Monday, March 16, 2009

New bank regs-Right; Systemic risk manager-Sure

As if requiring banks to have more capital on hand will solve the problem...

The losses banks suffered in this episode should make it clear that no amount of capital would have been enough. This idea of getting tough by gritting you teeth and stomping your feet and making banks do something unpleasant just is not going to get the job done.

Banks simply did stuff they never should have done. Banks took on a load of securities they had no grasp on at all. Banks lost their way and got involved in a business that was totally inappropriate for banks - institutions with insured deposits.

Banks need to be excluded from such transactions in the future. Watch the regulators closely as to how they approach this issue because the most important politicians on the most important regulatory committees get the most MONEY from the financial and real estate lobbies. So watch that closely when these guys say things like,' Oh I think banks have something to offer in that area"... Right.

In the G-20 as well as in the US there is starting to be some interest in something called systemic risk. What is this? Systemic risk is when everything goes wrong and you are the regulator and didn't have a clue.

More specifically (and less sarcastically), it refers to a condition of a broad-based breakdown in which elements that markets usually depend upon no longer function. In short it could be anything. How a regulator will 'look out for it' I don't know.

Look back at our recent little episode when 'everything' went wrong. What would a systemic risk manger have highlighted? Too many sub-prime loans? Or would it be to note that sub-prime loans themselves are too dangerous? Would he have tried to talk the rocket scientists back to earth and out of orbit? Was it the banks that stopped getting 20% down on most houses or testing for income? Would he have seen the leverage? What the system experienced, was the breakdown in prudence. As far as I can see there was nothing systemic that went wrong apart from bad judgment fueled by greed-systemic bad judgment and systemic greed.

At the time of the Latin American debt crisis in the late 1970s had you looked at the domestic factors that correlated with debt problems across Latin American countries you would have been satisfied that your Latin American lending was well diversified, At the same time those domestic factors that correlate with national debt problems were not highly correlated across those countries. But then they were; of course, and that shift was unexpected. Something happened that had not been present before and that could not have been been identified/predicted. Excessive lending to them: all of them? each of them? Okay, we might have picked up on that. But when the shift came, it put all the Latin American borrowers in the same boat then proceeded to sink it. In the event you would have found that all your Latin American lending was in trouble. Would a systemic risk manager have seen any of that?

In 1998 the same sort of thing triggered across developing economies. Once the darling of international lenders suddenly, they became the goats of the markets and totally undesired.

The S&L crisis in 1980 was easier to predict. You had banks with fixed rate long term assets acquired in an era of interest rate ceilings for depository institutions. That ceiling protected them and the values of their securities. But then regulators removed the rate ceilings. Uh, Oh... Then the central bank let inflation creep, Uh oh, then climb, Uh oh, and then soar. A systemic risk manager could have seen that one coming. But I don't know what could have been done about it other than to have run monetary policy better from the outset.

On balance I guess I don't believe much in systemic risk as a factor that can be managed. It stands to reason if a new and untested asset class is being piled up it is a risk. It is untested. I have never believed that statistical 'stress testing; could take the place of actual tried and true market behavior. So if anyone thinks that a systemic risk manager could have stopped all the securitization and derivitivization in the markets then that person would believe that a systemic risk manger could do some good. I'm not that person.

I think that the very idea is a joke. The markets, the regulators and the politicians all drank the same Kool Aid and passed it along to their friends. It served a purpose for each of them. Who that might have blown a systemic whistle would have stood a chance to be heard? I think no one.

Systemic risk manager is the guy you hire to lock the barn door after the horses are gone to reassure people that next time things will be different. But they won't.

The secret here is to have better regulators and tougher ones and not mince words or thoughts about what better regulation will mean. It will mean denying banks certain activities. and I wonder if we are up to it? Dodd was against reforming Fannie Mae. Frank wanted to let poor people into the booming housing market; he wanted to break down barriers to entry like down payments and income tests for home-buyers. We did that, it didn't work the way he thought. How were these Poobahs of oversight going to back a systemic risk manager who would have told them NO?

If there is one common theme of some sort, however, for a systemic agency to glom-onto it is that in the late 1970s and in the 2007-09 period huge shifts in he BOP positions emerged internationally due to oil dollars that had to be recycled. They put financial intermediaries to a test that they failed. One 'trigger' for a systemic risk manager to watch is what happens when oil revenues surge and must quickly be recycled? Follow the money. A related problem is the structural US current account deficit and the capital that the US sucks in. Chronic deficit and surplus countries must find ways to shed those labels. Do that and the money flows are less likely to become a problem.

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