Just like the question of whether BP's cap on its oil leak will hold, and whether the oil slick can be cleaned up at an economic cost affordable by BP and its cohorts, we still have similar anxieties about our banks. Credit Crunch writedown losses have recovered by 75% over nearly 3 years. BP's oil slick has been reduced by 75% by burning off, hoovering up, and break-up by sea action - but with another problem emerging that of the toxins in the enormous volume of dispersants used! 
It is three years since ratings agency Moody's announced that their securitized bond valuation models were buggy with bugs that meant the system was preposterously indifferent to defaults rates - and hadn't been updated for over 2 years for changes in mortgage obligor defaults until January 2007! That said, even Ben Bernanke got his mortgage default data spectacularly wrong in a speech in January 2007. After six months to figure out how to deal with the errant valuation system, Moody's announced a replacement almost exactly three years ago, after which they and other ratings agencies and underwriters had to re-value all $2.7 trillions of securitised bonds in a batch process that inevitably took many months. This was like BP leaking oil well, operating at a depth that people and equipment had difficulties operating at. It was like Chinese Torture on the stock markets, on banks' share prices, or like the months of the Gulf of Mexico pollution crisis and the question day after day how can these streaming losses be contained?
Governments stepped in to try to quarantine the debt markets and banking systems. But these were long since not geographically containable like an oil slick, but global.
Note that BP's oil slick, to take the analogy further, has escaped the gulf and is threatening the USA East coast and spreading into mid-Atlantic (see graphic below of 10th June).
The Credit crunch slick spread across The Atlantic not in nano-seconds as some may imagine the analytic speed of finance, but taking months to spread, speeding over some spectacular events such as the problems of Bear Stearns, Citi, UBS, NR, Dresdner, Hypo-real, Soc Gen, WaMu, Commerz, Fortis, Dexia, HBoS, Bayerische LB, until culminating in September 2008 with the implosion of Lehman brothers and AIG resulting in fire-sales of Merril-Lynch and HBoS and then nationalisations of RBS, Anglo-Irish, and partial state ownership of LBG, AIB, BoI, and so on. All happening as RMBS and other ABCP covered bonds were downgraded, subject to sometimes desperate sales or central bank asset-swaps, and on and on being reprocessed through the revised or 'new' ratings models when the graded assets fell sometimes spectacularly by as many as 17 risk notches, straight from triple-A to 'junk', thus dramatically and progressively shaking, and sometimes shocking, the confidence of 'wholesale' funding sources (including money-market funds and banks who would lend cross-border to each other) who lent to banks by buying banks' Medium Term Notes, on whom the banks were typically reliant for 20% to 30% of their liabilities. The long period over which this shock reverberated without any obvious end in sight was longer than a typical recession. It is surely remarkable that bankers like Sir Fred Goodwin of RBS witnessing the growing slick of asset write-downs could think this is a temporary problem and the values would bounce bank to return to 'normal' sometime soon? Did he, and others like him, have any inkling, based on any analysis, of the likely balance sheet clean-up time and costs? That we still don't know, just as we do not know how many group risk officers or chief economists issued severe warnings to their boards or whether central banks did so other than buried in their stability reviews? There were warnings, lots of them, but whether they were sufficiently strongly worded or taken full account of by banks, or whether the banks thought it was too late anyway to avoid the storms ahead, we don't know.
It is three years since the run on Northern Rock, the UK bank most reliant on short to medium term borrowings to fund its very large gap between deposits and loans. It could not book its next quarter's borrowings and could not envisage paying the higher spread demanded and temporarily losing its profit or changing its business model. Over the year that followed, US banks and EU banks were dragged into a vortex led by those most exposed to refinancing their own maturing securities. Then, when Lehman Brothers was allowed to collapse funding margins spiked and interbank money market deals failed to complete on a massive scale. 
Governments had no choice but to intervene on an equally massive scale, essentially by stepping into the vacuum wherever the private sector failed to fill the gaps in balancing both sides of banks' balance sheets, the gaps on the liabilities side of the balance sheets, that side that banking regulation had been least diligently concerned about!What has changed in the interim 2-3 years to make the global financial system safer, better risk diversified, and prepared to change culture? The answer is not a whole lot so far. Why, because the general idea that everyone seems to have is to get back to normal, to how it was before the credit crunch and recession. But that 'normality' is not available and cannot be for some more years; the macro-economy balances of the world and in each country has changed. Therefore, banks have to change their lending profiles and their risk diversification - are they on the job of figuring that out? Banks are still in a stunned reaction, recoiling from lending like anyone would recoil from a fire after getting their fingers burned, or maybe like a seabird still dripping in oil. They are desperately cutting costs before looking for new business, defending deleveraging on the basis that they have a fiduciary responsibility to lend only to borrowers who they can be sure will pay back. What they cannot face is the accusation that if the banks all do this it is a systemic risk to all of them via the underlying macro-economy. How many SME firms on whom economies rely for most job-creation see banks collectively as their biggest single risk factors?
The regulators want more detergent, fire-retardant hoses and fire-guards installed and bankers to wear oven gloves - but above all they want well-head caps on risk-taking, on leverage and on 'own portfolio' speculative trading that is seen as detracting from and displacing banks' proper focus on traditional 'transmission mechanism' banking, that of converting deposits into loans. From the perspective of the banks they are being burdened with requirements that their systems have great difficulty processing. As I often repeat, most if not all banks need new general ledger systems with full risk accounting and have great problems obtaining solutions that work accurately and cleanly. The system suppliers are over-stretched and the banks are over-stretched - intellectually and technically. regulatory standards are one thing, but technical standards expressed in reliable templates and detailed blueprints that can be safely implemented are quite another. I doubt any major bank can say hand on heart that either their credit risk or market risk accounting and analytics grown from the bottom up, deal by deal, account by account, are totally fit for purpose.
Banks have increased their capital reserves and economic capital buffers and liquidity reserves. Before the credit crunch minimum regulatory capital reserve (Tier 1 common capital to risk-weighted assets ratio historically stood at 7¼% over 1997–2007 for all FDIC banks in the U.S.) compared to a requirement of 8%. You can monitor this by looking at total US banks reserve capital, which should be no less than $1 trillion where banks' domestic assets are roughly 100% of GDP, and about $2tn in the EU where banks' domestic assets are 100-200% of GDP.
In Q2 2009, the U.S. Supervisory Capital Assessment Program (SCAP) performed the stress tests to assess risks faced by banks, assumed a target of 4% Tier 1 common capital (before supplementary capital) to total loan assets ratio, which is lower than the historical standard but should be equivalent roughly to an 8% ratio to risk-weighted assets. The SCAP also assessed the capital needs of the largest 19 Bank Holding Companies (BHCs) under pessimistic scenarios. To achieve a 4% ratio, it found that the banks needed $185bn in additional capital and estimated that all U.S. banks would need $275bn of additional capital to maintain a 4% ratio (tangible common equity or 'own capital' to tangible assets) or $500bn to maintain a 6% ratio, over the same period. Now, a year on, the IMF says small US banks needs another $76bn in reserves. But FDIC has this surely under close monitoring control?
Europe's banks have been subjected to a similar stress test that, however mild it might be at least comes on top of a crisis stressful period and shows us that even given sovereign debt issues, the exposures to loss in further adverse scenarios (double-dip so-called) should in net terms be relatively mild, or actually trivial, because banks are more risk-diverse than before. How they have achieved this is arguably economically damaging because the banks shrank their loan-books to all classes of borrowers (except Government) and run off amortising loans, cancelled undrawn overdrafts, sold operating units and other assets, and shrunk their 'own portfolio' trading exposures.Regulators are concerned to improve banks' safety margins, like asking them to install two-stage airbags to cope with head-on collisions.
This week, regulators set new standards for bank capital and liquidity, except that the Bank for International Settlements (the global authority in these matters) has, according to most of the media commentary, diluted earlier proposals and gave banks eight years to comply. This is not so. BIS has insisted on a longer parallel working period of reporting both old and new reserve ratios, before the new ones are the only only ratios. The time frame of 8 years will take us into the next cyclical downturns and recessions if the past is any guide. The idea expostulated by politicians is that the new safety standards will mean that the governments' ambulance services and fire brigades (central banks and treasuries) will not be required to save anyone next time. No one who know anything should truly believe that, nor should they want that to be true, in my opinion. Why would bankers listen to central banks and regulators if they are no longer to act as lenders of last resort, ready, willing and able to intervene to save the banks.
This is where the moral hazard argument falls down. The moral hazard argument supposes that if important banks know they will be saved from insolvency they then indulge in excessive risk-taking. But, against this, is the argument that there remain plenty of disincentives against excessive foolishness and furthermore, regulatory and government authorities exert a full market price for saving banks and without this role of final guarantor of banks, which includes rights to exert penalties, why should banks be motivated to listen to central banks and regulators and to follow their advice about systemic risks?
What were the leverage ratios before the credit crunch?
The fact is that leverage is not a precise science and has many issues below the simple ratios taken straight from the balance sheet.Governments are in the business of protecting vital interests and these include major banks. Who can envisage an economy where major banks are not vital economic interests? There are restrictions on them in the Frank-Dodd US Banking Bill, in various measures being worked on in the EU, and in the UK the government has formed a commission under Sir John Vickers (Martin Wolf, the FT economics columnist, is among its members and I'm providing briefing papers) to consider whether big high street banks should be split? The impressive but Future of Banking Commission that involved many politicians, experts and submissions from bankers advocated splitting investment from traditional banking. Vince Cable, the business secretary, supports the idea but is at present most concerned to persuade banks to lend more not less to small businesses. Such issues may be re-manufactured as tradable levers? Arguably such policy issues were traded in the compromises in the Frank-Dodd bill over the Volcker Rule. All this is about seeing in the iceberg above the waves, in what is in public view, the true scale and structure of what lies below. Regulation is also about making such matters more transparent and there is inevitably a conflict between what is systemically important to show, what is necessary for shareholders to know, and what is commercially sensitive or only for the regulators to see, and therefore not even subject to Freedom of Information Acts?
BIS is above such things, one imagines, but it does see the technical and timing issues of enforcing major changes all at once on the whole banking sector. Some of the reform issues are significant but relatively minor or merely technical such as reducing hybrid instruments in Tier 1 capital. The FT says "It is extremely hard to understand what “mortgage servicing rights” and “deferred tax assets” are, let alone what use they will be to any bank when the next crisis blows up, as it inevitably will." But, these are straightforward matters of what counts as usable revenue sources to predict net cash-flow and internally-generated capital. The FT says, "Yet the BIS succumbed to pressure from Germany and France not to be too hard on their banks by allowing both these oddities to count towards core capital." I don't see that - the matters are simple ones of what is operating revenue? In the case of deferred tax, obviously this is available capital if it reduces with bookable losses.Regulatory changes (up to about 100 by my reckoning) to respond to banks’ misjudgments and deceptions (including self-deceptions) are still in process, inviting comment and further analysis. Many legal actions are in train that will take years to process through the courts and court judgements will add to regulatory law.
As the FT rightly comments, "By and large, however, as they break for the summer with their bonuses and jobs intact, bankers can reflect that it could have been a great deal worse. Conversely, the rest of us are left to wonder how all that regulatory resolve slipped away?"
The Ft says, "reforms are not only inconsistent but – particularly in the case of the BIS – have a lowest common denominator feel. Taken as a whole, they only go a small way towards addressing the two problems made obvious by the 2008 crisis: that global banks are too big and too interconnected to be allowed to fail." I disagree; they are not inconsistent. There are inevitably some national and even regional variations, but most reforms are merely fleshing out what is already in Pillar II of Basel II.
The above graphic of the supervisory process that is Pillar II typically underplays the key element that is the biggest challenge which is how to macro-economically model and forecast under different scenarios the banks exposures and performance relative to economic factors.
Modelling all the above and a lot more is technically daunting and stretches banks' intellectual resources to the maximum. The more regulators agree with that view the more they will think simplifying banks is a very good idea. And maybe they are right, maybe large banks have not just become too big to fail but too complex to manage? John Gapper of the FT, reflecting the views of many writes, "The most disappointing aspect of the reforms is how easily these banks have brushed aside the obvious solution – to break them up into retail and investment banking operations. That would help to curb excessive risk-taking subsidised by retail deposits and taxpayer guarantees – what Martin Taylor, former chief executive of Barclays, calls investment banking divisions’ “parasitic” nature." 'Parasitic nature' maybe, but this is not obviously a solution - we do not yet know enough about it. Paul Volcker, the former chairman of the Federal Reserve, did include his 'rule' in US financial reforms provisions to ban proprietary trading at large banks and force them to limit exposure to 'alternative investments', hedge funds and private equity. But, we have yet to see a full analysis of what this means.BIS in its report this week says other structural reforms are needed to curb incentives for banks to keep on getting bigger, more complex and more macro-economically powerful. My view is that the banks need to be guided by regulators forcefully to risk diversify better across the whole of the economies they serve. This idea is currently drowned out by the idea that banks are too burdensome on taxpayers, while in my opinion this view has failed to see how well taxpayers have been protected in the nature of the measures that governments and central banks have taken, and can repeat again in the future.
It is relatively easy for banks to define organigrams to cope with all operating lines of business and risk factors, but a totally different task to combine all of that into a holistic view and then take decisions based on how 'the risk appetite' (a much over-used yet vital term about which bankers have very poor understanding) is an altogether different problem. here is the risk organigram of troubled Commerzbank, which is not especially different from any other large bank.
The US is looking for new legal powers including to be agreed internationally to regulators to collaborate to be able to seize and break up very large financial institutions (as they contemplated doing with Citigroup until the FDIC pointed to the many cross-border legal problems of a bank with half its assets abroad) that they deem to be in severe solvency trouble, as well as insisting on banks preparing their own “living wills” to simplify how their internal group structures so that financial restructuring or breaking up is easier Nearly two years since Lehmans went bust and the shell broken up between Barclays and Nomura, we now hear that its financial balance sheet may be unravelling profitably? hence, it is clear that insolvency can be a difficult matter to judge. What was true however was that Lehmans' net cash-flow had petered out and in the short term it was technically bust. Some US politicians suppose that new laws will end the “too big to fail” problem but that is surely a naive and vain hope.The US problem banks appear to be currently concentrated among small banks with assets of under $1bn, many small local banks with less than $0.5bn. Private equity and vulture funds looked at buying these as entry into banking, but now that looks less attractive, an entry cost problem new entrants find everywhere, the cost of capital adequacy, and yet the set up cost of a bank from scratch is also daunting. But when all banks need new core banking systems to accommodate risk accounting and transition from US GAAP to IFRS accounting standards, and when most banks have zero or very little brand value, building a new bank from scratch looks relatively sensible. essentially a traditional bank should have a balance sheet that may be viewed succinctly and where connection between different lines and sides of the balance sheet may be known and the factors driving the performance (the net interest and other income) should be easy to model for different scenario forecasts. But, of course, even that is quite a complicated task, even for such a simple bank as the balance sheet below:
In the UK, some networks are for sale, but new 'green field' banks formed by JS Flowers, Virgin, Tesco, Blackstone and other groupings that may or may not buy existing networks as well. In the USA, Apollo is taking advantage of a change that allows banks to operate in multiple US states without a national charter. It has $55bn under management, and hired a team from Countrywide Financial, and is awaiting regulatory approval. It is asking its investors to put money in the new bank, which will have a separate board and operate independently of Apollo. Like others keen to own banks who believe they can set up a new more attractive customer service model, Apollo has a back-to-basics model based on the belief that bank lending will become more important as capital markets lessen in importance and so long as the securitisation market remains frozen.Most private equity groups appear to have abandoned plans to create banks based on buying FDIC 'saved' banks that were thought could be lucrative 'fire-sale' deals. In FDIC auctions, it became clear FDIC preferred strategic banking sector buyers over private equity groups, probably because the former offered better prices.
Blackstone last week said it had “changed focus from assisted bank deals”. Others ar looking at buying minority stake in banks for sale.
If the biggest banks are too big to be allowed to fail that is certainly not the case for small banks. And yet their failure can be traumatic for local communities and need protection of regulatory oversight that the FDIC provides.
Regulators can impose limits through capital, leverage and liquidity rules, and by refusing to accept banks' risk accounting. Auditors do not audit banks' risk accounting - only regulators do this. In my view banks' quarterly and annual reports should be signed off by both regulators as well as auditors. But, until now, regulators lack sufficient resources to risk-audit all banks. they should however be able to audit the biggest banks and to provide published opinion in the banks' financial reports. That would go far in ensuring banks listen carefully to the regulators. All this is a lot more than just about over-leveraging by banks, so called exuberant risk-taking. Over-leveraging is a blanket concern but it remains a subjective judgement until precise studies are published that look at all major risk factors and can size and sequence them. The regulators have to equip themselves with precise analytical tools and make these work in the wider context of systemic risk.
Over-leveraging is a factor "among other things" as th e FT's John Gapper rightly caveats. The links between investment banking, especially 'own portfolio' trading, and traditional retail and commercial banking, how these worked, have yet to be rigorously examined. It is generally adjudged so far on the basis that the higher the leverage the bigger trading books are in banks' assets - hence, less own portfolio trading means lower leverage means safer banks - if matters were so simple.
Insolvency risks in a systemic risk crises hit all banks, small as well as big. Property bubbles bursting can hit small retail banks and building societies or mortgage banks most, as we saw spectacularly in Japan in the early '90s and asian banks in the late '90s and western banks in recent years. Credit crunch hit those banks with maturing debt that had grown recently fastest and had to refresh their borrowing in the middle of the credit crunch. 
Arbitraging between what is in trading books or banking books given the much lower capital reserve required to support trading book value at risk compared to banking book credits is being squeezed by new regulations that should triple the capital reserve for banks' trading books and arguably by other regulatory requirements and accounting treatments that are still feeding through into banks' implementations. We should see a reversal therefore of the growth in trading books versus banking books in banks' total assets.
The above factors may appear more important than national leverage and sovereign risk, but while this is less obvious to track and more a problem after the fact of the credit crunch, it is an area into which funders' risk assessments now appear to be focused, even if, as I believe, the sovereign risk crisis is hysterically over-blown, not least because of the opportunities that debt-shorters see in the turbulence of the sovereign debt markets. 
It may be that the bigger issues are really to be found in the area of management systems and management skill, in insufficient macroeconomics education as well as lack of in-depth regulatory risk training of senior bankers, especially of those in the boardrooms. Attendant on that is the question of not just whether boardrooms can steer the risk appetite of large banks in and across all their constituent business units and franchises, but how is it that they actually do this? Are executive boards and supervisory boards truly in masterful control of large banks or are they dogs wagged by their tails instead of being led by their heads?
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