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August 26, 2012 7:10 pm

We need much simpler rules to rein in the banks

Congress, lobbyists and editorial writers have been engaged in an intense debate over how to provide effective governance for the US banking system in the wake of the 2008 financial crisis and, more recently, JPMorgan Chase’s billion-dollar derivatives losses. It is a complex subject and, not surprisingly, the language has been at times as opaque as the derivatives themselves – and the inability of the public to understand the system is contributing to a decline in trust and confidence. I believe the real solution lies in formulating a simpler, not a more complex, set of regulations.




Begin with the reality that banks’ operations are vastly different now than they were even 10 years ago. The days when a large multinational bank could borrow money from depositorsbacked by a government insurance guarantee – and then lend it out to customers at a reasonable spread are gone, at least as their main source of revenues. With net margins squeezed, banks have had to reach for profits in increasingly esoteric areas, such as derivatives trading, which rely on complicated computer models and mathematical algorithms few people understand.



Most of these activities boost profits by cranking up leverage, which the banks feel comfortable using because of confidence in their computer models. As this is a highly complex process, in turn, the regulatory oversight must grow in complexity simultaneously.



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Consider that despite more than a year of effort the standards for implementing the so-called Volcker rule, intended simply to prevent banks from engaging in proprietary trading, have become exceedingly complex and have yet to be finalised. (Paul Volcker’s original idea is a prudent step that I support.)





This computer modelling is impressive stuff. However, while these models create the appearance of mathematical certainty about the relationships between markets and the way world events will affect prices, it is essential to recognise that, at their root, these models rely on man-made assumptions about human behaviournot iron-bound laws of nature.



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In addition, the behaviour of derivative markets can be episodic and illiquid at precisely the times we most need greater liquidity and confidence. No matter how sophisticated the maths or how large the data base supporting a model, no one can predict behaviour human or market – with certainty. Inevitably, this means the formulas break down at the most critical times.




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I have no reason to doubt the managerial capabilities at JPMorgan Chase, but given the nature of the bank’s recent trades, and the models on which they relied, we should understand that those same highly leveraged, highly complex positions might, with some shift in the assumptions embedded within them, have produced no loss, or one even larger than the $5.8bn recently reported, or even a big profit. None of those results would have threatened the bank’s viability, but stepping back and looking at these divergent possibilities, should the public be asked to understand and give its seal of approval to such a complex system? After all, these multibillion-dollar transactions encoded in high statistical theory are a distant science to most of us.




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Certainly, the complexity of the models behind the trading makes it exceptionally difficult for the regulators to have benchmarks that allow them to make their own independent – and differentassessments of the risks. The regulators themselves may have an alternative view of the underlying assumptions in the derivatives.



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This is why regulation should shift to simplicity, not add more complexity. We took this approach when I was Treasury secretary confronting the Latin American debt crisis, by adopting a flat rule: the solution to too much debt is not more debt. We forced ourselves to think only of ways to reduce leverage, not increase it, and the so-called Brady plan brought about an actual reduction in debt and interest rates. Today, we need to reduce the complexity of the regulations rather than add more layers.




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Regulators need a clearbright line” that they can apply to bank activities. The aim should be to permit innovation, and prudent risk taking, while also creating less varied and complex boundaries that banks cannot cross and that everyone can understand. The new simplicity should establish a clear ability to determine when to say yes, and when to say no; and the meaning of “noshould be unambiguous.





The debate should shift to focus on the total leverage permitted in the bank’s books – that is the “bright line”. Banks should be permitted to devise their own strategies and use trading as they see fit, but they should be restricted from taking positions that use leverage of more thanX-to-1”. That may limit the upside of their operations, but at the same time it will limit the downside for taxpayers. It also puts responsibility for operational decisions where they belong, in the hands of the bankers themselves. What should be the boundary? Will it take additional time to design? Yes, but it will be worth it. For a change the public will both understand and agree with it.



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The writer, a former US Treasury secretary, is chairman of Darby Overseas Investments and a principal of Holowesko Partners



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Copyright The Financial Times Limited 2012.




August 26, 2012 7:11 pm
 
The ECB must still do its bit to help solve the crisis
 
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Can the European Central Bank solve the eurozone crisis on its own? The answer is clearly No. But without ECB intervention, the crisis is insoluble. So what should the goals of such an operation be? And how should this be accomplished?


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I would consider three goals, subject to two constraints. The first and most important is to get rid of market expectations of a eurozone break up. Whatever the ECB’s governing council decides on September 6, it must be big enough to squash expectations that Spain or Italy will leave the eurozone. A Greek departure is different. This programme is not about Greece.


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Second, it must be part of an overall resolution strategy. Mario Draghi is right to say that ECB support should depend on an official application for support.


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But this is when it gets tricky. How will the president of the ECB adjust his programme if a country fails to meet the criteria? And who decides?




Third, he has to address the issue of investor subordination. If the ECB’s holdings are considered senior to those of other investors, it may never be possible to get private investors back into those countries.




But would an announcement that the ECB accepts equal rank, also known as pari passu, be credible? The ECB rejected participating in the Greek debt restructuring because it constituted a monetary financing of debt. This is illegal under European law. It is easy for the ECB to state that it ranks pari passu, but is it really prepared to take a hit in the event of a debt restructuring?


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The European Stability Mechanism cannot indemnify the ECB for any losses. I would suspect that ECB legal constraints will ultimately outweigh the credibility of an informal pari passu pledge. There is a law against monetary financing of sovereign debt. There is, however, no law against lying.


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Of the constraints, the first is political. If you push this too far, you may simply replace a southern European debt crisis with a northern European political crisis. The German establishment is already howling. The second constraint is legal. A legal dispute, especially in Germany, could endanger the credibility of the operation. It is one thing for the Bundesbank to disagree with an ECB policy. It is quite another for it to say publicly that
Mr Draghi is breaking the law.


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Yesterday, Jens Weidmann, the Bundesbank president, issued the sternest warning yet that he opposed large scale bond purchases. He said they came close to outright debt monetisation.


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With those goals and constraints, what can and what cannot be done? I do not expect to see any explicit targets for interest rates, or for spreads, as some media reports have suggested. The markets would test any published target.



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Also, what would they do if German interest rates rise? What if the guaranteed interest rate for a programme country ends up being lower than the market interest rates of a non-programme country?



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A guarantee may also be too blunt an instrument to manage a conditional programme. If a country fails to meet the condition, the only real sanction available would be to drop the guarantee and cause a massive financial and political crisis. A simple bond purchasing programme may be easier to fine tune.


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I suspect the ECB will endorse a conditional purchasing programme, targeted at Treasury bills, perhaps also at bonds with a short maturity. There will be no explicit or implicit interest rate targets, but a promise of unlimited intervention. There will be a pari passu pledge of uncertain credibility. Unless I have misjudged the ECB’s room for manoeuvre, the programme is going to be more modest than markets had hoped for.




Since the ECB is rightly concerned about the eurozone’s broken monetary transmission mechanisms, it might also consider the purchase of other debt instruments, including corporate bonds. A broadening of the programme would have two advantages: it would help parts of the private sector directly and it would be less suspect legally. A broad-based programme of quantitative easing would also be warranted because the economy has fallen back into recession.




Angela Merkel, the German chancellor, is on the side of Mr Draghi in this debate. But if the German public reaction to ECB bond purchases is negative, the political support for this action might change.



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An ECB bond purchasing programme would form an important staging post in the resolution of this crisis, but it would be wrong to regard it as a magic bullet.



The eurozone crisis may look less acute once the bond purchases start but we have been through phases in the past where the crisis appeared to be receding, only to come back a few weeks later. Unless the programme is accompanied by a swift move towards banking and fiscal union, it will not make a difference.


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And that means it probably won’t.


 
Copyright The Financial Times Limited 2012.



August 25, 2012 .
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Where the Mob Keeps Its Money .
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By ROBERTO SAVIANO
Rome


 Alfredo Estrella/Agence France-Presse — Getty Images
A man hung fake notes during a protest in front of an HSBC branch in Mexico City last month




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THE global financial crisis has been a blessing for organized crime. A series of recent scandals have exposed the connection between some of the biggest global banks and the seamy underworld of mobsters, smugglers, drug traffickers and arms dealers. American banks have profited from money laundering by Latin American drug cartels, while the European debt crisis has strengthened the grip of the loan sharks and speculators who control the vast underground economies in countries like Spain and Greece.
 
 
 
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Mutually beneficial relationships between bankers and gangsters aren’t new, but what’s remarkable is their reach at the highest levels of global finance. In 2010, Wachovia admitted that it had essentially helped finance the murderous drug war in Mexico by failing to identify and stop illicit transactions. The bank, which was acquired by Wells Fargo during the financial crisis, agreed to pay $160 million in fines and penalties for tolerating the laundering, which occurred between 2004 and 2007.
 
 
 
 
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Last month, Senate investigators found that HSBC had for a decade improperly facilitated transactions by Mexican drug traffickers, Saudi financiers with ties to Al Qaeda and Iranian bankers trying to circumvent United States sanctions. The bank set aside $700 million to cover fines, settlements and other expenses related to the inquiry, and its chief of compliance resigned.
 
 

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ABN Amro, Barclays, Credit Suisse, Lloyds and ING have reached expensive settlements with regulators after admitting to executing the transactions of clients in disreputable countries like Cuba, Iran, Libya, Myanmar and Sudan.

 
 
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Many of the illicit transactions preceded the 2008 crisis, but continuing turmoil in the banking industry created an opening for organized crime groups, enabling them to enrich themselves and grow in strength. In 2009, Antonio Maria Costa, an Italian economist who then led the United Nations Office on Drugs and Crime, told the British newspaper The Observer that “in many instances, the money from drugs was the only liquid investment capitalavailable to some banks at the height of the crisis. “Interbank loans were funded by money that originated from the drugs trade and other illegal activities,” he said. “There were signs that some banks were rescued that way.” The United Nations estimated that $1.6 trillion was laundered globally in 2009, of which about $580 billion was related to drug trafficking and other forms of organized crime.


 
 
A study last year by the Colombian economists Alejandro Gaviria and Daniel Mejía concluded that the vast majority of profits from drug trafficking in Colombia were reaped by criminal syndicates in rich countries and laundered by banks in global financial centers like New York and London. They found that bank secrecy and privacy laws in Western countries often impeded transparency and made it easier for criminals to launder their money.
 
 
 
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At a Congressional hearing in February, Jennifer Shasky Calvery, a Justice Department official in charge of monitoring money laundering, said that “banks in the U.S. are used to funnel massive amounts of illicit funds.” The laundering, she explained, typically occurs in three stages.



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First, illicit funds are directly deposited in banks or deposited after being smuggled out of the United States and then back in. Then comeslayering,” the process of separating criminal profits from their origin. Finally comesintegration,” the use of seemingly legitimate transactions to hide ill-gotten gains.


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Unfortunately, investigators too often focus on the cultivation, production and trafficking of narcotics while missing the bigger, more sophisticated financial activities of crime rings.



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Mob financing via banks has ebbed and flowed over the years. In the late 1970s and early 1980s organized crime, which had previously dealt mainly in cash, started working its way into the banking system. This led authorities in Europe and America to take measures to slow international money laundering, prompting a temporary return to cash.
 
 
 
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Then the flow reversed again, partly because of the fall of the Soviet Union and the ensuing Russian financial crisis. As early as the mid-1980s, the K.G.B., with help from the Russian mafia, had started hiding Communist Party assets abroad, as the journalist Robert I. Friedman has documented.




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Perhaps $600 billion had left Russia by the mid-1990s, contributing to the country’s impoverishment. Russian mafia leaders also took advantage of post-Soviet privatization to buy up state property. Then, in 1998, the ruble sharply depreciated, prompting a default on Russia’s public debt.

 
 
 

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Although the United States cracked down on terrorist financing after the 9/11 attacks, instability in the financial system, like the Argentine debt default in 2001, continued to give banks an incentive to look the other way. My reporting on the ’Ndrangheta, the powerful criminal syndicate based in Southern Italy, found that much of the money laundering over the last decade simply shifted from America to Europe. The European debt crisis, now three years old, has further emboldened the mob.
 
 
 
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IN Greece, as conventional bank lending has gotten tighter, more and more Greeks are relying on usurers. A variety of sources told Reuters last year that the illegal lending business in Greece involved between 5 billion and 10 billion euros each year. The loan-shark business has perhaps quadrupled since 2009some of the extortionists charge annualized interest rates starting at 60 percent. In Thessaloniki, the second largest city, the police broke up a criminal ring that was lending money at a weekly interest rate of 5 percent to 15 percent, with punishments for whoever didn’t pay up.
 


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According to the Greek Ministry of Finance, much of the illegal loan activity in Greece is connected to gangs from the Balkans and Eastern Europe.



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Organized crime also dominates the black market for oil in Greece; perhaps three billion euros (about $3.8 billion) a year of contraband fuel courses through the country. Shipping is Greece’s premier industry, and the price of shipping fuel is set by law at one-third the price of fuel for cars and homes.

 

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So traffickers turn shipping fuel into more expensive home and automobile fuel. It is estimated that 20 percent of the gasoline sold in Greece is from the black market. The trafficking not only results in higher prices but also deprives the government of desperately needed revenue.
 
 
 
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Greece’s political system is a “parliamentary mafiocracy,” the political expert Panos Kostakos told the energy news agency Oilprice.com earlier this year. Greece has one of the largest black markets in Europe and the highest corruption levels in Europe,” he said. “There is a sovereign debt that does not mirror the real wealth of the average Greek family. What more evidence do we need to conclude that this is Greek mafia?”
 
 

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Spain’s crisis, like Greece’s, was prefaced by years of mafia power and money and a lack of effectively enforced rules and regulations. At the moment, Spain is colonized by local criminal groups as well as by Italian, Russian, Colombian and Mexican organizations. Historically, Spain has been a shelter for Italian fugitives, although the situation changed with the enforcement of pan-European arrest warrants. Spanish anti-mafia laws have also improved, but the country continues to offer laundering opportunities, which only increased with the current economic crisis in Europe.
 


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The Spanish real estate boom, which lasted from 1997 to 2007, was a godsend for criminal organizations, which invested dirty money in Iberian construction. Then, when home sales slowed and the building bubble burst, the mafia profited again — by buying up at bargain prices houses that people put on the market or that otherwise would have gone unsold.
 
 
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In 2006, Spain’s central bank investigated the vast number of 500-euro bills in circulation. Criminal organizations favor these notes because they don’t take up much room; a 45-centimeter safe deposit box can fit up to 10 million euros. In 2010, British currency exchange offices stopped accepting 500-euro bills after discovering that 90 percent of transactions involving them were connected to criminal activities. Yet 500-euro bills still account for 70 percent of the value of all bank notes in Spain.
 

 
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And in Italy, the mafia can still count on 65 billion euros (about $82 billion) in liquid capital every year. Criminal organizations siphon 100 billion euros from the legal economy, a sum equivalent to 7 percent of G.D.P.money that ends up in the hands of Mafiosi instead of sustaining the government or law-abiding Italians. “We will defeat the mafia by 2013,” Silvio Berlusconi, then the prime minister, declared in 2009. It was one of many unfulfilled promises. Mario Monti, the current prime minister, has stated that Italy’s dire financial situation is above all a consequence of tax evasion. He has said that even more drastic measures are needed to combat the underground economy generated by the mafia, which is destroying the legal economy.
 
 
      
Today’s mafias are global organizations. They operate everywhere, speak multiple languages, form overseas alliances and joint ventures, and make investments just like any other multinational company.
 
 
 
 
You can’t take on multinational giants locally. Every country needs to do its part, for no country is immune. Organized crime must be hit in its economic engine, which all too often remains untouched because liquid capital is harder to trace and because in times of crisis, many, including the world’s major banks, find it too tempting to resist.
 
 
 
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Roberto Saviano is a journalist and the author of the book “Gomorrah.” He has lived under police protection since 2006, when he received death threats from organized crime figures in Italy. This essay was translated by Virginia Jewiss from the Italian.