Tuesday, November 13, 2007

Do financial risks add up to a constant number?

I am no physicist and one my main frustrations is how little I really get to understand of what the greatest thinker that has coincided with my life span, Albert Einstein, explains, and therefore I might be completely off the wall when I refer to having heard something like that the mass of the university, though it can take many shapes, is by the end of the day always a constant number.

Nonetheless these line of thoughts have lately crossed my more financially oriented mind when exposed to facts that seems to suggest that no matter what we do with the risks, no matter how we hedge them, no matter where we hide them, at the end of the day their amount could remain a constant.

If this proves correct then it must have great implications for how we design or perhaps even abandon our efforts to design our regulatory systems. At least it would not be so easy for our current bank regulators to go into their total immersion of risk adverseness, expecting to be applauded, if we knew that all they were doing was pushing the risks around.

Facts about our current financial turmoil

Fact 1a: Without the blessing of the credit rating agencies the lousily awarded mortgages to subprime lenders would never have been able to go global and turn into a tsunami.

Fact 1b: It was the short-sighted bank regulators who appointed the credit rating agencies as their imperial credit risks overseers even though they must have known this entailed severe systemic risk creation.

Fact 2a: If the banks have kept the mortgages on their books they would have been much more observant about what was going on and never ever would so many lousy mortgages to subprime lenders been awarded.

Fact 2b: It was the short-sighted bank regulators who through their minimum capital requirements and that were exclusively based on risk perceptions induced the banks to place their assets elsewhere.

Fact 3: As always small fish like mortgage brokers will carry the full blame while the real intellectual perpetuators will go free.

Monday, October 1, 2007

Are the bank regulations coming from Basle good for development?

The document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007, as a member of New Rules for Global Finance.

ARE THE BASEL BANK REGULATIONS GOOD FOR DEVELOPMENT?

1. It is very sad when a developed nation decides making risk-adverseness the primary goal of their banking system and places itself voluntarily on a downward slope, since risk taking is an integral part of its economic vitality, but it is a real tragedy when developing countries copycats that and falls into the trap of calling it quits.

2. In his book “Money: Whence it came, where it went” (1975), John Kenneth Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment. Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.

3. Few things can be so relevant to the financing of development as the regulations that are being applied to commercial banks. Unfortunately, as the world has been quite infatuated with the banking regulations emanating from Basel ; as they seemingly kept the bank crisis at bay so efficiently –although some of us believe they seemed more destined to stop the small tremors than to help to avoid the big quakes, or what in recent Alan Greenspan terminology would amount to a lack of "benevolent turbulence"– there has been no room to question the basic principles of the regulations, much less so from the perspective of developing countries that "needed" to be "saved" from their recurring bank crises.

4. As a former Executive Director at the World Bank (2002-2004) who tried to voice this issue frequently, among others at an ECOSOC-Bretton Woods-WTO meeting at the UN in April 2004, I can testify to the difficulties.

5. Some specific problems, such as the possible reinforcement of the pro-cyclicality of bank lending, and some specifics of the Basel II reforms such as its high costs, which could give the larger banks a comparative advantage, have been recorded as discussed, though resulting in nothing special of practical consequence. We should also comment that it is a bit surrealistic to debate the Basel II reforms without ever having entered into and much less exhausted the discussions on the fundamental principles imbedded in Basel I, which clearly contain the genesis of a series of factors that could affect the financing of development.

6. The recent financial turmoil that has cast some serious shadows on some of the Basel operational methods, for instance the high reliance on credit rating agencies, can perhaps now provide us with the opportunity to ask and debate "Are the bank regulations coming out from Basel truly compatible with the best interests of developing countries?" It is in this vein that we would like to start by raising the following issues:


Current regulatory arbitrage favors risk adverseness

7. The bank regulations that come out from Basel are almost exclusively against-risks-at-any-cost driven and so they completely ignore the other two major functions of banking systems, namely to help generate growth and to distribute opportunities.[1] The fact that in a developing society there are some risks more worthy to take than others is completely ignored in the minimum capital requirements ordained by Basel. The argument that "a stable banking system is critical to the long-term growth of an economy" is repeated like a mantra with no consideration of the stage of development and circle of growth in which a country finds itself.

8. Credits deemed to have a low default or collection risk will intrinsically always have the advantage of being better perceived and therefore being charged lower interest rates, precisely because they are lower risk. But, the minimum capital requirements of the Basel regulations, by additionally rewarding "low risk" with the cost saving benefits resulting from lower capital requirements, are unduly leveraging the attractiveness of "low risk" when compared to "higher risk" financing.

9. Allow us to illustrate this central argument in a very simplified way. Under the current Basel I Standardized Approach, a low risk corporate loan (rated AAA to AA-) requires a bank to hold only 20% of the basic 8% capital requirement, meaning 1.6 in units of capital, while a much riskier loan (rated below BB-) requires it to hold 150% of the basic 8%, meaning 12 units of capital. If the current cost of capital for the bank is 15%, then the bank's carrying cost for the low risk credit is 0.24% (8%*20%*15%) while the bank's carrying cost for the high risk credit is 1.80% (8%.150%*15%), thereby producing an additional cost of 1.56% that must be added on to the normal spread that the market already requires from a high risk compared to a low risk loan in a free market.

10. The extra Basel spread on risk makes it more difficult for higher risk borrowing needs to have access to credit from the commercial banks. In a developed country this might not be so serious because there are other alternative sources, but in a developing economy this is fatal, as the commercial banks frequently represent the only formal and supervised source of finance.

11. And of course the Basel effect does not limit itself to the extra carrying cost. From the perspective of the balance sheet we see that each unit of bank capital can sustain 62.5 units of low risk lending but only 8.3 units of high risk lending, and since bank capital itself is more scarce in a developing country, this also induces channeling of local savings increasingly towards the low risk side of the economy.

12. In Basel II, while the "Internal Ratings-Based Approach" provides a much more refined instrument for assessing risks it creates even more bias against risk, much the same as a health insurance scheme is able to offer more differentiated rates the more they know or think they know about the expected health prospects of their clients. We should not ignore that the finance of development requires the current generation to be willing to share in the risks of the future so as to help the society and coming generations to progress. In this respect the Basel risk adverseness could be described as a baby-boomer generation's invention to assure that their savings are there when they need them, with little consideration to what might come after.

13. By adding on a new layer of sophistication and digging deeper in the hole created by Basel I, Basel II will ironically increase the possibilities of new systemic risks and make the fight against the risks targeted by the Basel Committee even more difficult. This particular problem lies outside the context of this paper but for those interested we refer to the Statement number 160 of the Shadow Financial Regulatory Committee, March 2000,[2] where they propose instead the more logical route of harnessing more market discipline by using subordinated debt to make capital requirements more risk sensitive.

14. We are by no means implying that the risks in lending should be taken lightly, but since development normally does not make a living in the land of low risks, much the contrary, this regulatory arbitrage of overly benefiting risk adverseness, and adding on costs, is very costly for development. In short, Basel provides economic signals for maintaining the status quo rather than fostering development.

15. In this respect, and since the current Basel II proposals do contain much that could stimulate the banks to better quantify and manage risk, an alternative that could perhaps provide some of the benefits with less regulatory-ordered bias would be to require a flat percentage of assets as the capital requirement for the banks but forcing them to report to the market a Basel-calculated minimum capital, thereby allowing the market participants, investors or depositors, to price in their views on the differences between these two figures. Going this route would also diminish the quite dangerous possibility that the markets begin to believe that the Basel minimum capital requirements constitute a perfect risk equalization machine among banks with totally different risk structures.

16. As much of the risk management used by Basel is based on the analysis of old data, so as to establish loss probabilities, we also need to acknowledge the fact that a desired future does not stand on past statistical data, much less in the case of developing countries where that past statistical data refers precisely to what should be avoided in the future, and bears little relevance to what needs to be done.

17. But again we wish to make absolutely clear that this is NOT a proposal to abolish the Basel minimum capital requirements outright, but rather to study its other social costs in order to contain these or develop alternative methods that better balance the different societal objectives for the banks.

Current regulatory arbitrage leads to risk hiding

18. An excessive anti-risk bias will naturally stimulate risk hiding. Let us not forget that the need for assets to be qualified as more or less risky is exactly the reason why the credit rating agencies were so much empowered that now we also have the credit rating agencies bias risk, which already helped to create the sub-prime mortgages debacle.

19. One of the dangers for a developing country, where regulatory weaknesses might be more easily exploitable, is that the banks deviate all assets that in their opinion carry a lower capital requirement than what the regulator-credit rating agencies order into other formal or informal places of the market, while loading up their balance sheet with assets for which the risk/capital allocation seems a bargain; giving new meaning to the Thomas Gresham's principle that states that "bad money drives out good money.”

20. The mentioned risks are clearly not limited to developing countries and we can find a discussion of it in the context of developed countries in a speech of Alan Greenspan on "The Role of Capital in Optimal Banking Supervision and Regulation"[3] in 1998.

Excessive empowerment of new participants

21. Credit rating agencies. The Basel I Standardized Approach regulations led to the credit-rating agencies substituting for some of the traditional in-house credit analyst departments in local banks which, for better or for worse, had allowed credit analysis to be more colored by local factors. This has affected the whole credit environment, and the recent drive towards "development banks" and the establishing of the micro credit institutions can be seen in great part as efforts to satisfy needs created by the Basel inspired bank regulations.

22. It is indeed very difficult for developing countries to understand how authorities that have frequently preached to them the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies, especially as this must surely be setting us up for very serious new systemic errors.

23. Powers to the Supervisors. The Basel II "Internal Ratings-Based Approach" returns much of the credit analysis to the banks themselves, where it belongs, but in doing so it generates a series of new hands-on activities for bank supervisors who will need to consent, concur, approve and what have you, and which can only create new sources of distortions. In this respect suffice it to read the book by James R. Barth, Gerard Caprio, Jr. and Ross Levine, "Rethinking Bank Regulations: Till Angels Govern" [4] to reflect on the possible consequences.

We need much more research

24. When looking at how consumer credit is growing fast in so many developing countries, mainly because it can be more easily packaged (or camouflaged) as a low risk operation while traditional entrepreneurial credits barely skimp along, it would be natural to ask whether this could not be the direct result of the Basel regulations.

25. Could Basel be hindering development finance? What are the consequences of regulatory arbitrated risk adverseness? Is Basel introducing a bias in favor of public sector finance? Could the paradox of the increasing net outward financial flows from developing to developed countries be in any way related to these regulations?

26. These are all vital questions but there seems to be no ongoing research to try to understand how global financial flows have been affected by the Basel regulations and by the use of the credit rating agencies. The topic seems almost taboo, but given the importance of banking regulations for the financing of development, we would urge giving more priority to the research of these issues.

Who is the lender of last resort?

27. One concern, much aggravated by the new Basel II regulations, is that the world might have been irrevocably placed on a route that leads it to end up with just a couple of big international banks. In such a case, if one of these banks that have captured a very large share of local deposits in a developing country runs into problems, who is the real lender of last resort? Is the European Central Bank, for instance, willing to furnish Latin American countries with at least a letter of intent to provide support if a European-owned bank runs into problems while working in Latin America? Clearly there is an urgent need for close international collaboration on this matter.

28. The issue of a possible tendency to have fewer banks, which would seem to imply that damages caused by an individual bank default could grow as a result of upping the ante, also raises the question of why this is not considered by Basel. If the Basel risk assessment methodology favors a diversification in the portfolio of a particular bank, then shouldn’t society, and the lender of last resort, also apply this criteria to their own portfolio of banks? Is there not a need for an additional capital requirement based on the individual bank's market share?

What can be done?
29. There are no easy answers, but to discuss these problems openly and candidly is as good a start as any, and so therefore these questions and issues need to be brought to the forefront of the discussions, like for example:

30. Can and should the minimum capital requirements be supplemented or complemented in such a way as to neutralize the risk adverseness of current regulation by, for instance, providing an adjustment for credits destined to create jobs? If the bank regulators of the world insist on imposing the criteria of the credit rating agencies, should we development agents request the presence of our development rating agencies and distribution of opportunities rating agencies?

31. Instead of using the differences in the perceived risks of the credits to determine the formal capital requirements an alternative is to apply an equal percentage to all the assets of the bank but then having the banks to report something similar to a Basle risk valuation as an additional transparent information reference. Although this approach looks to incorporate a more holistic market view than the strictly risk related “subordinated debt route suggested by the Shadow Financial Regulatory Committee, there is nothing that stops it from being complementary to the former.

32. Some could argue that to rely on the markets is impossible in developing countries where markets are deemed to be non-existent or weak but the other side of that coin is that that constitutes precisely the reason for having to rely on whatever little market there is.

Who is debating?
33. Put together the chefs from many different countries and you might get a quite varied menu, but gather the brain-surgeons and there is not going to be a great deal of diversity in their opinions. One of the main problems in discussing the Basel issue, and more so of being able to introduce any changes, is the current lock-hold that central bankers and bank supervisors have on the debate. Sometimes it is argued that if developing countries are better represented in Basel, they will be better able to voice their development concerns, but if this representation of diversity is only to happen by convening experts from all around the world that profess the same principles and have the same mindset, then no matter where they come from, this will be a dead-end street.

34. The numerous comments made by Basel officials about the importance of not rushing the implementation of Basel II, would seem to indicate that experts from developing countries feel the pressure to be recognized as being just as up-to-date and risk-adverse as their peers in developed countries. This syndrome, that costs many developing countries dearly in many of their WTO negotiations, needs to be controlled by assuring the presence of professionals that have other interests beside bank regulations.

35. The World Bank, as a development institution, should have played a much more counterbalancing role in this debate, but unfortunately it has been often silenced in the name of the need to "harmonize" with the IMF. Likewise, the Financial Stability Forum is also, by its sheer composition and mission, too closely related to the Basel bank regulations to provide for an independent perspective, much less represent the special needs of developing countries. Therefore the introduction of independent development voices in the debate is absolutely crucial, and perhaps this could be arranged through a G77 or a G24 effort.

36. As evidence for the lack of inclusion of other points of view different from risk avoidance, let us just refer to the Policy Conclusion in the Report of the Secretary General on the International Financial System and Development dated July 6, 2007, where "surveillance" appears seven times and except for one reference to the development of the financial sector there is not a single word about development itself.

37. For the record, let us state that although we have made the above comments from the perspective of "finance for development," most of the criticism put forward is just as applicable to developed countries. In this respect it is interesting to note that in the United States there has been some serious questioning of whether those regulations are not too uniform as to be applicable to all of their banks.

38. To conclude, we wish to insist that no society can survive by simply maximizing risk avoidance; future generations will pay dearly for this current run to safety. So therefore, more than placing our trust in the banks’ financial standing, we need to trust in what the banks do. Let us make certain our bank regulations help us to do just that.
[3] Federal Reserve Bank of New York Economic Policy Review of October 1998.
[4] Cambridge University Press, 2006

This document was also reproduced in The Icfai University Journal of Banking Law Vol. VI No.4 October 2008


Monday, September 17, 2007

There’s an uproar in the Global Finance Park

The visitors are upset, they were promised a nice day in the park enjoying some risk free investments and now they find themselves running around frightened not finding anyone to tell them clearly how much they lost and how much they have left... and they are looking for the culprits.

First we have the credit rating agencies that were appointed as the official tour guides in this global financial theme park and led the crowds to instruments securitized by something called subprime mortgages and that in the end turned out to be just a trap of sub-primely awarded subprime mortgages.

Then there are the financial engineers who concocted many sophisticated attractions that offered to capture higher returns for lesser risk but that while designing these never took enough time off to figure out who were to compensate it all by taking more risk for less return.

Then we have the managers, the Central Bankers, who are running around in the park, not fully knowing who is in charge, for what when and where, ever since the attractions were spread out crisscrossing the whole park.

And then, behind the scene the Basel intellectuals, and who obsessed with driving bank risks out of banking thought they could achieve this by imposing some minimum capital requirements and monitoring it all from afar, just because they never walked the streets or real life enough to realize that risks, unlike old soldiers, never fade away they just go into hiding.

And then of course the salesmen, those extraordinary salesmen that build up what now reads like a pyramid scheme for the Guinness books of records and made billions in non-refundable commissions, most of these calculated using the same models that now are shown to be so lacking.

And we should not forget the theme park’s shareholders either, one of which coinciding with some of the attractions breaking down is also seeing some real unstable weather formation that could threaten his real economy.

As always, the hyenas are moving in drooling thinking of the fees to be made from just asking on behalf of the visitors for the proofs of the losses since let’s face it when you lose money in the stock market you might not understand why you lost it but you at least know you lost it, but when you lose money on contracts that are virtual in nature you might not even know for sure you lost it, you are just being told so.

To conclude, things do not look good at the Global Finance Park and to help put things in order we need some hardened and battle experienced financial sergeants to substitute for those many starred generals hanging around and that were just too arrogant to admit they simply did not understand what was going on.

What would I humbly suggest as some immediate measures?

Lowering the minimum capital requirements of the banks! The damage has already been done so let us use whatever life vests there are and not force the banks into wasting their time having to do more life vest procurement for now, at least until this emergency is over.

Concentrate all efforts on the real economy. There is nothing to be gained by keeping house prices high so that they are not affordable under tightened rules to any new buyers, the same way there is nothing to be gained from evicting a house owner from a house because he cannot service his current mortgage but could do so if he was a buyer at a revised lower price.

Whatever, don’t procrastinate. Like pulling out a tooth without anaesthesia the trick is doing it fast.

Thursday, September 6, 2007

Factors in the Financial Storm

David Ignatius, in his Sept. 2 op-ed, "The Real Causes of the Financial Storm," failed to mention the two lead actors in the financial mess we find ourselves in: the credit rating agencies, whose AAA ratings turned what should have remained a local problem involving some subprime lenders into a global financial storm; and, of course, the bank regulators who against all wisdom enabled the credit rating agencies to foist what they consider to be only their First Amendment-enabled opinions upon the markets.

In May 2003, as one of the 24 executive directors of the World Bank, and probably only because of that, I was invited to make some comments during a workshop arranged by the World Bank for bank regulators on assessing, managing and supervising financial risk. Along with offering some suggestions, I told the regulators, "I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit rating agencies. This sure must be setting us up for the mother of all systemic errors."

I never got invited to comment again.

Wednesday, August 22, 2007

But what are the non-professionals to do?

FT reporting August 22 on “IMF warns of risks to global growth” mentions that John Lipsky, the number two official at the International Monetary Fund, seemingly quite unseemly washing his hands in relation to the issue whether the credit rating agencies have done their job well said “The basic issue is that in the end, professional investors bear ultimate responsibility for risk assessment and management in a securitised market. It is not realistic to expect third parties to take that responsibility.”

There is of course nothing to object to that statement, c´est la vie, but it clearly leaves a question or two about what to do with all those who are not professional investors or that just thought they were and who followed the advice of the credit rating agencies just as the bank regulatory authorities, and the IMF, told them to do. Is the IMF now arguing for two lender of last resort now? One booth for the professionals and one for the credit rating agency followers?

Monday, August 13, 2007

Let us set the historical records straight

Yes! … keep blaming the housing market and the mortgages and the over lending for the mess and you will not see what is happening in front of your eyes.

And the real culprits are:

The arrogant financial modelers that thought they could predict the future based on quite brief statistics and that lost or forgot all the inhibitions as time kept postponing calling their bluff.

Greedy fund managers whose profitable business model was based on charging commissions on profits derived from their own valuation models and that were so handy in lieu of the non existing markets for their own investment products.

The credit rating agencies that enthralled were so busy celebrating how good their own business was doing so that they completely forgot the bolts and nuts of credit analysis, like walking the streets to see how the mortgages were awarded.

The banking regulators that behaving like former central planners from soviet looked to drive banking risks out of banking, having these risk go underground; and that managed to impose on the market so much obedience to the credit rating agencies, that much of the market forgot or found no need to do its own due diligence.

Finally the spreading of the mantra that the financial risks have finally been conquered, when the real truth was that the risks had only gone into hiding, to gather forces.

Clearly we need to understand very well that at this moment that there are a lot of incentives for the experts to try to take shelter behind “a slowing economy” though in fact the reality is that the economy will now be slowing because of them.

It is up to the rest of us to set the historical records straight.

Thursday, August 2, 2007

We need to eliminate the financial fortune-telling franchise.

I have nothing against the credit rating agencies, in fact I would like to have hundreds of them instead of the current only three. What I do not like though is when investors are forced to act in accordance with what they opine since when someone is told that someone else does the thinking for them, they lose the motivation to think for themselves and they have been empowered with the perfect excuse to hide their own shortcomings.

When you tell a pension fund it is not allowed to invest in anything below a specified level of ratings you are sending two messages. The first, that pension funds should only invest in safe ventures sounds about right but goes against current financial theories that say that a perfect blend of uncorrelated potions could just as well be the safest bet in town. The second message, the truly dangerous one, is that you are implying that there are objectively safe investments in the world and that the credit rating agencies have the tools to spot them.

We have already gone much too far down the road to a systemic risk explosion and we can already smell the subprime gases that have been accumulated. Anyone who lives in an earthquake prone region knows to be grateful for the small tremors that release the build-up of tensions and keeps the big one away. In these days we pray that the current financial uncertainties are only a minor tremor but if we really want to avoid building up the tensions that will lead to a true catastrophe, one of the first things we must do is to dismantle the fortune-telling franchise awarded by regulators to the credit rating agencies.

Tuesday, July 24, 2007

Have 100% guaranteed incomprehensive financial model…will travel!

This is a great and handy tool for hedge funds when valuating portfolios and that will produce maximum commissions; and also for the large US banks that have recently been authorized by their regulators to apply Basel II rules and now need to catch up with European competitors in lowering their capital requirements.

Low maintenance costs with access to an exclusive well churned and pliable data set licensed by the proprietor and that reaches back to 1840 and is equally impossible to scrutinize.

Friday, January 5, 2007

The dark side of knowledge

We heap praises on our knowledge economy but we must not forget that in some circumstances not knowing might be blissful for the society, or at least easier for it to handle. Let me briefly illustrate what I mean by referring to health insurance and credits. 

If we all share the same health insurance plan then we do all, in solidarity, share in our respective good or bad health. But if insurance companies are allowed to discriminate between us then little by little we will be divided in many groups depending on our health prospects, as determined by what we could call the health-rating agencies. 

When the health market limits itself to segment for instance between smoking and not smoking this does not have any serious implications since smoking is (supposedly) a voluntary decision and so the deterrent effect of having to pay a higher insurance premium because you smoke might not be that bad. Of course the volunteerism argument can also become exaggerated as currently there are insurance companies that offer even hefty discounts depending on how many hours you work out at the gym. 

But, if the health insures would be allowed to use all those genetically mapping discoveries that are just around the corner, then we might dangerously end up with some citizens insurable at very low rates, some at higher and some not insurable at all. And the question we will then have to answer as a society, is how to counteract the logical desperation of the latter. 

Something of the same happens with credits, like mortgages. It used to be that depending on your income, as a potential home buyer you could classify for more or less of borrowings, but the interest rate to be paid on the loan did not differ much or even anything at all between a “good” borrower and a “not so good” one. Not any longer. The knowledge economy now classifies the market in many different type of credit risks and although this is has been sold as something that creates more opportunities for poor buyers it might not necessarily be so. 

A thousand dollars paid each month servicing a mortgage during 15 years, when discounted at 11 percent per year, because the borrower is deemed “risky”, is worth 88.000 dollars today. Exactly the same payments, discounted at only 6 percent because the borrower is deemed creditworthy, are worth 118.500…35 percent more! And here lies one of the real problems of the subprime debtors… not only do they have less money, but the little money they have is also worth less. 

Now add to the above that the credit ratings might not even reflect correctly the repayment capacity of the borrowers and we can see how as a society we might be drawn into a totally unsustainable structure. 

And so what are we to do about this fact that knowledge in some cases works as a regressive tax in our society? Are we better off going back into obscurity? Of course not! What we need to do though is to arm us with a lot more with the humility we need to be able to recognize that handling all this new found knowledge requires a lot of wisdom…of that sort that can not easily be purchased in any databank or by accessing any experts with a PhD.

PS. Human genetics made inhuman
PS. If knowledge suffices then wisdom is worthless