Magic Banking

Based on an idea as presented in a joshing blog by Henry Blodge, CEO of The Business Insider, here's the slightly changed formula for making thousands of investors happy, becoming a millionaire within months while having a successful career as well.

Become a banker!
All it takes, is to start a new bank. Don't worry, it's simple as will be shown.

This is how it works:

1. Form a cooperative bank called: Cooperative Magic Bank (CMB).
   A cooperative bank is a financial entity which belongs to its members, who are at the same time the owners (shareholders) and the customers of their bank.
2. Appoint yourself CFO together with two of your best friends as Board members. Set your yearly Board Bonus at a modest 10% of CMB's profits.
   
3. Make a business plan (this blog IS the business plan)
   
4. Raise $ 100 million of equity and $ 900 million of deposits, as follows
• Offer your prospects/clients a guaranteed 4.57% guaranteed return on investment.
  
• Offer a 70% yearly profit share. First year return on investment guaranteed 13,35% !
  
• Everybody who wants to join the bank becomes a 'Lucky-Customer-Owner' (LCO)
• Every LCO is obliged to invest 10% of his investment as shareholder capital.
• The other 90% is invested in the CMB-Investment Fund (CMBIF).
• CBMIF guarantees the return (and value) on the LCO's account based on a 30 year Treasury Bond
5. Borrow $3 billion from the Fed at an annual cost (Federal Discount Rate) of x=0.75%.
6. Buy $4 billion of 30-year Treasury Bonds paying y=4.57%
7. Ready! Sit back and enjoy high client satisfaction and your Risk Free career and bonuses as a professional banker!

Magic Banking
Wrapped up in a 'Opening Balance Sheet and a first year ''Income Statement', this is how it looks like:


This is how the FED helps you to become a millionaire. but the party is not yet over.....

Pension Funds and Insurance Companies
If your the owner of a pension fund or an insurance company, starting a 'Magic Bank' could help you achieve a total 'risk free' return of 4,57% with an upward potential of 13,35% as well.

So why should you set up a complex investment model that you don't really see through, to achieve a risky 6% or 8% of return on investment, if you can have more than a 'high school comprehensible' 10% return without any substantial downside risk by starting a Magic Bank instead?

Together with the new Basel and Solvency regulation, this 'magic bank principle' will cause banks to sell their investments in more risky assets like insurance companies. On the other hand, insurance companies and pension funds will probably be interested in starting new banks to profit from the FED's 'free credit lunch'.

Criticasters and Risk
Some criticasters will rightfully point out that the magic bank is not completely risk free. Indeed there are some risks (e.g. the treasury bond volatility), but they can be adequately (low cost) managed by means of stripping or derivatives (e.g. swaptions).

Of course there's also the risk that the Fed will raise the short rates (Federal Discount Rate).In this case, instead of using derivatives upfront, one might simply swap or (temporarily) pay off the FED loan. Yes, your return will temporarily shrink to a somewhat lower level. But who cares?

Moreover, keep in mind that as long as we're in this crisis, the Fed's short money will be cheap. Don't ask why, just profit! By the time the crisis is over and Federal discount rates are more in line again with treasury notes, simply change your strategy again.

And if - regrettably - the federal discount rate and the treasury bond rate rise at the same time, simply book a life time trip to a save sunny island to enjoy your 'early pension' of $ 11.1 million (ore more).

For those of you who still doubt and for all of you who like a humorous crash course in investment banking, just click on the next video by Bird & Fortune....

Banking crash course

Let's get serious
Although for us actuaries it's clear that because of the Asset Liability Mismatch, the magical bank is a running gag, the principles and consequences of the situation as described above are bad for the economy.

Financial Health Management
Banks and financial institutions in general are discouraged to act in their primary role as risk transfer institutes by performing on bases of professional calculated risk.

Why would they take any additional (credit) risk if they can generate their revenues almost 'risk free' with help of the Fed?

We all know that without risk, there's no economic added value either. Continuing this Fed policy will lead to Bob hopes:

A bank is a place that will lend you money, if you can prove that you don't need it.

Maintaining the current Fed policy keeps the banks alive, but ill.

What's needed is a new Federal Financial Health policy.

Over the last decades the relative equity (equity in % of assets) of Banks deteriorated from a 20% level to a 3-5% level in this last decade.

Banks need to be stimulated to take appropriate healthy risks again, while maintaining a sound individual calculated 'equity to assets ratio', increased with an all over (additional) 5% risk margin.

The Fed should therefore act decisively and:

• stop the ridicule and seducing leverage risk levels
  Redefine the Capital Adequacy Ratio (CAR). The new Basel III leverage, calculated as 'total adjusted assets divided by Tier 1 capital', won't do. Strip the nuances, limit 'adjusting', add a surplus.
  
• Limit and make all new financial products subject to (Fed) approval
  
• Limit the proportion of participating in products that only spread risk (e.g. Citi's CLX) instead of neutralizing or matching risk
• Raise the discount rate as fast as possible,

to prevent moral hazard and economical laziness that eventually undoubtedly ends in a global economic melt down.

However, there's one small problem..... The FED has to keep the discount rate low because otherwise financial institutions that run into trouble aren't able to finance their loss in a cheap way and will activate the nuclear systemic risk bomb (chain reaction).

It seems we're totally stuck in a governmental financial policy paradox. Nevertheless the FED should act now!

Links:
- Henry Blodge Video on Modern marketing...
- 30 year treasury bonds
- Historical Federal discount rates
- Can Basel III Work?
- The Economist: Base Camp Basel (2010)
- Citi's Financial Crisis Derivatives Should Be Banished From Earth
- Capital Adequacy Ratio (CAR)
- Treasury yields

Whistleblower Risk Management

We all know Risk Management is key in our business.


Yet, almost all risk models (e.g. Coso) emphasize mainly on known or knowable risks.



Of course, as we could have seen in the 2008 credit crisis, the art of Risk management is in managing the unknown or unknowable risks.

But how?


Let's try to learn from two main major accidents:

I. The Challenger shuttle disaster (1986)
The accident was caused by failing O-Rings. Warnings of many engineers were overruled and ignored. This crash was the consequence of a typical effect called GROUPTHINK. Groups naturally look for consensus and will often come up with a false consensus, even when individual members disagree.
Watch a video of the space shuttle Challenger disaster that illustrates this GROUPTHINK phenomenon.

Other examples are the Columbia shuttle disaster and the 9/11 attacks. In all cases Management failed because the information suggesting a disaster was weakly transmitted within an bureaucratic system, and managers failed to authorize action because of bad communication and performance or time pressure.

II. The 2008 credit crisis

• Underestimating early signals
  The first indication of the coming credit crisis was the collapse of Enron in 2003, uncovered by whistleblower Sherron Watkins.
  
  After the collapse, the FED refused to come out with new 'rules based' guidelines . A Senate investigation showed that - starting already in 2000 - some major U.S. financial institutions had "deliberately misused structured finance techniques". But the Fed and the SEC underestimated the situation, kept to their 'principles based' system and consequently missed the opportunity to to flex their muscle by regulating market conditions for subprime mortgages.
  
  Lesson: It's not about 'rules OR principles', Football Or Soccer, but it's about 'Rules AND Principles'.
  
  

• Mixed Central Banks (FED) responsibilities
  Central Banks, The Fed in particular, have at the same time two main responsibilities with regard to (other) financial institutions:
  1. Supervision
  2. Providing financial (banking) services
  
  Those two functions clearly conflict with each other. It's impossible to independently supervise the financial company you're financing at the same time. Supervisory advises will be suspicious by definition.
  
  Secondly you can't supervise yourself as central bank. Therefore, every country needs an independent (that is 'without central bank board members'), professional supervisory board, that audits and supervises the central bank and the national bailout plan(s).
  
  
• Whistleblowers
  How could the credit crisis technically happen?
  Not an official, but a more outside kind of whistleblower, businessman Warren Buffet, warns in a 2003 BBC article that “Derivatives are financial weapons of mass destruction and contracts devised by madmen". The financial world isn't listening.
  
  Derivatives like Collateralised Debt Obligations (CDO's,) were developed to (re)fund the subprime loans. CDO's are packaged portfolios of credit risk, made up from different sliced and diced loans and bonds. They were hard to uncover without a whistleblower. At last an anonymous banker e-mails journalist Gillian Tett of the Financial Times about the situation. Only after she publices early 2007 what's wrong, the dices start rolling. This case also stresses the important role of journalism and whistleblowers in our aim for a healthy transparent financial market.
  
  
• The Greed Game
  One can argue about the roots of the credit crisis. However, essential in the 2008 credit crisis were, or still are, the excessive remuneration practices at private equity companies, hedge funds and banks. They encouraged unhealthy and excessive risk-taking. Key is the lack of balance between possible earnings and possible losses of board members.
  
  To prevent unhealthy pressure management (with groupthink effects), board members' total rewards should always be in line with the long term realized added value of the company and not be based on yearly P&L profits or short term added value.
  

Manage the unknown risks
Risk Management is not a static, but a dynamic process.

To gain and behold control of the unknown risks, it's necessary to create a transparent organization and company-process that guarantees whistleblowers' and whisperers' (= whistleblowers, that wish to stay anonymous) safety and encourages and even rewards compliance reports from employees, clients or any other stakeholders.

Because of GROUPTHINK and - on the other hand - possible negative employee outcomes (demotion, dismissal, etc) in case a reported compliance issue turns out to be compliant after all, it's important that whistleblowers are always given the opportunity to report directly, anonymously and safely to the independent federal Supervisor. Employees must have the choice to report internal within their company (small compliance matters) or to report directly to the federal Supervisory board.

Conclusions

• Separate the Supervisory and Financial Services functions of the central banks (FED)
  
  
• Redesign whistleblowers management
  Whistleblowers should have the opportunity to report compliance issues directly and anonimously to an independent federal Supervisory board.
  
  Whistleblowers that choose to report within a company, should always directly reporte to the compliance officer, the executive board and the supervisory board. On top of this they should always, especially in case of discharge, dismissal or demotion, have the right to escalate to the federal Supervisor.
  
  
• Change supervisory procedures and criteria
  Approval of (company) board members by the federal Supervisor should als be based upon:
  
  1. The 'ethical track record' of a candidate
  2. The feasibility of, in macro economic perspective, "realistic and balanced" board member performance parameters.
     
     The federal Supervisor should audit and approve the existence of a consistent 'company reward plan' that guarantees a sound and measurable balance between long term company results and board member rewards.
     
     CEO's that haven't established measurable long term added value for their company, shouldn't receive any bonus or golden parachute at all.