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Friday, 23 January 2009

Did I hear that right?

Did I hear the dulcet tones of Mr Brown this morning saying that the government had regulated the banks correctly. OK, he admitted, they may have made some mistakes over liquidity, but they got the rest right. Which is a little like a dam builder saying they got the steel reinforcement right but they may have made some mistakes with the concrete. It only takes one mistake for the dam to burst.

Unfortunately that is not the only mistake, although the mistake is common to many jurisdictions and their regulators. The Basel II capital adequacy rules are procyclical, meaning that when things are going bad they are exacerbated by the bank capital requirements and things are going well the burden eases, leaving banks with free capital to support extra lendeing.

Why is this? Because the amount of capital required by banks to be set against an asset is linked to the rating of the debtor. Under the old rules the weighting for a particular asset was determined by whether the debtor was a government, bank or corporation, and to be frank, this was very unlikely to change during the life of an asset. Under the new rules the risk weighting of an asset also depended on the rating of the borrower.

On its face this didn't seem unreasonable. Why should a standby credit facility to AAA rated multinational be treated the same as the subordinated of a leveraged buy out. AAA borrowers from banks were rare because they could get the money from the bond markets at better rates, so it seemed that these rare diamonds were relatively harmless. It was recognised that the rating of the borrower could decline, but AAA borrowers never went bust overnight (if we conveniently forget about Confederation Life) so the bank could always reduce its position by trading it away if it really had to, but in reality it would probably have the extra capital to support the position and a AA or A credit was still very bankable.

The problem was that neither the bankers nor the regulators saw what would happen next. Instead of being a rare jewel the AAA credit rating became a prized commodity that could be used to wrap around inferior credits. Fannie Mae, Freddie Mac and AIG became important not just because their sprinkling of fairy dust over an otherwise dubious asset gave it a higher credit rating, but also the assets became attractive to banks looking to maximise their returns to shareholders. The paper may have had a lowish yield, but it paid at a higher than normal paper with a similar credit rating because of complexity, and jo oy joys because of the high rating banks could hold much more of it per dollar of capital than they could hold of loans to corporates.

The demand for credit wrapped mortgage paper went through the roof until it became clear that there was little underlying credit in some of the assets and the high ratings for the guarantors were looking a little shaky to say the least. Now the regulators were looking at a different problem to the one they envisaged. Instead of looking at rare instances of AAA lending that might have been envisaged, the entire financial market was overhung by vast amounts of structured mortgage assets with likely ratings downgrades and capital requirements that could not be met.

Not all Mr. Brown's fault, but as the Cooke Committee was largely driven out of London, the UK government cannot avoid a lot of the blame, and as the financial regulator for one of the most significant markets for these transaction, the FSA has a lot of egg on its face.

And then there are all the credit default swaps written by AIG in London in an unregulated vehicle...

1 comment:

Occams Razor said...

The basic question remains unanswered. Does the world "need" a City of London finance market? If not, then does the UK need to have one remotely of this size? The past back to the Paleolithic is strewn with the remains of economic and human entities that passed beyond need. Some, like the ancient and more modern Empires, and for that matter the British Empire lasted too long after their day had come. It is my view that the City as it has been since the 1980’s, a temporarily revived relict of our imperial past, is now done for, and we need to sort out what pieces remain and adjust to a very different world. Tourism, retailing, and public sector expansion are not enough, and we need many fewer throwaway clothing, cheap jewelers’ outlets, various eateries, and other things. I saw the Lancashire Cotton Industry go, other industries go, once rich industrial towns lose their raison d'etre, and major changes to the political and economic geography of the world since my elementary school teacher pointed to a large map, pointed out the red bits, saying "These are ours, learn them off by heart." We have had to rewrite the history of the climate, and much else with new knowledge in the last two decades. We now have to adjust to a very different economic and financial world. And to do that soon, we need to answer the basic question above. Does the world need a City of London?