Monday, November 15, 2010

The financial crisis: What went wrong and what to do… in the eyes of an interested and concerned citizen observer.

In explaining the current financial crisis there are some very few pieces that allow for a quite clear image of the final puzzle and are obviously needed in order to find the best way to avoid repeating the same mistake… and so that we could at least give some new mistakes a chance to show what they´re worth.

1st piece: The Basel Committee had decided that the only risk it needed to consider with respect to the banking system was the risk that banks lent or invested in operations that could default. All other risks related to whether banks fulfilled adequately their capital allocation responsibilities, were taken off the table.

2nd piece: The Basel Committee because of its hysterical aversion of risk turned a blind eye to the fact that all bank crisis have resulted from excessive lending or investment in what was perceived ex-ante as having a low risk of default and never from excessive lending or investment in what ex-ante was perceived as having a high risk of default.

3rd piece: The Basel Committee, when determining the risk-weights by which it arbitrarily discriminated on the risk of default, amazingly ignored the fact that the market and the banks already clear for risks by the risk premiums they charge in interest rates, and so ex-ante perceived low risk was twice benefitted while ex-ante perceived higher risk were twice punished.

4th piece: The regulators naively ignored that the oligopoly of risk surveyors they empowered, the credit rating agencies, where human fallible and could also be captured. There has been a lot of comments with respect to the excessive trust placed by banks and markets in general in the “opinions” of the credit rating agencies but, if there is anyone that has showed the way for such excessive trust, that is of course the Basel Committee itself.

5th piece: On June 26 2004 the G10 substituted the 30 pages long Basel I adopted in 1988 with the 251 pages long Basel II, which allowed a bank to hold only 1.6 percent of fairly loosely defined capital (8 percent basic capital requirement multiplied by its 20 percent risk-weight) when lending or investing in anything related to a private triple-A rated client or security; which signified that a bank could leverage its equity on those operations to 62.5 to 1; which signified that if a bank expected to make a margin of .5 percent on a triple-A rated operation, it could expect a return on its capital of 31.25 percent a year.

6th piece: The primary and really only detonator of this crisis were the over two trillion dollars from all over the world invested and lost in triple-A rated securities collateralized with very badly awarded mortgages to the subprime sector. The market, as markets do, in response to a really mindboggling acceleration in demand after mid 2004 for triple-A rated securities, and because almost by definition real triple-A financial operations are extremely scarce, resorted to fabricate and supply fake Potemkin-triple-A ratings.

What are the first conclusions we should draw when seeing the image these six pieces create?

1st conclusion: If we are going to have global regulators, which we will need, it absolutely behooves us to make sure those regulators are chosen from an extremely diversified pool of talents, since the least we need is to allow for creation of incestuous mutual admiration clubs… like the Basel Committee is. We need urgently to change at least 80 percent of the professionals involved with the Basel Committee and guarantee the existence of multidisciplinary professional participation. Think of it, if the challenge of global climate change is placed into the hands of something like the current Basel Committee, we are all toast, before it even begins to heat up!

2nd conclusion: Before regulating the banks we need to define what the purpose of banks is. As just mattresses to stash away cash, mattresses might be better. For this the world, but especially the submerging countries, need to reconsider completely the issue of what is the necessary risk-taking a society must be willing to absorb in order to move forward.

3rd conclusion: Throw away the capital requirements for banks based on ex-ante perceived risk of default as fast as possible. As long as small businesses and entrepreneurs are discriminated to such an extent that banks need to hold 5 TIMES as much capital when lending to them when compared to when lending to triple-A rated clients, there is no sustainable way out of this crisis nor sufficient job creation.

4th conclusion: We also need all to work ourselves out of that amazing regulatory bias in favor of big governments represented by the fact that when banks lend to a triple-A rated sovereign, they need zero capital; a distortion that among others hinders us from seeing the real interest rates on public debt.