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

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

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