Regulation and the EU crisis

The current spat between the UK and France over whose economy is in worse shape is like two people, one with both arms broken and the other with both legs broken, arguing about who is in better condition to play a game of tennis. All they are achieving is to focus attention on the fact that both of them are not in a fit condition. In doing so, to mix metaphors, they are both placing each other further into the firing line. As it is, the firing line is already broadening:

Bank of America Corp., Goldman Sachs Group Inc. and Citigroup Inc. had their credit grades cut by Fitch Ratings as the impact of financial regulation and market turmoil weighed on the industry.

The lenders’ long-term issuer default ratings were cut one level to A from A+, Fitch said yesterday in a statement. Barclays Plc, based in London, Credit Suisse Group AG, Deutsche Bank AG and BNP Paribas SA also had their grades lowered.

[and] Credit ratings of the world’s biggest lenders have come under pressure amid weak economic growth and doubts about whether European regulators have done enough to end the sovereign-debt crisis. Lenders in the region must raise about 114.7 billion euros ($149 billion) in capital to help address the turmoil, the European Banking Authority said last week.

Fitch downgraded Barclays and Zurich-based Credit Suisse to A from AA-, while lowering France’s BNP Paribas and Deutsche Bank to A+ from AA-. Fitch corrected an earlier version of its statement to announce that Frankfurt-based Deutsche Bank was cut one level instead of two. Morgan Stanley’s long-term issuer default rating was affirmed at A.

And, of course, sitting underneath all of this is sovereign debt exposure. In 2008, I wrote a post which clearly lays the blame for this debacle in the right place; the banking regulators. I used a Bank of England paper on the impacts of the Basel accord framework (from the Bank for International Settlements, BIS) to highlight the problems the regulators were causing; in particular the idea that risk could be identified and codified by a group of experts. This is what I had to say about the first Basel Accord:

So here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.

So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.

Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.

 For Basel II, I had the following to say (the quote is from the BoE paper):

Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:

Under the standardised approach banks will slot assets into weighting bands according to ratings from ligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).

The BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:

Exposures to borrowers without a credit rating will be placed in an unrated band that will carry a 100% weight (ie 8% capital charge), but regulators are requested to review the default experience of the particular market (and individual bank) to decide whether this is sufficient. Undrawn facilities to corporates of less than one year, which currentlycarry a zero weight, will be weighted at 20%.

At the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound.

So here we are, years later, with banks having gorged on mountains of 'safe' sovereign debt (as a note, in some financial jurisdictions, they continued to ask banks to report based upon Basel I), and the ratings agencies playing 'catchup' with reality in their issuance of downgrades. Just to add to this wonderful array of regulation, the Basel III accords, a response to the crisis, are now about to be implemented and will require banks to hold larger capital buffers (see here for a summary from BIS). Although market pressures were already leading to banks increasing their buffers, the impact will be for banks to conserve capital to meet the new requirements with implementation of the rules in 2013. In light of the problems of 2008, this might seems like a good idea, but is closing the stable door after the horse has bolted. Or if I can stretch the metaphor, slamming the stable door shut whilst the horse is half way out of the door.

What really worries me however is the tweaking of the principles of Basel II into the overall structure of the Basel II accords (see full document here, note 1). For example, the new accord places greater emphasis on stress testing, but remember this:

When the European Banking Authority (EBA) published the results of ‘stress tests’ on 90 banks across 21 countries in the EU in July 2011, Franco-Belgian bank Dexia was given a clean bill of health. Barely three months later, however, Dexia needed a €4bn bailout package. The bank had been unable to raise the cash it needed on the financial markets, largely due to concerns about its ability to withstand losses on its €3.4bn exposure to Greece.

Also, for the external rating of assets, they seek to mitigate what they call 'cliff effects' (which I have understood to be 'falling off'), but the ratings agencies are still front and centre alongside the bank's internal risk assessment. The internal risk assessments are seen as an additional check:

Finally, the proposal will seek to reduce to the extent possible reliance by credit institutions on external credit ratings by: a) requiring that all banks' investment decisions are based not only on ratings but also on their own internal credit opinion, and b) that banks with a material number of exposures in a given portfolio develop internal ratings for that portfolio instead of relying on external ratings for the calculation of their capital requirements.

Just to add to the interest and conflicts of interest, for example Moody Analytics boasts that their systems are used by the major banks in supporting Basel I, II and III:

We also provide an integrated economic capital solution for Pillar II ICAAP requirements, as well as an internal rating framework with proprietary and customizable models and scorecards. Additionally, we also provide solutions that allow you to allocate and price risk more effectively and to integrate risk management into the business at the point of origination, increasing operational efficiency and optimizing risk and return, which will be critical in a world with higher capital requirements. Our products are complemented with comprehensive analysis and stress testing tools and expert advisory, implementation and customization services to assist you in all phases of your project.

This will be the same organisation that has, in recent times, been an exemplar of effectiveness in spotting high risk assets, as well as objectivity. For those of you unfamiliar with Moody's I pulled this story up from the WSJ to illustrate the point:

Yuri Yoshizawa, managing director of global structured credit, intends to leave the Moody's Corp. unit at the end of June, a person familiar with the situation said Friday. This person said Ms. Yoshizawa made the decision to step down. She couldn't be reached for comment.

The operation overseen by Ms. Yoshizawa was criticized as an example of what went wrong when rating firms analyzed CDOs and other mortgage-related deals before the worst of the financial crisis. Lawmakers and other critics say ratings firms like Moody's awarded their highest ratings to questionable mortgage bonds in order to win business from issuers of the bonds.

Collateralized debt obligations were among the hardest-hit investments during the crisis, causing tens of billions of dollars in losses for investors, many of whom were attracted to their high ratings.

At a Senate hearing last April, Ms. Yoshizawa was prodded about the back-and-forth between analysts and bond issuers as the analysts worked on ratings for new bonds. "There was always pressure from banks," she said, noting that the relationship could get contentious and "very abusive."

Emails between Ms. Yoshizawa and Moody's colleagues emerged during the investigation by the Financial Crisis Inquiry Commission, a panel formed to explore the causes of the crisis.

An October 2007 email showed that the firm's market share in CDOs had fallen to 94% from more than 98%. In her reply, Ms. Yoshizawa asked colleagues to "take a look at the deals we didn't rate … to double check the information and to let me know any of the 'stories.' "

Some critics cite the email as an example of pressure on Moody's analysts to win business. Ms. Yoshizawa told lawmakers last year that she couldn't recall ever removing an analyst from a transaction as it was being rated because of arm-twisting by banks, though she said future deals might be assigned to a different analyst.

So here we have the situation. Banking regulations determined that OECD sovereign debt was safe, banks gorged on the debt, and the debt was not safe. As Basel was adapted, it placed ever greater influence in the hands of ratings agencies who have a track record of being hopeless at assessing risk, have chronic conflicts of interest, and who only manage to downgrade assets at the point at which they are about to collapse (if not after they have collapsed). On top of this, the internal risk assessment looms large. It is hardly inspiring of confidence.

Most worrying is that, those who are determining policy think that this is all a good idea. Now that really does present a worrying picture.......


Note 1: I have not read the whole document (not an easy read, but interesting in places), but summaries can be found elsewhere.

Financing UK Government Debt - The Problems are Starting

I have a comment on my last posting, in which an anonymous poster very kindly provided a link to an article in the Financial Times. I quote from the start of the article as follows:

'The UK and Italy struggled to sell bonds on Thursday in a fresh sign of the difficulties governments are facing because of the debt needed for economic stimulus packages and bank recapitalisations.

The two bond auctions saw both governments forced to pay higher yields to attract investors and Italy scaled back the amount on offer.

Analysts say it is an “ominous” warning that debt raising is likely to become even tougher in the coming months if problems are emerging so soon after government announcements to increase issuance. A record of more than €1,000bn ($1,290bn) of debt is expected to be issued in Europe next year.'

Long term readers will know that I suggested the government would be hitting problems of default about now (as long as six months ago). I have continued in this view, and that means that my prediction was for the default to happen now. However, as you will note from the FT article, we are still at the warning shots stage. The move from warning shots to outright panic is difficult to predict, so it could be an immediate collapse, or might take a while yet.

Meanwhile, as government is going on a borrowing binge, it is worthwhile noting that this has severe knock on effects in the economy, as the government is competing with investment in private business. I discussed the problems that are caused in the wider economy in an article here, but thought it worth mentioning again as I have not discussed the subject for a long time.
If I have my history of economics right (please correct me if I am wrong), I believe that government borrowing (in the modern sense) was started to finance the Napoleonic wars. Regardless of the original purpose it has now become a very bad habit, and one that should really be prevented, by a constitutional constraint if necessary. For the moment, it appears that the problem is about to be addressed by the creditors to the UK, but better the country never got into the problems in the first place.

On a different but related subject, I was catching up on my reading yesterday, and managed to plough my way through the Economist magazine. In an article they discuss the re-ordering of the world financial system, the so called 'Bretton Woods 2'. It makes very depressing reading, as they are proposing that the solution to all of the difficulties is more regulation, and with the wisdom of hindsight criticise the Basel Banking accords (Wikipedia gives a good introduction with Basel 1 here, and Basel 2 here). Again, those who are regular readers will know that I have long 'fingered' the Basel Accords and government interventions as major contributors to the financial crisis. Essentially, the regulation in the banking system created huge distortions in the market whilst giving a false sense of security in the banking system (I discuss this in detail here).

The reason why I mention this is that the lesson being learned from the banking crisis is completely wrong. Instead of accepting that it was the regulation of the banking system that was the problem, the consensus is increasingly that it was the wrong regulation, and that more and closer regulation is the answer. Essentially, the consensus view is that it is possible to take the risk out of banking which, when you think about it, is a very odd idea. The nature of banks is that they lend to individuals, governments and businesses, and some individuals and some businesses do better than others. By nature, whenever a bank lends money, they take a risk.

Now, if we look at Basel accords, they are founded on the idea that different classes of assets have different levels of risk. This means that, for example, a UK issued bond would normally be viewed as low risk, such that banks will be encouraged to lend to the UK government, such that they maintained a balanced risk portfolio. Now, I would suggest that you stop and think about that for a moment.....

We have a system of regulation that encourages banks to lend to a government? Governments are not a productive asset class. They do not do anything to generate concrete wealth. They provide some services, which might be seen as productive activity, but they do not generate income from that activity, they just farm tax from their populace to pay for it. It is a fine distinction. For example, if we go to a restaurant, we pay the restaurant for the service of cooking our food for us. If we pay tax to the government it provides the service of health care. The real difference here is that when the restaurant borrows money, it does so with an expected return, and the restaurant owner/s are risking their own money. On the other hand, when a government borrows money, it is risking the money of the population at large and the money of businesses, with no way of calculating the return on what is borrowed. Furthermore, the business and individuals have no choice but to have the government risk their money for them.

Despite the use of word 'investment' by politicians, this is not the role of government, as their role is spending the money of other people.

So here we have a regulatory system, that encourages banks to lend to government. If they are lending to government, they have less capital to lend into productive activities that actually generate the revenue necessary for government to function. It is rather odd when you think about it.

However, there is something even more disturbing about the whole system of regulation. An inherent part of the system is prescience. Apparently, it is possible to know the future of different classes of investment. For example, the Bank for International Settlements can apparently see the future and determine what is risk and what is not, and national regulators do then do the fine detail of what they will accept as safe or unsafe investments. Amazingly, these very clever people have an insight on risk, and can determine what is a risk and what is not. They must be very clever indeed.

The trouble is that, UK government debt has long been seen as very low risk, but we are now seeing that it is actually very high risk. The trouble is that, over the last 12 months, all kinds of 'safe' investments have proven to be unsafe. Essentially, what you have is a system in which lots of apparently very clever people can supposedly determine where risk resides. However, as experience is telling us, they have absolutely no idea where risk resides.

So now we come to the answer that is being proposed. More clever people will now sit down and re-determine how risk should be calculated, having learned lots of lessons from the recent crisis. All of these very clever people will get together, and once again will strain themselves to see the future, and determine what the future might be. But the trouble is, that is what they did before.....

Essentially, there is no escaping the fact that the world is a complex place, the world is unpredictable, and individuals are fallible and make wrong decisions. No amount of regulation of the banking system will change this. There is no reason to believe that the people who determine the particular risk of asset class have any better grasp of the risk inherent in that class than the holder of that asset - the banks themselves. The simple fact is that, what was safe yesterday, can become unsafe the next day. No one individual, or group of individuals, is infallible, so why should they be able to determine risk?

As such we come back to the start, and have to say that, whenever we deposit money in a bank, we are taking a risk that the bank will lose that money. We need to accept that risk, because we make that risk with possible trade-off that the bank will invest the money and increase our wealth. However, any idea that this can be guaranteed is just foolish, and no amount of regulation will make that guarantee. All such regulation serves to do is create a false confidence, and thereby encourages systemic risk.

What we have now seen is that such guarantees are worthless and, as a result, we have governments having to accept liability for their former guarantees of the safety of the system. However, it is not government that picks up the tab for that guarantee, but every individual and business within the country. In other words, there is a system in which people apparently know better than banks where the risk of those banks reside, they then say that if the bank follows their rules, they will guarantee that all the money invested in those banks is safe, and they make that guarantee with the money of tax payers.

When you think about it, it is a completely absurd idea. However, lots of very clever people all think this is a great idea, and persuade us all that governments offering guarantees (based upon their mystical knowledge of future risk) using our money is a good thing.

Note 1: Thank you all for the comments on energy policy, which were interesting and challenging. I had an interesting comment from HYDROGENPHILE (his caps), who suggested that hydrogen is the answer to storage of energy. This is presumably based upon the use of fuel cells, which are an interesting emerging technology that I have followed for some while. However, until the switch to a hydrogen energy economy is made, this does not address the problem of the here and now. In other words, the switch to a hydrogen economy needs to be made before the investments in energy provision that relies on that switch is undertaken.