Credit control will be much more intrusive in future

January 26, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

The international system of bank regulation, epitomised by the Basle II process and the light-touch principles-based regulation of Britain’s Financial Services Authority (FSA) has comprehensively failed.

In too many instances, light-touch principles-based regulation with an emphasis on banks’ internal risk controls turned out to be no effective regulation at all.

Former Fed Chairman Alan Greenspan was the most prominent proponent of this approach, which relied on the profit-maximising self interest of financial institutions to limit risk-taking to prudent levels.

In this view, bank leaders themselves could be relied upon to manage their institutions prudently — after all bankruptcy is not in the interest of shareholders. Previous bank failures (such as Barings) were the result of failure to measure risks properly, or failures of internal communication and control.

So the job of regulators was to set out principles and ensure banking institutions had adequate internal systems and controls, then allow senior management to ensure the overall level of risk was prudent.

This reliance on internal risk-management systems has proved to be a huge error. As Greenspan himself noted recently, bank leaders had not acted in the careful manner he had expected when he pushed for them to be freed from the old, more restrictive regime.

As a result, credit control will be much more intrusive in future. As noted in a companion column, there is renewed interest in some form of overall credit policy to limit the quantity of credit (and debt) within the economy and ensure it is consistent with macroeconomic stability.

But intensive contra-cyclical credit controls will only work if they are imposed on a broad range of institutions and on a worldwide basis — otherwise the banking system will arbitrage between regulators, and business will be booked in the jurisdiction with the “lightest touch”.

This is precisely what happened in the last decade, when the FSA, and the Commodity Futures Trading Commission (CFTC) in the United States, arguably led a race to the bottom among regulators to offer the most generous regime in the hope of creating a competitive advantage for their home jurisdiction and winning more business.

So any new credit control instruments will need to be implemented on a multilateral basis and agreed through the Basle Committee on Banking Supervision, in tandem with the Madrid-based International Organisation of Securities Commissions (IOSCO).

The Basle Committee’s updated Capital Accord (Basle II) has already been rendered moot even before it has been fully implemented. Basle II’s decision to allow banks to rely on their own complex internal risk control systems when judging how much regulatory capital they need to hold now looks quaint. Of the three pillars in Basle II — (1) capital requirements, (2) supervisory review, and (3) market discipline — the third now looks wholly outdated, and elements of the first and second need substantial re-working.

Some form of Basle III will be needed to buttress the contra-cyclical credit instruments which national regulators and central banks will deploy to manage the credit cycle and limit debt to GDP ratios to more safe levels.

Basle III needs to settle on an agreed range of credit instruments and credit-creating institutions that will be subject to regulation, how regulation will be applied on a counter-cyclical basis, the respective roles of supervisors and bank management, and how to ensure against regulatory arbitrage.

BANK REGULATION AND MONETARY POLICY
The failure of Basle II process bank regulation at multilateral level has been matched by failure among national regulators. The events of the last 18 months have demonstrated that a credit-fuelled banking crisis cannot be contained within the financial sector and has potential to destabilise the rest of the economy severely. Credit policy is a matter of macroeconomic strategy, not just financial regulation.

If credit expansion has the potential to destabilise the real economy, and the liabilities of much or all of the financial system are contingent liabilities of the central bank and the finance ministry as lenders of last resort, then the quantitative control of credit is arguably too important to be left to a financial regulator, such as the FSA or the U.S. Office of the Comptroller of the Currency (OCC) and U.S. Office of Thrift Supervision (OTS).

Quantitative credit control needs to be brought within the remit of the central bank, so that credit expansion can be adjusted in tandem with interest rates (and indirectly in response to changes in government fiscal policy) to ensure internal, external and financial balance simultaneously.

While banking regulators may still have a “tactical” role in supervising prudential management and risk controls within individual institutions, the “strategic” role of limiting credit extension across the financial system as a whole to a safe level is too important, and properly belongs to the macroeconomic managers at the central bank.

Recent regulatory trends have seen institutional responsibility for financial regulation dispersed across multiple institutions, and separated from monetary policy at the central bank. This trend may now have to be reversed.

A more consolidated and intensive approach appears inevitable. Proposals to combine the various US regulators or at least to give the Fed over-arching responsibility as a super-regulator for the financial system have received widespread support, though the details of institutional reform have yet to be agreed.

In the United Kingdom, the wisdom of separating financial regulation from the Bank of England and passing responsibility to the FSA is increasingly questioned. The need for a lender of last resort support to a wide range of institutions, and the macroeconomic consequences of a widespread debt crisis, have pushed the Bank of England back into the heart of financial regulation.

If a new instrument for controlling the quantity of credit is eventually implemented, it will probably have to be managed out of the central bank. The FSA may retain responsibility for the prudential supervision of individual banking institutions, but the overall framework of control will need to be set by the central bank.

EMERGING REFORM AGENDA
If proposals for regulatory reform are to stand any chance of being implemented, they will need to move beyond a sterile debate over market-led discipline and innovation versus stodgy heavy-handed state regulation.

They will have to recognise that collective action problems and moral hazards in the credit creation process make some form of quantitative control essential. The system needs to achieve a financial balance alongside internal balance and external balance, and for that it needs to develop a third instrument, credit policy, alongside the traditional monetary and fiscal policies.

Credit policy will need to act directly on the volume of credit created, and amount of risk, independently of its price, which is the province of interest rates and monetary policy.

It will need to be contra-cyclical and apply to a broad range of institutions to be effective.
It must be dynamic, capable of being modified as the financial system evolves and pioneers new ways to circumvent the existing controls.

It must also be applied on a multilateral basis to prevent the type of regulatory arbitrage which occurred in the late 1990s and 2000s.

The Basle Committee is the most promising forum for reaching agreement. But Basle III will need to be developed much more quickly than Basle II, which took more than a decade, has still not been implemented fully, and risks becoming a stillborn historical curiosity, a monument to an age which has passed.

That suggests Basle III should focus on a much simpler set of credit control instruments, and eschew complexity in favour of a blunter but more effective approach. Crude but effective safeguards may be preferable to interminable arguments and theoretical elegance.

26 comments

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To vest the Fed with yet more authority is like adding more foxes to the ones now guarding the hen house. It’s time to reconsider the merit of the Fed.

Posted by grandpa | Report as abusive

I love reading John Kemp’s stuff. He is one of the best financial columnists I ever had the chance of reading. I’ll admit, I don’t always understand what he’s saying, but I get the jist of it. 1 question for Mr. Kemp,

1. If re-regulation is the answer and especially at the levels you’re discussing, then what happens next time when the system(And I believe our system, Americas is fine. It just needs a little tweaking)is besieged by greedy investors, dilatory commissioners and lack of government transparency? All those things will happen again. Like they did now. If the government is so involved then, when it will happen, then who does the government turn to when there’s no one left to turn to?

Posted by Jose. | Report as abusive

While I agree with most of what the author has written. I would like to point out that it’s not only credit, as important as that is. But it is also the whole derivatives business that must be brought back under control.
The danger did lie to a large part in those CDOs and CDSs.
In essence this was and is money creation by private institutions, especially if the government starts printing money to redeem them to the banks. This is in most countries completely illegal, as derivatives are not legal tender.

Posted by Robynne | Report as abusive

Mr. Kemp’s informative and technical article really misses the point and in my opinion his advice would head the country and the world in a worse direction.

He identifies the effect but not the cause when he states, “This is precisely what happened in the last decade, when the FSA, and the Commodity Futures Trading Commission (CFTC) in the United States, arguably led a race to the bottom among regulators to offer the most generous regime in the hope of creating a competitive advantage for their home jurisdiction and winning more business.”

In my opinion it is neither the repeal of Glass-Steagal, nor securitization of loans, nor improper risk-management that is at the heart of the current crisis. Instead it is the fact that we had an executive branch so far tilted toward a corporatist perspective, that the titans of industry realized, “My God, we have a license to steal!” With no one at the helm of state looking to balance the push-pull of economic competition and fair play, the aptly identified “race to the bottom” began and in fact is still going on.

Why? Because no one (outside of Madoff)has been arrested! As long as there are no sharp sanctions for economic piracy, there will be no return to the relative normalcy o0f the 1990′s when well-educated technocrats were at the helm.

Congress must look to itself for abdicating its responsibility as soon as it became clear that the Administration saw itself as above the law. When the top people are above the law everyone starts thinking that ignoring such things is what the smart people do. That precipitates a race to the bottom in economics, ethics, and in the end the deconstruction of the foundations of society.

Posted by Jonathan Cole | Report as abusive

Excellent discussion, thank you.
Two flys in the ointment though in terms of your proposals:
(1)Monetary policy in the U.S. as elsewhere has been targeted on containing inflation as measured by CPI. Whilst the approach you sketch aims to reduce the forces that fed asset price inflation, it doens’t overcome the problem of overly narrow targetting of CPI.
(2) The two most powerful central banks – the Fed and the ECB – are unaccountable to government. the Fed because it’s not part of the U.S. government, the ECB becuase there is no central government to be accountable to.

(1) + (2) gives pause to worry over further empowering the central banks. As we’ve discovered with commercial banks, one has to look at what will be the behavioural drivers in practice. William Buiter at the L.S.E. has suggested less power for central banks but beefing up other regulators with a clear mandate to control credit etc.

More controls will be implemented as they were after the Great Depression. Decades later, the economy will prosper, and everyone will have forgotten why we ever implemented the controls. Some Reagan-like figure will emerge and begin mass-castration of all the regulatory agencies in the name of free enterprise, and the cycle will repeat…

Posted by lb | Report as abusive

A suggestion on how to reinforce the banking industry’s internal risk-management policies: Require that all performance-based compensation for senior executives be assessed and paid after a five delay. In other words, CEO Bob Smith would be getting his stock options and bonuses in 2009 based on his performance in 2004.

This is hardly a faultless proposal, but it does encourage executives to look at the longer-term, and it gives the company five years to determine if the executive was a genius or a fool back in 2004 when he proposed investing the pension plan fully in Lehman.

Posted by farcast | Report as abusive

I like your columns too and even without degrees in economics I can understand them. But I am very surprised to read that the Federal Reserve system is not part of the Government. I thought it was a semi Governmental apolitical entity chartered by the government with a chairman that is appointed by the President. That’s not part of the Government?

But if controls on credit become more rigid than I guess we kiss the good old days of the last 20 years goodbye forever. “The rich will get richer and the poor will definitely get poorer” by statute and regulation. How soon will it take before the country gets into the business of printing “patents of nobility” Silly me – that’s unconstitutional – but who will need to worry about that when deeds and very large bank accounts are the only thing that ever really talked anyway – even if you had a “de” or “von” in your background.

The only thing that made the developed world economies still look like broad based lands of opportunity was the easy credit. If that goes – so goes the “land opportunity”.

I wish someone would tell all this to the town assessors. They still think the last property tax assessments are going to reflect reality someday soon.

Posted by p rosa | Report as abusive

Hi, I am spanish from Spain (Europe) and I don,t understand the total faillure of the SEC (sorry for my english). In Spain we have a huge crisis (international and internal as you know) but we have problems with credit loss allowances but because we have a lot of unemployment and in USA you have two problems, provision for credit loss for unemployment and the main problem is the huge losses in Banks.

In brief we have the presentation of SANTANDER http://www.santander.com/csgs/Satellite? canal=CAccionistas&cid=1148977291570&emp r=SANCorporativo&leng=en_GB&pagename=SAN Corporativo/Page/SC_ContenedorGeneral the more important spanish bank, we have the percentaje in provisions of credit losses.

Sincerely

Posted by benito | Report as abusive

I agree with what Jonathan Cole noted in his comment.

I believe it’s a very bad idea to vest power for credit policy with our current, constitutionally questionable, FRB. And at this particular time there is a serious question about the opacity of fed activities and their role in the our current debacle. The FRB is a private closed organization that is at the root of our problem in the US.

I don’t see further regulations as being a reasonable solution. The system will simply find another way to achieve what it has before, which in the end means that the existing regulatory framework will be worthless.

What I really care about and what we should be concerned about is stable currency and the failed monetary policy of the last 30 years. Along with that I would argue that we already have very bad monetary / credit policy in the US, after all, what we’re witnessing now is a failed credit policy that endorsed credit expansion to the population’s detriment.

Posted by steve | Report as abusive

The timing of the article is appropriate. It is necessary to analyse the mistakes made, so we learn from the same. I agree with the importance of credit risk management as highlighted by the author. But don’t agree with the remarks that Basel II has failed. Had the Basel II been implemented in right spirits, the losses could have been contained. The credit risk evaluation tools used by the banks were faulty, supervisors did not play the role as per Pillar II well and disclosures were false and misleading. The credit rating agencies did play foul. Thus, I feel it is high time, the regulators and bankers have to act with prudence and save the economy from further going down. We should learn from the mistakes and improve. The guilty should be punished quickly and this should set as a deterrent to others.

Posted by Mrudul Gokhale | Report as abusive

Years ago, the “old” regulation system worked fine. Was a lack of regulation really the cause of the banking mess? My view is that the money supply(in the broadest sense “capital”) was allowed to get out of control. And right along with too much money, too much debt. YOU CANNOT HAVE TOO MUCH OF ONE WITHOUT TOO MUCH OF THE OTHER!!! It is almost bipolar that people on the one hand talk about there having been too much easy credit(debt), and then later talk about all of the loss of wealth that has occurred(money, capital). Too much money….Too much debt….Daaaah!!! The bubble bursts and… Lending dries up….Money goes bye bye….Daaaah!!!

Posted by JRaymond | Report as abusive

Some form of global credit exposure is the preferred option in my opinion. I work in the compliance / audit of a large bank. One would have to be extremely gullible to think that Basel II (even though it has been implemented fully etc) is able to contain the single minded apetite for corporate driven recklessness abandoning all the principles it stands on, especially in times of affluence. A bank will never do a bad loan. So forget that credit risk alone is an issue. Failed investments made at the top of the market caused the biggest loses which in turn drowe down the value of any collateral the banks used in the traditional model. Complexity of securitizations was not backed up by adequate assessment of the existing risk models coupled with poor knowledge of compliance officers was the the single biggest failure of the regulatory framework. The Madoff case is a monstrous example of how poor judgement and incompetence leads to massive failure of a system thought to be a cornerstone of capitalism. There is no such thing as a free lunch as they say.

Posted by Franz Kafka | Report as abusive

Money supply growth and credit expansion go hand in hand. The government controls fiscal policy. The central bank controls monetary policy. Government controls its debts and deficit spending. A stimulus to the economy. The central bank can either target money supply or control interest rates. It cannot do both effectively. If interest rates are set too low then they are also stimulative to the economy. If interest rates are set too low and governments are running budget deficits then that is extra stimulative.

How is some sort of super regulator then going to control credit expansion? Minimum capital adequacy ratios can limit credit expansion somewhat, but this assumes all regulators work effectively together. They do not. Global financial imbalances are caused in part by central banks artificially manipulating their own currencies to remain export competitive. So long as regulators favor local banks and national champions over international cooperation we will see funding arbitrage and asymmetrical risk. Especially as governments attempt to fund themselves as cheaply as possible, while investors and pension funds need higher returns to repair their balance sheets, prepare for retirement, and to meet future liabilities.

The only way you can square low interst rates on one hand with the higher returns demanded by investors and pension funds – along with a triple A rating – is through leverage and financial engineering. Sound familiar?

So regulate all you want. The result will be low, slow, no growth; higher unemployment for longer; downward pressure on wages; lower tax revenue; and ultimately fewer social programs as servicing government debt takes a bigger share of revenue and government borrowing crowds out private investment initiatives.

Balance your budgets, pay down debt, keep interest rates broadly neutral and you go along way to controlling money supply growth a rapid credit expansion. That in turns creates a more stable investment environment where risk can properly be priced according to interest rate gap risk, foreign exchange risk and credit risk.

Posted by MrBill, Eurasia | Report as abusive

This one is for Mr. Kemp. What I still ask – and nobody has answered yet is: Why didn’t the PMI that mortgage holders pay to protect Lenders in case of default prevent the mortgage meltdown? Presumably, Fannie and Freddie would recover their money in spite of defaults and the “securitized investments” they bought would still have value. Its amazing that nobody in the Press has brought this up!!!

Posted by Electron | Report as abusive

With respect to the Fed, I believe few people are aware that this so-called “federal” bank in fact is partly owned by the major banks. Does this make it independent? Why not make it a truly Central Bank, owned by the state, like its predecessors in England, Germany and France (for example)? This has nothing to do with nationalization, no more than when it was decided that printing money was the perogative of the State. We have seen that State-owned Central Banks still can be very independent from the Ministry of Finance / Treasury Depts in many countries. e.g. the German Bundesbank, and normally the Bank of England, no less so than the Fed under Greenspan.

REGARDING REGULATION, MORE OR LESS
I believe it would be worthwhile to do a survey today to see which regulators have functioned well (best), and not so well under this crisis. Here in Norway, where I currently live (after USA, UK and Swizterland) it is clear that the local Financial Supervisory Authority has excellent insights into each bank’s challenges and has kept itself on top of the situation for several years leading up today’s problems, to which Norway has also not been immune. Fortunately, we have hardly any CDO issues and no SIVs. The regulator has learned a great deal, like in Sweden, after our debacle in the early 1990′s. When looking at Sweden’s Bad Bank example from those days, economists might also learn something from how the crisis was handled in Norway. There (i.e. here), shareholders who had let their banks run wild got wiped out, deservedly so. Then the banks were re-capitalized. Sometimes you just have to take your “medicine”.
For the TARP to be used to provide non-voting preferred stock to banks was ludicrous, not true dilution (the stock would be retired, in practice repaid like just another bond-issue, in the future, with a “coupon”.
Dilute the silly shareholders who didn’t pay attention to how their elected Board represntatives stewarded their assets!
The issue is both one of quality and quantity of regulation. When even people like Madoff were able to effectively lobby US regulators to soften proposed regulation, it isn’t strange that the US regulatory system failed.
When the ideal carreer-path for a senior person working for a regulator is to as soon as possible wander to the “other side”, changing over to lucrative jobs on Wall Street, it stands to reason that these people hardly are incentivized to “rock the boat” and to ask the difficult questions, a bit like ignoring the 1,000 lb gorilla in the room.
Then to regulatory arbitrage: I recently advised a start-up bank in the credit car sector in Europe. In stead of starting up in the UK, under FSA supervision, it started in one of the smaller EU states with less than 1/2 the capital requirement. This is not good!
Basel II may be great, but something is seriously wrong with banks are capitalized today. Until this is fixed, we will be stuck in a rut.

Mr Kemp seems to be forgetting that it was the bad data/information, namely the rating agencies “wrong” ratings of what became known as “toxic” assets, not the banks’ models nor their risk standards that caused the current financial problems.

And some portion of these toxic assests became toxic through variable interest, zero down, poor lending standards loans which were made, not by the banks, but by second rate (fly-by-night?) “brokers”.

These are the regulatory failures that need fixing, not the parts of Basel II that Mr Kemp highlights.

The part of Basel II that might need some review is the strict “mark-to-market” standard. The toxic assests if held to maturity are not worth (nearly?)”zero” as the amrket now holds them. This is a related cause of the banks’ problems.

Posted by Phil Sher | Report as abusive

Private Mortgage Insurance (PMI) is paid by borrowers with less than 20% down on most home loans. The insurance polices are written by regulated insurance companies. They all failed early in the foreclosure waves hitting us. Some are zombies begging for bailouts.

As with most insurance today, your policy is only worth their promise to pay. Not comforting given their net worth disappearing.

Posted by skinner | Report as abusive

Irregular Deposit Contract is the root cause of all the problems in banking.
What makes the banking industry so special from other industries (like Auto, Steel) that they can legally get away with holding less asset than their liabilities?
In any other industry, it would result in a criminal fraud case. If FORD represents it has more cash than it actually has, by showing its unbuilt Autos as Cash, the next day we would see FORD CEO and CFO being hauled to jail.
This is what a Bank does everyday.
Insist on holding 100% reserve and force the bank to risk its own capital FIRST instead of last (as today), and you will see no more crises.

Capitalism rules.

The incentives for individual regulators not to regulate, governors not to govern, or prosecutors not to prosecute will always exist not matter what you put on paper.

You might as well propose a race of robots to guard our safety.

I thought of posting what “we” need, but realized that I’d be posting what “I” need: I want to see greater transparency. Then I would be able to judge where to put my money. This is because I am smart and educated. However, this would not help the average and uneducated.

I wonder what your article would look like if you were honest about how you came to the conclusions you did, i.e. what you need and why.

Jamie

Posted by James | Report as abusive

The origins of the debt load that has been accumulating since the Reagan administration, finally precipitating the current “crisis” are quite well understood, but remain unmentioned and unexamined in popular discussion of it.

The rich seek not just a redistribution of wealth, but a reordering of society and the structure of the economy, and by all appearances they shall have it.

Posted by John | Report as abusive

1st – The Basel (not Basle) Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.

2nd – The purpose: The Basel II Framework describes a more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rule-making and adoption procedures. It seeks to improve on the existing rules by aligning regulatory capital requirements more closely to the underlying risks that banks face. In addition, the Basel II Framework is intended to promote a more forward-looking approach to capital supervision, one that encourages banks to identify the risks they may face, today and in the future, and to develop or improve their ability to manage those risks. As a result, it is intended to be more flexible and better able to evolve with advances in markets and risk management practices.

3rd – Do you know what Country/ies is/are most behind implementing ? If you do you should inform your readers !

4th – Ongoing: Basel Committee on Banking Supervision announces enhancements to the Basel II capital framework – http://www.bis.org/press/p090116.htm

Last – I find you article interesting, I believe your wrong about the third pillar of Basel, the problems were: supervision, supervision, supervision…
I would love to write some more but I have to work ;)

Posted by Carlos | Report as abusive

Humbly I offer the thought, “if the law was not implemented, it doesnt mean the law was wrong”

The problem, as the author correctly pointed out was assuming that banks will work in the best interest of their shareholders.

The problem that was not highlighted was the complicated transactions, financial instruments and derivatives that were born out of the idea that risk could be divided until only the beta remained.

Do you think that there is a correlation between Basel compliance and bank failures? Or Basel compliance and income robustness despite the crisis?

Who were at BASEL I and II, and were the most loud during their forum, or had the most voluminous treatises published backed with fanfare and hoopla? Were they actually correct? Did they practice what they preach?

Posted by Marty Abuloc | Report as abusive

The short-sighted Results-Based Compensation programs which emphasize bonuses for short-term results, which came into vogue in recent years, in combination with insufficient oversight, had more than a little to do with why Greenspan was so wrong.
The simple human truth that Greenspan ignored is that there are in fact no banks, no institutions, as monolithic entities, in any effective sense. Large organizations are fundamentally large bunches of people. And most of them are looking out, more than anything else, for Number One. What does risk matter to a bright young financier, if he can pump his illusory profits (and correspondingly huge bonus) through the roof, (for example, by writing lots of CDS contracts, whose revenue will fall straight to the Bottom Line). So what if the whole thing implodes next year? It’s only this quarter’s profits, and this year’s bonuses, that count. And next year? Well, if this year’s bonus is big enough, what should I care?

Posted by Hugh | Report as abusive

Investment is an idea born of sacrafice which is born of religion – our low savings rate is a symptom of all kinds of types bankruptcy. Our banks have no faith because the government has co-opted all faiths by bribing would-be ministers into the military. Think of all the seargents and medics who would be supervisors within companies enforcing a sunny, optimistic but disciplined outlook on these company’s futures but are now fighting a war. The other problem we are wrestling with as a nation is the issue of scale. During the Reagan years it was not un-common to hear complaints from Wall St. that the sheer size of foreign banks and brokerages was so large that the relatively fragmented but healthy economy was falling victim to economies who did not mind the aggregation of wealth into a single company – the grass is always greener. We have big companies now but with only a few in business – who will lend us anything? Where was the oil boom when oil reached 145$ per barrel? Now I remember. Past oil booms were a the product of a scattered S&L system we dismantled for reasons of fraud – oh well.

Posted by kronos_ad | Report as abusive

Why this backlash against Basel II?

The first lesson I learned 15 years back when I joined an Indian Bank (incidentally by name Indian Bank) as Probationary Officer was to never ever get in to the Real estate lending. The Real estate lending was seen, is seen and will be seen by the public sector banks in India that cautiously. It’s a kind of taboo for public sector banks in India. Over a period, they have also liberalized their policies but still with a lot of caution. Indian public sector banks have largely survived the present turmoil. I am not blaming the banks who are bullish on the real estate funding. But, it reflects the underlying risks involved in this exposure.

Let’s visit American market for once:

1. Banks knowingly take exposures on sub-prime borrowers.
2. They are nicely wrapped under CDSs
3. CDSs are rated high in the market.
4. Banks buy nicely packed CDSs at high premiums without knowing the crap under the wrap.
5. Sub-prime borrowers default.
6. Banks collapse.
7. Basel II has failed.

Why can’t the so called John Kemps and Alan Greenspans say for once CDSs failed? The high bonus driven profit maximization strategies of the banks with least sympathy to the public funds are prime reasons for the market turmoil.

Let us now get in to a story mode:

I earn 100 bucks a month, I can invest a maximum of 100 bucks in stock market or take an exposure for 5 times of that which is 500 bucks if I do day-trading (depending upon the margin requirements, assuming 20 per cent). I invest in good scrips based on the market research and some kind of tips from my broker. (This is similar to the Standardized Approach for credit risk suggested by Basel II wherein banks take external ratings supplied by Moodys, S&P, Fitch etc. into consideration). Once I get some sort of maturity as a player in the market I develop my own mechanisms to identify which company is good and which company is bad etc. (This can be correlated to the Internal Ratings based approach suggested by Basel II wherein you rate your own customers based on various risk parameters and risk profiling). I make all my sincere efforts to understand the market dynamics before taking any exposure. I leave no stone unturned to dig out the risks involved. After all, it is my hard earned money. I don’t require any Basel II here.

Let us suppose, my stock market exposures are regulated by Basel II, then Basel II has given me ample room to initially understand the market over a period (The Standardized Approach) and then move on to my own developed mechanisms (The Advanced Approach). Do I still expect Basel II suggest me to restrict my exposure to only 500 bucks, as this is the maximum I can leverage? Can’t the so called best brains of the world (Harvards, London BSs, IIMs) working with Lehmans with fab bonus driven packages understand the basic risk management principle in any walk of life, in this case the LEVERAGE (Mind you, there is a leverage point in dealing with spouse also). When Lehmans were collapsed, their leverage was well above 25 times.

Further extension to the above story, If I am greedy enough, I start borrowing from my next door neighbor and invest in the market and when market collapses, I sit pretty and blame my wife (Banks blame Basel II) as I was never told by my wife not to borrow from others. I apply for an IP and there ends my liability to my next door neighbor.

Basel II is aimed at improving the risk management practices, not policing against deeds and misdeeds of the banks. If the Banks’ management chose to be dishonest, Basel 20 or 200 also can not help.

Posted by Vijay | Report as abusive