Monday, April 20, 2009

Where were they when needed?

On June 26, 2004 the central bank governors and the heads of bank supervisory authorities in the Group of Ten (G10) countries met and endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework, the new capital adequacy framework commonly known as Basel II.

The framework was primarily based on the concept that financial risk could be measured and that the measurement itself would not affect risks. It therefore represented one of the most astonishingly naive financial regulatory innovations in the history of mankind.

As an example, the framework stated that if a bank lent to a corporation that did not have a credit rating then it needed to have equity of 8 percent, resulting in an authorized leverage of 12.5 to 1. But, if the corporation had been awarded an AAA to AA- credit rating by a human fallible credit agency, then the loan would be risk-weighed at only 20%, effectively elevating the authorized leverage to an amazing 62.5 to 1.

We all know that the market always contains plenty of incentives for high-risk credit propositions to dress up as being of lower risk, and so, when these incentives were exponentially elevated by the regulators, the biggest race ever towards false AAAs got started.

It took just a couple of months for the home mortgages to the subprime sector to manage to dress up about the lousiest awarded mortgages ever as AAAs. And It took just a couple of years for the market to massively follow those AAAs over a precipice, detonating one of the most horrendous financial crisis the world has ever encountered.

Now, one of the questions we need to answer, in order to have a better chance of finding a sustainable solution to this crisis, and alert us to the many other future crisis that will most certainly threaten us, is where were all the financial experts, the tenured professors and the members of think-tanks, all of whom we pay, honor and invite to opine, and that said absolutely nothing about all this? How come they did not see that this crisis was doomed to happen? Or, if they saw it, why did they not speak out?

At the end of the day, the simple truth is that the costs of regulatory innovations far exceeded the costs of financial innovations, and that the benefit from financial innovations far exceeded the benefits from regulatory innovations. And so, if we cannot have much better and more intelligent regulations then we are better off without them altogether.