Three discrete events over the past couple of weeks have confirmed the worst
suspicions of non-Keynesians that governments remain not just beholden to banks
around the world but positively scared of them.
Exhibit A is the cartoonish European bank "stress" tests, Exhibit B is the US
government's alleged attempt at financial system overhaul through the
Dodd-Frank bill and Exhibit C is the hilarious Basel-III regime unveiled this
week.
Exhibit A: The "stress" test
The simplest way of describing last week's European stress test
is, in the words of an anonymous commentator passed on by e-mail to me, "if all
the Greek banks passed, the Stress Test failed". No seriously - imagine how
good any stress test can be simply by looking at the results.
The major source of disappointment for analysts examining the dynamics of the
stress tests was the underlying assumptions. I wrote about the dynamic of
stress in European banks (see
The 'why' of Europe's banks, Asia Times Online, July 23, 2010); knowing
full well that these issues wouldn't be revealed - much less resolved - by
whatever the stress tests could possibly accomplish. The wonderful John Kay,
writing in the Financial Times, comments as follows:
The concept of
stress tests is derived from the procedures used to ensure the robustness of
complex engineering structures. There are three stages. You begin by testing
each component in conditions considerably more demanding than it is likely to
encounter. Then you review system design to ensure that, even if several
elements break down simultaneously, this does not jeopardize the integrity of
the whole structure. Third, and most importantly, you test the total system for
outcomes far outside the range of experience. You do not ask, "Will the bridge
survive a strong gust of wind?" You ask, "Will it survive a gale worse than any
at this site in the last century?"
And his conclusions of how
the Europeans did:
There is much that the finance sector could learn
from this, but no indication it has done so. The adverse scenario of the bank
stress tests, far from being outside the range of experience or expectation, is
not far from the mean... Worse, the stress tests are self-referential. Their
purpose is to show, not that the bank is sound, but that it meets the
requirements for regulatory capital. But one lesson of 2008 was that capital
adequacy was almost irrelevant in a crisis... Shamefully, the purpose of the
stress tests is not to ensure that depositors' money is safe or that taxpayers
will not be called on again. The purpose is to reassure banks and their
shareholders that they will not be required to provide significant additional
capital. The lesson - perhaps the only lesson - of the stress tests is that
Europe's politicians and regulators have not begun to address, far less
resolve, the issues posed by the crisis of 2008.
Readers will
remember that little bit of concern that, oh I don't know, the whole world had
concerning the potential for European sovereigns to default due to excessive
debt loads. The infection from that view to European banks was led by the
simple fact that they held the greatest proportion of European sovereign debt.
So what do the folks doing the tests - the Committee of European Banking
Supervisors - do in this situation? Do the right thing and assume that banks
are "stuck" with the sovereign debt and suffer massive defaults? Or do they
quietly whitewash the issue?
Here is what they did. They put the whole lot into a "hold to maturity" account
for banks, and assumed that any sovereign default that did occur (say Greece)
would have a fairly small impact ("severity" in the lingo). In other words,
there was no need for banks to worry about the volatility of holding European
government bonds, and even if there was an actual default actual losses would
be minimal.
If that wasn't bad enough, there is no actual evidence that the banks'
liquidity access to the European Central Bank (ECB) was stress-tested. In other
words, what would happen to the liquidity position of European banks if the ECB
were to change collateral eligibility requirements (say due to pressure from
the German government)? What would happen to European banks if a large
institution were to collapse? How about the "what if" scenario associated with
more than one European sovereign going into refinancing stress later this year?
The obvious conclusion from all this is that the European stress tests were
designed for banks to pass, not fail. That alone ensures that the design and
implementation of the tests was faulty from the first day.
Exhibit B: US financial reforms
The Dodd-Frank Bill that was passed in the US this month has been hailed by its
architects as an important piece of financial regulation that will reduce the
chances of financial crises in years to come. As the Washington Post reported
on 16th July:
Sen Christopher J Dodd (D-Conn), who shepherded the bill
through the Senate, said the legislation will help restore Americans'
confidence in the badly battered financial system. "More than anything else, my
goal was, from the very beginning, to create a structure and an architecture
reflective of the 21st century in which we live, but also one that would
rebuild that trust and confidence."
... Meanwhile, most Republicans continued to argue that the bill creates
bigger, more intrusive government and fails to prevent future bailouts of
financial companies using taxpayers' money. These critics joined with leaders
in the banking and business communities in insisting that the new regulations
will undermine the competitiveness of the US economy, stifle growth and kill
jobs at a time when unemployment is high.
... For weeks, Treasury officials have been holding daily meetings to plan how
they would carry out the wide-ranging bill. Similar efforts have been taking
place at other agencies, such as the Securities and Exchange Commission, the
Federal Deposit Insurance Corp, and the Federal Reserve, each of which will
have new responsibilities. The Treasury Department has already assigned dozens
of employees to carry out various provisions, such as the creation of the
consumer protection bureau.
The Wall Street Journal didn't like
the bill (not a surprise per se given their editorial slant) but did make an
important point about complexity and unknown side-effects:
Given the
radical and experimental nature of this bill, they will, like with the stimulus
and health care, have cause to read in coming months about unintended
consequences. The White House is not going to be able to prove it fixed the
financial system. But it will have to answer questions about the small business
that can't get credit, or the Midwest farmer who has been priced out of the
derivatives market.
And the timing is hardly fortuitous. The White House got this far by trashing
Wall Street and greedy CEOs. It did this so frequently that the discussion is
shifting to how its antibusiness policies are hurting recovery.
Take the derivatives market for example. The object of the bill was to restrict
US banks from holding excessive derivatives on their book relative to their
requirements on trading with customers. However, it is well nigh impossible to
determine which trade is which, that is, for banks let alone regulators to
figure out the nature of trades that were executed by banks in order to enable
trading for their customers, and what represents outright speculation in
riskier activities alongside. For example, to hedge a bank's positions on
fixed-floating interest rate swaps (the most common form of interest rate
derivatives) traders may choose to position significantly on LIBOR (London
Interbank Offered Rate) contracts or on bonds issues by US mortgage agencies
(Fannie Mae and Freddie Mac). The trouble is, for both the supervisors of
traders and their regulators, it is impossible to distinguish between those
trades and outright interest rate "bets" by similar traders on another side of
the floor.
A simple split of what is known as proprietary trading doesn't cut ice either.
Most banks that lost money during the financial crisis did so on account of
"customer" trading activities, for example asset-backed securities or
collateralized debt obligations created and structured for sale to customers.
Nor is the size of an activity relative to a bank's capital position an
indicator of risk much less tolerance. While some banks such as Lehman Brothers
failed on account of the sheer size of illiquid assets on their books, the same
wasn't true for smaller commercial banks for example; in any event the
Dodd-Frank Act doesn't do anything new in the area of monitoring and
controlling risk exposures.
The more that one tries to examine the real motivations and potential
ramifications of the Dodd-Frank Act, the greater the suspicion that this was an
overly complex law that was pushed through for the sake of expediency but
without much regard to the likely enforceability let alone its eventual impact
on reducing systemic stress. The government is seen to be acting but banks
continue with business as usual because they have a law that cannot be
realistically implemented to any great efficiency.
Exhibit C: Basel-III cop-out
Perhaps the worst case of all though is the new Basel-III regulations. News of
the adoption sparked a rally of over 10% for European bank stocks on Wednesday,
a true indication if one was needed at just how poorly constructed the regime
was likely to be (investors greeted the notion that no new equity or very
little equity would need to be raised due to Basel-III).
As the Lex column in the Financial Times explained:
First the European
bank stress tests that most banks were bound to pass; now the easing of Basel
III capital and liquidity proposals that, by the new implementation date of
2018, banks are bound to fulfill. It is very hard not to view the Bank for
International Settlements' relaxation of rules and stretched implementation
timetable as yet another win for the banking lobby. The threat of regulators
whacking up capital adequacy ratios was one of the last big unknowns for
investors. That European banks' stocks jumped 5 per cent on Tuesday suggests
that fear is rapidly evaporating.
Initial news reports had
suggested that Germany was against the watered-down proposals by Basel-III as
it had managed to clean up large tracts of its banking sector beforehand.
Instead, the government chimed in to avoid shaking the boat, as the Financial
Times reported:
Germany's bank regulator has dismissed concerns that
the country is unhappy with international proposals revealed this week to
strengthen lenders against a financial crisis. Jochen Sanio, head of Bafin, the
financial services supervisor, said Germany expected to reach agreement on
schedule this year but had expressed reservations this week because important
elements of the proposals remained unclear.
The committee, made up of central bank governors and regulators, said "one
country" - Germany - "still has concerns and has reserved its position" until
later this year. Mr Sanio told the Financial Times: "You can only reach the
final agreement on the whole capital accord. Until now we have only seen some
partial portions. We are waiting now for the finalization of the Basel III
package. We want the accord to be delivered in time for November's G20 [Group
of 20] summit in Korea."
The Basel committee has still to set a key element of its plans: the amount of
capital that must be held relative to a bank's risk-weighted assets. "What is
still lacking is calibration," said Mr Sanio. "Without it we cannot assess the
impact for the German banking system."
The sum total of all of
the machinations over the past few weeks is that regulators have expressed a
clear desire not to control the future risk-taking of banks, have not expressed
concerns over the current composition of balance sheets, and furthermore
refused to set a longer-term plan in motion for capital accretion.
Taken together, these missteps guarantee the recurrence of financial crises in
future, with each episode likely to be worse than the previous one.
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