Wednesday, September 1, 2010

The six questions the Financial Regulatory Establishment refuses to answer.

1.- Knowing as we know that all bank or financial crisis have had their origin in excessive investments in what was ex-ante is perceived as having no risk... can you please explain the rationale behind a regulatory system that by means of allowing much lower capital requirements when lending or investing in anything is related to triple-A rated operations, provides the banks further incentives to accumulate excesses in what ex-ante is perceived as having lower risks?

2.- Knowing as we know that a perfect credit rating, though providing some useful information for capital allocation, provides none of the two sides in a operation with any real profit, something which only wrong risk appreciations can do, the wronger the larger the profits for the side that benefits... what is the rationale behind empowering the credit rating agencies with asymmetrical risk information oligopolies which dramatically increases the financial system´s exposure to catastrophic systemic risk?

3.- What is the rationale of a regulatory system where if the bank lends to an unrated small business or entrepreneur it needs to have 8 percent in capital but, if it instead lends to the government of an AAA rated sovereign, like the USA, so that government bureaucrats lend or give stimulus to the unrated small businesses and entrepreneurs, the banks need to hold zero capital? Is this not plain pro too-obese-to-succeed government regulation? What do the interest rates on public debt really signal with this type of regulations interfering?

4.- If a bank was required to have the same capital when lending to a country with a credit rating like that of Greece before year end 2009, as when lending to a small unrated businesses, then it could leverage itself 12.5 to 1. If it then made a spread of .5 percent when lending to a Greece it would obtain a return on capital of 6.25percent per year. But since the banks were allowed to do the above with only 1.6 percent in capital they could leverage their capital 62.5 to 1 and earn 31.25 percent on capital. Is this not exactly the stuff from which unbelievable bonuses are made of? Is this not exactly the growth hormones that results in too-big-to-fail banks?

5.- How come when regulating the banks the Basel Committee does not establish what is the purpose of banks? Is that not a pre-requisite for adequate regulation? When you regulate traffic it is to facilitate the traffic between two points... not to guarantee that the road will never need maintenance. Do the regulators really aspire for a world where there are no bank defaults? I shiver at the thought!

6.- Institutionally and given that the world will be in need of more global regulations, how is the oversight of the Basel Committee and the Financial Stability Board managed? To whom are they transparently accountable? I ask this because for instance if we had delegated the solving of global warming into a global institution that made mistakes like those made in the regulation of banks... there´s no question we would all be toast.

The questions at the IMF blog