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.

Fiscal Chickens Coming Home to Roost

This is my third attempt to post. Each time I finish a post, it seems events are overtaking me, which says a great deal about the volatility of the current situation. One of the elements that prevented the publication of the last attempt at a post is a report by the Bank for International Settlements (BIS), which I found through a Telegraph report. The report is of particular interest, as this comes from a mainstream institution, and makes very worrying reading. In fact, many of the points made in the paper are a mirror of the arguments that have been made on this blog, since the day that the blog was started. I will review a few of the key points.

The overall thrust of the paper is to look at the developed economies that are currently running large fiscal deficits, so that there is considerable focus on the PIIGS (Portugal, Italy, Ireland, Greece and Spain), as well as on the US, UK and Japan. One of the early points that is made is that the current deficits are not simply a temporary aberration, but are structural in nature:

Even more worrying is the fact that most of the projected deficits are structural rather than cyclical in nature. So, in the absence of immediate corrective action, we can expect these deficits to persist even during the cyclical recovery. (p3)

One of the longstanding arguments of this blog is that the UK, and other economies, must undertake reform of their economic structures, and I long ago suggested some reforms for the UK which would, over the medium term, see reductions in government expenditure, whilst maintaining health and welfare systems (NHS, Education, Benefits , taxation). These posts were specifically made due to the absolute necessity to reduce the structural deficits, and redirect activity in the UK economy into real wealth creation.

Another theme of this blog has been to continually ask where the growth in economies might actually come from. Whilst the mainstream economists make their projections of future GDP growth, what is notably absent from such projections is exactly where, or what sector, might conceivably produce such growth. On a couple of occasions, including in a comment in the Guardian comment is free section, I have challenged anyone to offer a sector that might produce these magical projections of growth. On each occasion I have done this, I have been met with silence. Apparently, growth will just happen, because it just must. It might be noted that I am not talking about the so-called 'growth' which results from massive government borrowing, which is really just a growth in debt. This is what the BIS report says:

We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future.8 As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained. (p4)

Aside from the weasel words at the end, in which the word 'investment' is used, the message is very clear. There is no reason for the magical growth to take place. In fact, the report goes on to give very clear reasons later for why growth is likely to be constrained in the future, due to the cost of servicing massive deficits:

The distortionary impact of taxes is normally further compounded by the crowding-out of productive private capital. In a closed economy, a higher level of public debt will eventually absorb a larger share of national wealth, pushing up real interest rates and causing an offsetting fall in the stock of private capital. This not only lowers the level of output but, since new capital is invariably more productive than old capital, a reduced rate of capital accumulation can also lead to a persistent slowdown in the rate of economic growth. In an open economy, international financial markets can moderate these effects so long as investors remain confident in a country’s ability to repay. But, even when private capital is not crowded out, larger borrowing from abroad means that domestic income is reduced by interest paid to foreigners, increasing the gap between GDP and GNP.

What they are really discussing here is the downward spiral. The cost of the borrowing now, even if fiscal reform were undertaken, is going to have a long term impact on the ability for economies to grow. If the debt binge continues, the problem of the downward spiral will be more acute.

Another point made in the paper again echoes the theme of this blog, but also reflects the views of many other commentators and analysts. The cost of pensions and health care are, due to demographic factors, and the rising cost of health care, about to explode. At this very moment in time, governments should not be running deficits, but running surpluses to fund these future costs. The BIS report puts this more delicately as follows:

The related unfunded liabilities are large and growing, and should be a central part of today’s long-term fiscal planning.

It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly. (p16)

Another problem seen by BIS is that, although the deficits are unsustainable, the bond markets are too short sighted to see this yet, as their time horizons are too short. However, they warn that 'the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point' (p1). Their point is much like the analogy of the steady appearance in cracks of in a dam of belief that I have often used. It is the belief of the markets that bonds invested in the developed world are 'safe', even though the fiscal policies of many economies are completely unsustainable. Eventually, the bond markets will realise their mistakes....the cracks in the dam of belief in the 'safety' will eventually lead to a deluge.

As for the possible reactions of government to their unsustainable fiscal position, they also contemplate the idea that governments will seek to inflate their way out of debt, with money printing one of the options in the indirect default armoury. They do not put it as bluntly as I do, but the message is clear:

Finally, looming long-term fiscal imbalances pose significant risk to the prospects for future monetary stability. We describe two channels through which unstable debt dynamics could lead to higher inflation: direct debt monetisation, and the temptation to reduce the real value of government debt through higher inflation. Given the current institutional setting of monetary policy, both risks are clearly limited, at least for now. (my emphasis - p17)

Overall, their report makes alarming reading, but I suspect that nothing in the report will surprise the regular readers of this blog. What might surprise readers is to see the same arguments that have long been made in this blog now appearing so clearly in a publication from mainstream economists. I strongly recommend reading the report in full. With the exceptions of a few places, it is a relatively easy read for those who have a reasonable grasp of economics (and most readers of this blog seem to have a very good grasp, so the report should pose no problems).

Whilst many of the concerns expressed in the report have long been the subject of this blog, it is interesting that such a highly respected organisation should write this report at this time. Evans Ambroise-Pritchard of the Telegraph noted, correctly, that the UK is seen by BIS as particularly vulnerable:

Britain emerges in the BIS paper as an arch-sinner. The country may have entered the crisis with a low public debt but this shock absorber has already been used up, exposing the underlying rot in the UK's public accounts.

Tucked away in the BIS report are charts and tables showing that Britain faces the highest structural deficit in the OECD club of rich states, with a mounting risk that public debt will explode out of control.

Interest payments on the UK's public debt will double from 5pc of GDP to 10pc within a decade under the bank's 'baseline scenario' before spiralling upwards to 27pc by 2040, the highest in the industrial world. Greece fares better, and Italy looks saintly by comparison.

The BIS said the UK's structural budget deficit will be 9pc of GDP next year, the highest in the advanced world. A primary surplus of 3.5pc of GDP will be required for the next twenty years just to stabilize the debt at the pre-crisis level.

In the context of this report, it is interesting to take a view on the current UK election. What first struck me on this journey through the UK news was a recent report of nervousness in markets about the £GB, leading to a fall in the currency:

"The sensitivity of sterling to election news is likely to increase over the next month – while it has appreciated recently, we think a further significant advance from these levels is unlikely until the uncertainty around the election is resolved," said Adarsh Sinha, an analyst at Barclays Capital.

One trader said: "It's been a phoney war for months and the markets are all over the place. We just need some details to work from, not just this wish-list stuff, or it's just going to get worse over the next few weeks."

Ratings agencies have already warned that the UK's prized top AAA credit rating is under threat unless a credible fiscal plan is put forward soon after the election.

This nervousness is inevitable, with both the Labour Party and the Conservative Party both offering little to reassure the markets. Even in the Guardian, we have this from Simon Jenkins:

We have had the hilarity of health service spending being protected by "a £1bn cut in sick leave among NHS staff" (Labour). We have had an extravagant pledge of "a right to a new school" (Tories). We have had free care for the elderly (Labour), tax cuts for marriage (Tories), new trains for all paid for by more potholes (Liberal Democrats), no rise in VAT (Tories), no more council taxes (Liberal Democrats) and any cancer drug you like paid for by holding down national insurance on the NHS (Tories).

This is from David Wighton of the Times:

On the other hand, they [the Conservative Party] don’t want to cast doubt on the Treasury’s forecast that growth will shoot up to 3.25 per cent next year. Most City economists reckon this is way too optimistic. And, privately, the Tories probably agree. But if they admit that growth will almost certainly be lower they are faced with a big problem.

They will have to come up with even more unidentified cuts in public spending, promise further tax increases, or admit that they will cut the deficit by less than Labour promises to do — none of which is a big vote winner.

And finally, we have this from the Telegraph, written by Jeremy Warner:

On fiscal consolidation, the Labour Government's plans are widely thought inadequate as well as unduly reliant on taxing wealth creators more heavily. Meanwhile, the Opposition has struggled to deliver a coherent message on either deficit reduction or tax.

One moment the Conservatives promise to make deficit elimination the priority, the next they pledge to reverse the Government's planned rise in National Insurance, but with no credible explanation of where they will find the money.

There is a commonality to all of these reports and analysis, and that is that the politicians are living in a world of fantasy, and that the bond markets have recognised this. Both Labour and the Conservatives are just not telling the truth - that there must be real austerity, and that the UK is on the edge of a precipice.

Alongside this news, the situation in Greece continues the roller-coaster ride, with news that there is capital flight from Greece, and surging bond yields. Meanwhile, the Euro continues to weaken as fears spread in the wake of the Greek crisis. What we are starting to see is the fiscal chickens coming home to roost in Greece, and the same process is now threatening the UK. Now that the election process has commenced, there is still no sign of addressing the fundamental problem that investors need firm commitment to action, not wish lists. I am perhaps repeating myself, but where Greece leads, the UK may well follow, at least if the election continues on the current trajectory. A good summary of the situation again comes from the Telegraph:

Labour now promises £15bn of public sector efficiencies – which begs the question of what it has been doing for the past 13 years? Now, Cameron's efficiency chief, Sir Peter Gershon, has topped that, claiming the Tories could deliver another £12bn. That implies up to 40,000 job cuts – though talking about them is hardly a way to voters' hearts.

And that's the problem. Are we really in for four weeks of campaigning on just about everything but the central issue? Public spending this year is expected to reach a stonking £704bn – a figure the CBI believes Britain could cut by £130bn over time. How you cut it is a key political battleground – always assuming career politicians have any idea how to go about it.

The reality is that, one way or another, the fiscal chickens laid by the UK government are coming home to roost. As the BIS report points out, there is a reluctance from politicians to address the problems, and that they only seem prepared to do so as a result of an external push. The big question that this raises is not whether there will be a push, but when the push will take place, and how bad the fallout might be.