Saturday, May 11, 2013

Professor Alan S Blinder. If you listen carefully enough, you will notice the music hasn´t stopped.

Professor Alan S. Blinder in his book “After the music stopped” 2013, discusses the origins of the recent bank crisis. In it he lists as “the malevolent seven” the following factors as the villains that conspired to create the recent financial crisis. (Page 28)

1. inflated asset prices, especially of houses but also of certain securities; 
2. excessive leverage throughout the financial system and the economy; 
3. lax financial regulation both in terms of what was left unregulated and how poorly the various regulators performed their duties; 
4. disgraceful banking practices in subprime and other mortgage lending; 
5. the crazy-quilt of unregulated securities and derivatives that were built on these bad mortgages; 6. The abysmal performance of the statistical rating agencies, which helped the crazy-quilt get stitch together; and 
7. the perverse compensation system in many financial institutions that created powerful incentives to go for broke. 

These are no doubt malevolent villains, but Professor Blinder misses what really helped to insufflate so much life into these: 

In chapter 10 Professor Blinder writes: “A bank that earns1 percent profit on assets will earn a 15 percent return in capital, if it is leveraged 15 to 1. But if its leverage drops to 10 to 1, that same 1 percent return on asset will translate to only a 10 percent return on capital. If a bank is forced to hold larger volumes of highly liquid assets like Treasury bills, its average return on assets will decline. This is just arithmetic.” 

That is indeed correct arithmetic, but, unfortunately, as currently regulated, it does not apply to banking. This is so because regulators have imposed a system of different capital requirements based on “perceived risk”, and mostly as perceived by the credit rating agencies. 

These capital requirements allow banks to hold much lower capital against exposures to what is perceived as “absolutely safe” than for exposures perceived as “risky”. Just as an example, a German bank, to which after June 2004 Basel II applied, needed, and needs, to hold 8 percent in capital when lending to for instance a small German business, signifying a leverage of 12.5 to 1, but if buying a triple A rated security, like those collateralized by lousy awarded mortgages to the subprime sector, then it only needed, and needs, to hold 1.6 percent in capital, signifying a mindboggling authorized leverage of 62.5 to 1. Fifty times more! 

In fact the advantages that these capital requirements gave anything officially perceived as “safe” suddenly signified that the expected risk-adjusted returns on equity when lending to The Infallible became much larger than when lending to The Risky. 

That the US had not yet fully implemented Basel II is somewhat irrelevant. The US had committed to do so, and in fact SEC in April of 2004 had already approved that these capital requirements were going to apply for the investment banks they supervised. 

As Professor Blinder should be able to understand this senseless regulations introduced huge distortions into the banking system. Since those distortions are far from over, and could in fact become even worse with the introduction of liquidity requirements which are also much based on perceived risk, he might also understand that in reality, the very bad music, hasn’t stopped. 

“Did Bear Sterns, Lehman Brothers and AIG founder over insolvency or illiquidity?” asks Professor Blinder. He advances that is “Not easy to answer”. I have no doubt though. It was an insolvency which resulted from bad incentives and which led banks to dangerously overpopulate safe-havens. 

AIG, as an example, would not have been able to sell a fraction of the credit default swaps they sold had it not been for the fact that since AIG was rated AAA, the purchase of such a CDS immediately allowed the banks to reduce the capital they needed to hold against the exposure being insured.