Although this is a simple and straightforward concept, it is far more complicated to create within an organization (of any type) than to plan.

But once this mindset is in place, or even moving in that direction through leadership or a core group of people, the possibilities for process innovation as it relates to service delivery are tremendous. In an article in Strategic Finance titled, Innovation is for CFOs, Too, the authors Davila, Epstein and Shelton suggest an integral connection to financial operations, organizational innovation and technology,

The accounting and finance functions are an important place to start. Although accounting has changed incrementally over time, we’re grounded in a model that was developed 500 years ago, and we still use that same basic model. That’s okay. The development of information technologies has changed the way we process transactions—and the speed—but the basic model hasn’t changed. Yet approaches to financing organizations and managing cash have changed dramatically over the years. Maybe most important, the role of the CFO has been totally expanded in the last decade or two. Although regulations in accounting and finance constrain some innovation in the corporate finance function, there’s still so much that can be done.

Further discussion of the “much [more] that can be done” will be in a subsequent post discussing this article, which can be downloaded from IMA here.