The Central Banks' Bank Says Global Banking Is Too Complicated

When the world's financial clearinghouse says the world's banking system has gotten too complicated, then something is wrong.

But that is exactly what the Bank of International Settlements said today in its 250-page annual report/credit crisis autopsy report:

The truth is that as financial institutions grow more complex, the demands on risk management grow much more quickly. A large, integrated financial institution today has hundreds of subsidiaries, all operating quasi-independently; it is impossible for any individual to understand what all the parts of such an organisation are doing, much less how they will interact in response to a major event. Enterprise-wide risk management would seem to be an impossibility in such cases. Moreover, some banks are not only too big to fail but, in having important relationships with a large number of other institutions, are also too interconnected to fail. Officials must insist that institutions be comprehensible both to those who run them and to those who regulate and supervise them. And, in the future, a financial firm that is too big or too interconnected to fail must be too big to exist.

BIS's solution may not be appealing to this nation's largest banks (and the regulatory agencies that support them):

In summary, as officials look forward they need to balance stability with efficiency. Reducing moral hazard, keeping institutions simple and small, and reducing their international reach will all come at the expense of economies of scale and scope. In the end, a safer and more stable financial system may very well be a less efficient one. Hence it is critical that policymakers work to build a system that is as efficient as possible for the maximum tolerable level of risk they choose.

Then, BIS takes a mighty swing at US regulators and their policy of preventing the nation's largest banks from failing. Bernanke's not going to like this one:

In summary, financial regulators, fiscal authorities and central bankers face enormous risks. To avoid deepening and prolonging the crisis, they need to act quickly and guard against policies that hinder adjustment or create additional distortions in financial flows. Governments will be tempted to subsidise
industries that need to contract – but losers need to be allowed to lose. They will be tempted to encourage banks to lend to those who should borrow less – but it is not possible to deleverage by borrowing. And they will be tempted to turn a blind eye to insolvent institutions, allowing them to continue operating – but as hard experience teaches, zombie banks must be closed or returned to health as quickly as possible. In all of these cases, governments must realize that, by insisting on speedy resolutions despite political controversy, they are acting in the best interests of the public.

I couldn't agree more.

In my next blog, I'll analyze BIS's formula for containing financial risk. You can find the full BIS annual report here.

Tags: bernanke, bis, compliance, credit-crisis, monetary-policy, regulation

Comment by Andrea Psoras on June 29, 2009 at 4:48pm: ah, it's tough when you have to cover up for the crimes of senior managemetn of the world's largest banks who should have been fired with all their worthless asset generation. originate to syndicate doesnt have the ability to hide for too long. regardless of the musings of the BIS, collapsing the US economy and the financial system to fit g20 constraints rgardless of the way stealing more than 1T was achieved, the BIS isnt going to expose. blame is layed elsewhere as the diversion.

Comment by Andrea Psoras on June 29, 2009 at 4:50pm: Lehman, et all saw the Enron pattern and institutionalized it for replication elsewhere in this case in the financial sector.

Comment by Andrea Psoras on June 29, 2009 at 4:53pm: reducing moral hazard nixes the Fed from being a final supra regulator. and on the OTS all they needed to do was force it to do its job and discipline miscreants long before places like IndyMac collapsed. that too is another pattern. have a regulator under the treasury departmetn and foul with it so that it acts incompetently. looks bad for geithner who is saying that the fed should control the financial sector; why listen to him when he has difficulties management his own house.

Comment by Andrea Psoras on June 29, 2009 at 5:04pm: perhaps they should speak for themselves. in their own back yard in swabian land, they have miscreant CS and the bank they crippled UBS. CS had access to inside information gained by insidious means, while UBS was plundered. the other european players need to keep their noses in their own back yards. those banks are supported by their governments and major corporates. we had a functioning system until our global corporates and other creepy little guys behind the curtain sold us down the river to collapse the US economy to fit the g20 constraints. how do you think if we had a functioning system this is achieved? by 'deregulation' like Ken Lay and Enron. net capital rule, CMA 2000, corrigan ending dealer surveillance in 1993. failure to keep origination away from securitization/syndication.

Comment by Andrea Psoras on June 29, 2009 at 5:06pm: wow, Phil Gramm was at UBS. either it was his 'heaven' after leaving senate and chairing the banking committee or UBS was his waterloo.

Comment by Neil Robinson on June 30, 2009 at 4:13am: A very thought provoking post, JJ.

I've long maintained that the new banking post sub-prime world to emerge over the next 10 years will be led by smaller boutique style banks providing specialist services and optimised to sell a limited, highly efficient portfolio of products.

Having said that, in the immediate future, we have to run with what we've got, flawed as it is. I'm really disappointed we've not seen a "!night of the long knives" routing out and firing/prosecution of the pseudo-criminal bankers that put us into this situation. But I guess their influence extends further than we thought.

A sharing out of Madoff's 150 year jail term around some BoA and Citi execs would do wonders to focus our bank's corporate mind on change and a more moral stance.

I think you make a valid point regarding risk management. Most banks aren't integrated companies, but a confederation of states each vying with each other to add more to the bottom line. Good I hear you say. Yes, but not when the resulting cumulative risk profile becomes untenable. What do I mean by that?

I mean a customer may have a mortgage with one department, a loan with another and finance for their business with another. A risky decision taken on one, while the remainder is strong may be acceptable risk, but quite the opposite if the other facets are shaky too.

The answer is to integrate and collaborate with risk; ensure the individual person is assigned a profile, not the individual transaction.

I guess I'm saying banking should move back to being about managing customers as people, not as transactions or even services - and that's a fundamental but vital concept. And a lesson we fail to learn at our peril.

Comment by Brad Emeron on June 30, 2009 at 1:14pm: In terms of economies of scale, there are clearly diminishing returns after the first couple of billion dollars of asset size in a banking instituion. I am thinking of a $500 billion institution with an efficiency ratio of aroung 50%, but can think of plenty of much smaller firms with ratios the same or better. So why not have smaller instititions? Why concentrate the risk into very large banks? In part, the regulators act like think their jobs will be easier (Note: not more effectively done) if there are fewer/larger banks. Think of the auto finance oriented banks called ILC's (or "thrift and loans") that used to be commonplace in the western US. The FDIC and state regulators have all but killed this industry sector because they have feared "monoline" banks. And has that served the public interest? I doubt it. What is wrong with the proposition that there is room in the marketplace for banks with a special skill set doing what they do best? On the other hand, if a bank can be a enormous, complex organization and thrive, so be it. But if they fail, they should be allowed to do so. If the governments regulators are allowed to hide their own errors by employing a "too big to fail" approach, the net result will always be punishment to the taxpayer and consumer.