Friday, October 10, 2008

What's Black and Red all over?

Today is another unprecedented day in the markets, unprecedented since yesterday, whicvh was itself unprecedented since Monday and October is looking like being very black, blacker than any month since last month when prices were more often red than any month since same time 21 or is it 71 years ago? Today's falls are all across the board except bank stocks. The fear is recession, here already or coming soon to a screen near you! Banks appear to be cushioned so that when commodities, retail and even classic recession stocks like legal pharmaceuticals are falling, the question arises - have we passed the point at which saving banks from themselves will work and therefore is the only workable solution macro-economic reflation?
I've just been re-reading papers by fellow risk guru John Morrison which elegantly describe workable analytic approaches to economic capital modeling and restructuring for banks. Banks' existing models have no experience of the ferocity of today's shocks and stresses. new models and replacement accounting systems are needed urgently, but this requires time, and time is not in generous supply. Banks must urgently replenish their capital reserves and do so via intelligent economic capital models that minimise the harm banks can do to the underlying economy where they do business and which relies critically on banks not drying up their credit lines!

Alistair Darling drily sums up his view in today's FT in a diplomatic and statesmanlike way by saying "Over the past decade systemic vulnerabilities and imbalances in the global financial system emerged against a backdrop of increasingly integrated markets and enormous capital flows, low inflation and low interest rates. This encouraged financial institutions to seek higher returns and develop increasingly complex products [to manufacture ever higher returns]. We need to shift the IMF's focus [meaning also the G7] towards surveillance of the links between the financial sector and the real economy. It will identify risks in advance, co-operate with the Financial Stability Forum [of the BIS with the world's regulators] to design policy and regulatory responses and strengthen links between ministers, in the Group of Seven and beyond, to ensure effective follow-up. The world economy is changing. Sticking with the solutions of the past is not an option. Now, more than ever, we need new ideas."
The most recent new ideas in respect of prudential laws, rules and guidelines for banks is Basel II. Pillar II of Basel II concerns economic capital models for understanding the links between banking and the real economy. But, the fact is that neither BIS nor the banks know how to do this, and the IMF certainly does not either! Pillar II could not be expressed as a set of precise measures; it was only a set of principles. The regulators were hoping to learn from all the various ways that banks would work this out for themselves before eventually coming up with detailed solutions that would entirely frame the future regulation of banks (and insurers). Sadly, not one bank, big or small, not even the brilliance of central banks, has cracked the problems involved, and the academics have not done so either. BIS explicitly stated, however, that it did not expect the banks to become centres for doctoral research about this, though actually this is indeed what was required of them. What are the problems?
There are two cultures involved, that of short term markets, where banks (their investment banking parts)trade via their 'trading books' on behalf of themselves as well as their clients and customers, and that of macro-economics, which tend to govern more the risk of the retail parts of banks via their 'banking book'. It would be easy to analyse the links between banks and the real economy if the performance of both coincided, but they do not. The traditional business of banks is to respond to the demands made upon them for loans by the 'real economy' (households, big and small private enterprises and government). But, that demand is not in proportion to the shares of households, enterprises and government in the economy. Some parts need financing when other parts do not. It was in some degree to eke returns out of all parts of the economy that banks grew their own 'proprietary' investment and trading, not only to earn fees but also invest directly. If any of their customer segments did not need bank loans but were profitable either in rising asset values or generating current profits, banks wanted a slice of that, one way or another. In this respect too, not just geographically, banks sought to become more global. In respect of the classic risk mitigating principle that of diversification this was good. But, banks leveraged their traditional lending to the hilt (asset securitisation etc.) in order to gain this diversity and thereby made themselves considerably more vulnerable than was safe. They drained the capital ratios of traditional lending in order to grow their proprietary investment trading and supporting this with more complex chains of counterparty risks whereby it became near impossible to disentangle and gain perspective on how their balance sheet performance linked to the underlying economy. They did not develop anything like adequate economic capital models with which to see this. Where banks had a financial contractual relationship to the economy somewhat akin to that of government, they had now become an integral part of that economy but one that was two or three times more leveraged than non-financial corporations. The biggest sector by far of the economy borrowing most from the banking system was other banks. Hedge funds and other Alernative Investment vehicles did so too but this was transparently part of their business model and the leverage was mostly short term and funded by high risk appetite parts of other investment funds. Their game was high return for high risk and being prepared to lose eveything, but they did not seek funds that their investors could not afford to lose.
Banks, with a much wider social responsibility lost oversight and prudential control of the dangers in the overlaps between banking books and trading books, between servings customers and proprietary trading and investment (the conflict of interest that Glass-Steagal had identified and banned).
For banks now to complete the sensible aims of Basel II (still falsely perceived by many bankers and even their shareholders as merely some kind of regulatory tax and not as means to more intelligent banking which is what Basel II really is).
Banks traditionally enjoyed a commanding role over the economy and they presumed they would continue to enjoy and be secured by this even when becoming more deeply invested in the underlying economy and far more heavily borrowed than even their most indebted corporate customers. Instead of learning the lessons of ENRON there was an ENRON aspect developing in all universal banks (precisely what Basel II set out to disentangle). Where traditionally the stock market first and then the real economy would turn down and the banks afterwards by which time recovery was beginning to gather momentum, this time it is the over-indebted banks that stumbled and fell first with the rest of the economy following after!
Governments traditionally rely on economic downturns not immediately impacting the banks; they need the banks to thereby assist in climbing out of recessions. It is no wonder therefore that the prospect of insolvency among the banks at this stage in the cycle is looking like leaving the governments with no choices short of partial or total nationalisation!

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