Basel 3 - Financial Stability....but at what cost??

The much awaited recommendations from the Basel Committee on new capital standards were announced on 12th September 2010. The immediate market reaction was a sigh of relief with bank stocks staging a smart rally on the back of a much diluted set of provisions with a longer implementation timeline.
Is this a case of too little too late as some have implied or a pragmatic compromise between maintaining financial stability and ensuring robust economic growth? Let’s examine the key provisions of the proposed regulations to assess its impact on the banking sector and consequently on credit costs / credit availability.

I. Minimum capital requirements – more than 3 fold increase to core equity

The minimum capital for common equity, the highest form of loss absorbing capital, will be raised from the current 2% level, before the application of regulatory adjustments to 4.5%, after the application of regulatory adjustments. This increase will be phased in to apply from Jan 1, 2015.

In addition to the above, the committee recommended a 2.5% of additional core equity capital as a conservation buffer above the regulatory minimum taking the aggregate minimum core equity required to 7%. The conservation buffer is also phased in to apply from Jan 1, 2016 and will come into full effect from Jan 1, 2019.

Certain regulatory deductions (material holdings, deferred tax assets, mortgage servicing rights etc) that are currently applied to tier 1 capital and/or tier 2 capital or treated as RWA will now be deducted from Core equity capital. This will also be progressively phased in over a five year period commencing 2014.

Phasing-in effect:

	2013	2014	2015	2016	2017	2018	2019
Minimum core equity	3.5%	4.0%	4.5%	4.5%	4.5%	4.5%	4.5%
Conservation buffer				.625%	1.25%	1.875%	2.5%
Total core equity	3.5%	4.0%	4.5%	5.125%	5.75%	6.375%	7.0%
Min. total capital incl. buffer	8.0%	8.0%	8.0%	8.625%	9.25%	9.875%	10.5%
Phasing in of other deductions from core T1		20%	40%	60%	80%	100%	100%
Counter cyclical buffer	In addition the regulator can specify a counter cyclical buffer of up to 2.5% of fully loss absorbing capital for macro prudential objectives

Regulatory buffers, provisions, and cyclicality of the minimum

The capital conservation buffer should be available to absorb banking sector losses conditional on a plausibly severe stressed financial and economic environment. The countercyclical buffer would extend the capital conservation range during periods of excess credit growth, or other indicators deemed appropriate by supervisors for their national contexts. Both buffers could be run down to absorb losses during a period of stress.
Deductions from Core Tier 1

• Minority interest - The excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.
• Investments in other financial institutions - The gross long positions may be deducted net of short and the proposals now include an underwriting exemption.

Minority interest in a banking subsidiary is strictly excluded from the parent bank’s common equity if the parent bank or affiliate has entered into any arrangements to fund directly or indirectly minority investment in the subsidiary whether through an SPV or through another vehicle or arrangement.

Other deductions
The other deductions from Common Equity Tier 1 are: goodwill and other intangibles (excluding Mortgage Servicing Rights), Deferred Tax Assets, investments in own shares, other investments in financial institutions, shortfall of provision to expected losses, cash flow hedge reserve, cumulative changes in own credit risk and pension fund assets.

The following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:

• Significant investments in the common shares of unconsolidated financial institutions (banks, insurance and other financial entities). “Significant” means more than 10% of the issued share capital;
• Mortgage servicing rights (MSRs); and
• Deferred tax assets (DTAs) that arise from timing differences.

A bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1.

The combined effect of the above is shown below:

II. Qualifying non core tier 1 and tier 2 capital, transition arrangements

Capital instruments that do not meet qualifying criteria for inclusions in non-core tier 1 capital (i.e no incentive to redeem, full loss absorption capacity, full discretion on coupon payments etc) will be progressively phased out at an amortization rate of 10% p.a. effective Jan 1, 2013 to the earliest call date after which it will fully be derecognised if not called.

Only one type of tier 2 capital and the terms will have no incentive to redeem (i.e. no step-ups in coupons).

III. Leverage Ratios

A. Definition of the leverage ratio
The Committee is proposing a minimum Tier 1 leverage ratio of 3% during the parallel run period. While there is a strong consensus to base the leverage ratio on the new definition of Tier 1 capital, the Committee will also track the impact of using total capital and tangible common equity.
Off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review to ensure that the 10% CCF is appropriately conservative based on historical experience).
Derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method.

B. Transition to the leverage ratio
The supervisory monitoring period commences 1 January 2011. The parallel run period commences 1 January 2013 and runs until 1 January 2017. Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a Pillar 1 treatment on 1 January 2018 based on appropriate review and calibration.

IV. Liquidity

A. Liquidity coverage ratio (LCR)

The stock of liquid assets should be higher than the projected liquidity outflow over a 30 day time period.

Definition of liquid assets: The proposal outline that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. As part of the narrow definition of liquid assets, the proposal allow for the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction.

Allow Level 2 of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets. Include (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardised approach for credit risk, as well as high quality non-financial corporate and covered bonds not issued by the bank itself (eg rated AA- and above), also with a 15% haircut.

Retail and SME deposits: Lower the run-off rate floors to 5% (stable) and 10% (less stable), respectively. These numbers are floors and jurisdictions are expected to develop additional buckets with higher run-off rates as necessary.

Operational activities with financial institution counterparties: Introduce a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities.

Deposits from domestic sovereigns, central banks, and public sector entities:
For unsecured funding, treat all (both domestic and foreign) sovereigns, central banks and PSEs as corporates (ie with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate.

For secured funding backed by assets that would not be included in the stock of liquid assets, assume a 25% roll-off of funding.

Secured funding: Only recognise roll-over of transactions backed by liquidity buffer eligible assets.
Undrawn commitments: Lower retail and SME credit lines from 10% to 5%. Treat sovereigns, central banks, and PSEs similar to non-financial corporates, with a 10% run-off for credit lines and a 100% run-off for liquidity lines.

Inflows: Rather than leave it to the bank’s discretion to determine the percentage of “planned” net inflows, establish a concrete harmonised treatment in the standard that reflects supervisory assumptions.
B. Net stable funding ratio (NSFR)
The main concerns related to the calibration of the standard and the relative incentives across business models, in particular retail versus wholesale. A number of adjustments are under consideration.

V. Counterparty credit risk

The Committee is making modification to the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA). The bond equivalent approach will be amended to address hedging, risk capture, effective maturity and double counting. To address the excessive calibration of the CVA, the 5x multiplier that was proposed in December 2009 will be eliminated. More advanced alternatives to the bond equivalent approach could be considered as part of the fundamental review of the trading book.

Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.

VI. Systemic banks, contingent capital and a capital surcharge

In addition to the reforms to the trading book, securitisation, counterparty credit risk and exposures to other financials, the Group of Governors and Heads of Supervision agreed to include the following elements in its reform package to help address systemic risk:
The Basel Committee has developed a proposal based on a requirement that the contractual terms of capital instruments will allow them at the option of the regulatory authority to be written-off or converted to common shares in the event that a bank is unable to support itself in the private market in the absence of such conversions. At its July meeting, the Committee agreed to issue for consultation such a “gone concern” proposal that requires capital to convert at the point of non-viability.

It also reviewed an issues paper on the use of contingent capital for meeting a portion of the capital buffers. The Committee will review a fleshed-out proposal for the treatment of “going concern” contingent capital at its December 2010 meeting.

SUMMARY

The short term implications are muted as the implementation timeline is phased over 8 years to ensure that economic growth is not threatened. But the combined impact of the above proposals will have significant long term implication for bank profitability, availability of credit, cost of credit and would challenge the current wholesale bank model (GS, MS, GE Capital etc)…..

While attempting to make the financial sector stable, the central bankers are driving the insurance premium too high for the banks and its customers. It remains to be seen when they would be rushing into Basel 4 to address the adverse impact of Basel 3 on credit availability and credit costs.

A more effective deterrent would have been to make bank’s board personally liable for negligence and mismanagement! That would, in my opinion, lead to good governance standards….more than any amount of rules can ever achieve!!

Any takers????????

The Emperor Has No Clothes

The Federal Open Markets Committee (FOMC) on Tuesday, downgraded its assessment of the pace of the economic recovery from “moderate” (in June) to “more modest than anticipated.”

The Federal Reserve took a symbolic step toward additional easing of monetary policy. The Fed will “keep constant” its securities portfolio, reinvesting the principal payments from agency and mortgage- backed securities in long-term Treasuries, according to the statement released following yesterday’s meeting. Much of the economic commentary following FOMC’s meeting suggested the Fed had embarked on a second round of quantitative easing, familiarly known as QE2.

The Fed committed to, for the moment, is to maintain the size of its securities portfolio at $2.05 trillion rather than engage in passive tightening by allowing the balance sheet to shrink due to principal payments and maturing debt. How can it be quantitative easing when the quantity remains the same? Well, the Fed will buy some $100 billion to $200 billion of Treasuries a year to offset the maturing Mortgage Backed Securities.

The decision to substitute Treasuries for maturing MBS will be welcome news to those Fed officials who want the central bank to get out of the credit business and return to a “Treasuries only” policy.

Another option for the Fed would be to raise the cost of not lending. Banks now earn 0.25 basis points on their reserves. Reducing or eliminating the interest on reserves would, at the margin, entice banks to buy securities or make loans, expanding the money supply.

Some Keynesian economists say any further stimulus over the next few years won’t affect US’s ability to deal with deficits in the long run. Hmmm….not really…

“The Emperor has no clothes”

We have heard the children's story by Hans Christian Andersen entitled, "The Emperor's New Clothes". It is a very interesting story about human nature. An Emperor who cares for nothing but his wardrobe hires two weavers who promise him the finest suit of clothes from a fabric invisible to anyone who is unfit for his position or "just hopelessly stupid".
When the swindlers report that the suit is finished, they dress him in mime and the Emperor then marches in procession before his subjects. The Emperor cannot see the cloth himself, but pretends that he can for fear of appearing unfit for his position or stupid; his ministers do the same. A child in the crowd calls out that “the Emperor has no clothes” and the cry is then taken up by others. The Emperor cringes, suspecting the assertion is true, but holds himself up proudly and continues the procession.

The Emperor, i.e.the U.S.is delusional that continued loose fiscal and monetary policies will expand the economy and consequently increased tax takes in the future will pay for it. The US fiscal gap is projected to be grow to 14% according to IMF if current policies are pursued.

What is a Fiscal Gap?

The infinite-horizon fiscal gap measures, in present value terms, a country’s excess of total expenditures—including those arising from its commitments to spend in the future—over available current and future resources. It is commonly defined as the current federal debt held by the public plus the present value in today’s dollars of all projected federal non-interest spending, minus all projected federal receipts. Simply put, can the government continue to pay its bills.

An adverse fiscal gap implies that the federal government is violating its budget constraint, meaning that it will not be able to finance its expenditures at some point in the future.

…..and the IMF says

Last month, the International Monetary Fund released its annual review of U.S. economic policy. It’s summary on U.S. fiscal policy:

“Sizeable fiscal actions would be needed to close the U.S. fiscal and generational imbalances. Under current policies, the United States federal debt is projected to grow rapidly due to a combination of large budget deficits before and during the crisis, as well as, over the medium term, demographic factors and healthcare inflation. As part of the medium term adjustment, the authorities would need to raise taxes and/or cut transfers (i.e. social security benefits) substantially to avoid an undesirable escalation of the debt-to-GDP ratio. The longer the wait, the larger the necessary adjustment will be and the greater the burden on future generations.”

The U.S. fiscal gap associated with today’s federal fiscal policy is huge for plausible discount rates. It adds that “closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.”

Fiscal overview

Revenue - $ 2.381 trn
Expenditure - $ 3.552 trn
Deficit - $ 1.171 trn
As % of GDP - 9%

Debt - $ 9.6 trn going up to $ 14.9 trn in 2015

Rising from 64% of GDP to almost 100% of GDP in 2015. And the likely increase in debt servicing costs are going to drive the deficit higher!

The IMF report essentially calls for substantial deficit reduction. To put 14 percent of gross domestic product in perspective, current federal revenue totals 15 percent of GDP. So the IMF is saying that closing the U.S. fiscal gap, from the revenue side, requires, roughly speaking, an immediate and permanent doubling of personal-income, corporate and federal taxes as well as the payroll levy set down in the Federal Insurance Contribution Act. Or a combination of tax hikes and spending cuts….something has to give…

Such a tax hike or spending cut would leave the U.S. running a surplus equal to 5 percent of GDP this year, rather than a 9 percent deficit as it is now. So the IMF is really saying the U.S. needs to run a surplus now and for many years to come to pay for the spending that is scheduled. It’s also saying the longer the country waits to make tough fiscal adjustments, the more painful they will be.

Demand siders say forgoing this year’s 14 percent fiscal tightening, lowering taxes and spending even more, will pay for itself, in present value, by expanding the economy and tax revenue.

Simple arithmetic shows that this is not true. The fiscal gap is like the government’s credit-card bill and each year’s 14 percent of GDP is the interest on that bill. If it doesn’t pay this year’s interest, it will be added to the balance. Eventually will lead to a debt trap...

The country’s fiscal position needs immediate redressal and no longer can it pursue the no- pain, all-gain solutions. Put simply, “The Emperor has no clothes”…….

………….can it become like Greece?

The longer the current loose monetary and fiscal policies continue into the future, more likely will we see a dramatic increase in tax rates, interest rates and consumer prices. That would be a slippery slope, one that is then too difficult to climb from and U.S. fiscal shape may well be…..er… worse than Greece!!

EU Stress Testing – will it be Eustress or Distress?

The EU will disclose the results of the stress tests it is conducting on the 91 banks within the EU tomorrow. Lenders accounting for 65 percent of the EU banking industry will be tested, including 14 German banks, 27 Spanish savings banks, six Greek banks, five Italian banks, four French banks and four British banks, according to the Committee of European Banks Supervisors (CEBS). CEBS’s role is to coordinate national banking authorities and make policy recommendations to the EU on regulation.

The results are expected to show how individual banks would hold up to economic and market shocks. Policy makers haven’t decided yet on the level of detail to disclose.

So, what are the stress assumptions?

The test assumes a 3 percentage point deviation from the European Commission’s economic forecasts over two years and a deterioration of sovereign debt risk as compared to market prices in early May, said. The Commission estimates the EU’s economy will grow by 1 percent this year and 1.7 percent next year.

In contrast the US stress test conducted last year assumed a “more adverse” scenario of the economy shrinking by 3.3 percent in 2009, while unemployment would rise to 8.9 percent. They also assumed the U.S. economy would grow 0.5 percent the following year, while the jobless rate would surpass 10 percent. The tests didn’t include a measure of the impact of a drop in sovereign debt.

The key measure for determining which of the 91 banks being tested will need more capital is whether they could maintain a 6% Tier 1 capital ratio under the loss assumptions imposed by the test. That's the same level that was required in the stress tests of U.S. banks, though that is where the similarities between the two tests end.

The U.S. stress tests carried out last year found 10 lenders requiring to raise $74.6 billion of capital.

Is the severity of the Eu stress test good enough?

Well, not according to the many market pundits. Regulators have asked the lenders to assume a loss of about 17 percent on Greek government debt, 3 percent on Spanish bonds and none on the German debt.

Some are commenting that ‘This isn’t a stress test and is merely the current valuation of government bonds’. Credit markets are pricing in losses of about 60 percent on Greek bonds should the government default, more than three times the level said to be assumed by CEBS. Derivatives known as recovery swaps are trading at rates that imply investors would get back about 40 percent in a Greek default or restructuring.

Will the results be credible enough to restore confidence?

EU regulators are relying on the stress tests to restore public confidence in banks amid concern that some lenders don’t have enough capital to withstand a default by a European country. A stress test of U.S. banks last May spurred a rally that lifted the Standard & Poor’s Financials Index by 36 percent in the following seven months. EU regulators are hoping for a similar result.

It is not clear what level of disclosure is going to be provided. Is likely that details will only be available in cases where if they have something negative to say will be when there is already a solution in place. This is unlikely to providing much needed market confidence.

For e.g. - Spain's unlisted savings banks -- known as cajas -- have been hit hard by real-estate related losses, forcing the recent seizure of CajaSur by the Bank of Spain. Regulators, however, are testing the cajas as though extensive mergers planned for the sector had already taken place.

A string of banks failing the European Union's stress tests could be one of the strongest signs the process has been a success, but analysts fear the tests could end up being a damp squib, offering too little information to boost confidence.

Overall, concerns over the severity of tests, the level of disclosure and the willingness of regulators to force more capital on banks have left many observers skeptical they can make a real difference.

Who will be the winners and losers?

The problem is that a steady drip of leaks and optimistic predictions from lenders, central bankers and politicians all suggest that the vast majority of banks in even the most troubled economies are likely to pass.

In recent days, Luxembourg Prime Minister Jean-Claude Juncker, French Finance Minister Christine Lagarde, Greek Finance Minister George Papaconstantinou, Irish central bank governor Patrick Honohan and his Italian counterpart Mario Draghi have been just a few of the officials to express confidence that their banks will pass the tests. "There are very few left to fail”.

Some of the banks that are likely to show need for additional capital include Hypo Real Estate, Commezbank, Deutsche Postbank in Germany, Sabadell in Spain and Banco Popolare in Italy .

So, is market then running ahead of itself?

The cost of insuring against losses on bonds issued by Europe’s banks and insurers fell to the lowest in a week yesterday on expectation of successful stress tests. The euro has rallied 8 percent from a four-year low last month. Greece, Spain and Portugal have managed to sell 50 billion euros ($64 billion) of debt since May 10, when the need to save the single currency forced finance ministers to create a nearly $1 trillion rescue fund and European Central Bank President Jean-Claude Trichet to begin buying bonds.

The extra yield investors demand to buy Spanish and Portuguese bonds instead of comparable German securities declined after debt sales this week and those spreads have narrowed 24 percent and 19 percent respectively from euro-era highs in May. The market seems to be much more convinced following the bailout that the euro zone is working and the peripheral countries will be able to finance their debt.

From this market reaction one could conclude that Europe may already have passed its biggest stress test.

…but we are not out of the woods yet…

“We are not the Titanic, but let’s not fool ourselves into thinking we are safe just because we have first-class tickets,” Italian Finance Minister Giulio Tremonti said July 20 at the University of Fribourg, Switzerland.

Pushback against austerity in Hungary highlights the risks for euro-region countries. Talks between Hungary’s two-month-old government of Viktor Orban, the EU and International Monetary Fund broke down this week, delaying payments from a 20-billion euro aid package. The standoff sent the forint to a 14-month low on July 19. Workers in Spain, Portugal and Greece have taken to the streets to protest against the budget cuts that include higher taxes and lower wages for civil servants, typically the core supporters of the socialist parties that rule all three countries.

Greece, which triggered the crisis with the revelation that its deficit was more than four times the EU limit, is trying to trim the shortfall to 8.1 percent of gross domestic product this year, from 13.6 percent last year. Spain’s shortfall reached 11.2 percent last year with Portugal’s at 9.4 percent. None will return to the EU’s 3 percent limit before the start of 2013.

Even if Greece achieves its deficit-cutting goals, the country’s debt is forecast by the government to peak at almost 150 percent of GDP in 2013, a level that may require a restructuring.

“We’re not out of the woods by any means,” said Nixon, a former ECB economist. “We’re dealing with a long-running, multi-year problem. You can have a good year, but you have to come back and do exactly the same next year and the year after.”

...so, will it be Eustress or Distress?

Markets are likely to remain nervous until the results are known tomorrow but the outcome will be "nothing but a damp squib," according to many market participants.

Unlike in the United States, we believe that the E.U. stress test is unlikely to restore confidence to underpin a strong share price rise. It may well end up not delivering either the Eustress to the market or the expected level of distress to the banks under review!

One more day and we will know………!

CHINA Depegs Yuan – Catches markets by surprise….

China’s move to as to de-peg the Chinese yuan (CNY) against the US dollar (USD) caught everyone by surprise. The timing of this announcement is uncanny as it comes a weekahead of the forthcoming G20 meeting. It is intended to take the pressure off at the G20 meeting where this was one of the top agenda items. This is also intended to silence the US lawmakers who have been vociferous in their call to levy countervailing duty as a retaliation to alleged Chinese currency manipulation.

The PBoC issued the following statement on Saturday:
“In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People's Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.

Starting from July 21, 2005, China has moved into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Since then, the reform of the RMB exchange rate regime has been making steady progress, producing the anticipated results and playing a positive role.

When the current round of international financial crisis was at its worst, the exchange rate of a number of sovereign currencies to the U.S. dollar depreciated by varying margins. The stability of the RMB exchange rate has played an important role in mitigating the crisis' impact, contributing significantly to Asian and global recovery, and demonstrating China's efforts in promoting global rebalancing.

The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.

In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.

China's external trade is steadily becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010. With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist. The People's Bank of China will further enable market to play a fundamental role in resource allocation, promote a more balanced BOP account, maintain the RMB exchange rate basically stable at an adaptive and equilibrium level, and achieve the macroeconomic and financial stability in China.”

What does it mean for markets?

This move should be an immediate positive for risk appetite as was reflected in today’s moves in financial markets. There is still potential for trade tensions between the US and China if CNY appreciation is viewed not adequate. However, the initial reaction from the US administration has been positive.

The commodity currencies – AUD, CAD, NOK, BRL, RUB and MYR – will particularly benefit from this, at least, initially. Similarly, Asia ex-Japan (AXJ) currencies should benefit across the board, but particularly those with high correlations to CNY – SGD, MYR, KRW, TWD and INR.

Flexible Fx regime

The PBOC statement clarified that any CNY appreciation will be modest China will not do another one-off CNY revaluation against the USD. In the same breath, they emphasized that
CNY depreciation against the USD cannot be ruled out if the EUR falls sharply against the USD.

This is where, I think, the Chinese authorities have hedged their bets. With the risk of widening European sovereign debt crisis, it is widely expected that the Euro will weaken. This would allow China to either weaken the CNY against the USD or manage the pace of appreciation.

The PBoC statement reflected a delicate balance between the need to reassure the domestic audience – which is worried about exports, jobs and what happens when the domestic stimulus wears off – and the external audience – which has expressed concern at what is perceived by some as a “manipulated” exchange rate. The clear emphasis in the statement was to reassure the domestic audience.

However, the risk is that the Senate sponsors do not accept China‟s move as sufficient and press ahead with the bill, which one Senator has threatened to attach to the Small Business Bill, which is currently being drafted and has wide-spread support.

Economic implications

A stronger CNY is expected to create upward pressure on other Asian currencies, especially Taiwan dollar (TWD), Singapore dollar (SGD) and Malaysian ringgit (MYR). This will imply stable crosses between CNY and other Asian currencies, which mean Asian exporters will stand to get little, if any, advantage via exchange rate competitiveness.

China’s import concentrate in raw material and high-tech capital goods and a stronger CNY should boost China’s demand for such products. For commodities, the expectation of robust demand from China could support prices and the rise in energy, metals and softs could easily more than offset the impact from a stronger CNY.

A more flexible CNY could affect Asia through increased capital flows. If the market is pricing in CNY to appreciate moderately in the long run, international capital flows could return to Asia in search for yield. Further to prospects of currency appreciation, a more sustainable fiscal environment and better growth prospects will continue to underpin its optimism on the region. This could imply that Asian central banks’ worries over asset price bubbles could return.

The global recovery remains on track, led by Asia. Major central banks will likely keep interest rates very low for an extended period to support growth whereas Asian (X Japan) central banks will tighten monetary policy. This should trigger renewed capital inflows into the region which should be bullish for Asia (X Japan) currencies.

On balance, the de-pegging of the CNY should be massively bullish for AXJ currencies even if China moves very slowly during the first months. The Reserve Bank of India’s (RBI) absence from the FX market may also make the INR particularly well placed to gain from CNY de-pegging.

The EUR-USD and GBP-USD will register modest gain initially though the overhang of the European debt crisis will limit any gains and may actually weaken as the debt crisis unravels. This, as I noted earlier, is the hedge against any steep appreciation of CNY.

The coming weeks and months will provide more insight into the basket of currencies against which the CNY is going to be managed. The devil is in the detail! Until then, we will continue to witness some knee jerk market reaction.....

Regulatory Reform – Is the pendulum swinging in extreme?

The scope and scale of the proposed regulatory reforms, while some of it necessary, will place enormous burden on the financial sector which will in turn impact availability of credit and threaten the fragile economic growth. Let’s examine:
A. The primary causes for the financial crisis
B. The overall regulatory objective
C. The proposed regulatory measures and its impact
D. The appropriateness / proportionality of the measures

A. Financial Crisis – ‘Sub-prime or House of Cards’

This was essentially a one-way bet on house prices to continue to rise. Institutions that did not originate these loans, bought structured instruments, the performance of which was linked to the underlying mortgages. The quantitative models used to assess the probability of default of the underlying mortgage contracts or the loss in the event of default was woefully inadequate. In the end, the original loans were taking experiencing larger losses than predicted, and the market value of the securities collapsed as it became apparent the assigned credit ratings were way off.

Some financial institutions were unable to absorb the losses and/or to meet their payment obligations as they fell due (margin/collateral calls) as no wholesale funding was available. As some financial institutions looked less credit worthy their peers did not want to lend them either; there was a round of secondary effects with consequent impact in the real economy…and ultimately recession. This has led to an unprecedented level of taxpayer support for banks, directly to add capital and indirectly by preventing defaults.

Embarrassingly, all this happened immediately subsequent to the implementation of a “risk sensitive” capital accord (“Basel II”) specifically designed to ensure banks were adequately capitalised! The Accord fell flat on its face at the first hurdle. Somehow, banks were still over leveraged!

B. Overall Regulatory Objective

Although not explicitly expressed these are generally held to be threefold: Financial Stability, Market confidence and Consumer protection. The market failures that are generally associated with these objectives are:
• Negative externality, Information asymmetry and Market power (Cartel)

Negative externalities occur when decisions adopted do not take account all the costs which result from a firms actions but which are not borne by the firm. In this case the possibility of market and funding liquidity drying up was not adequately taken into account. Reliance on rating agencies drove risk taking decisions without full deliberation of systemic consequences if underlying assumptions were incorrect. Therefore this would appear to be a relevant market failure.

Information asymmetry also played a part. Firms became wary of their counterparties because they did not have a full picture of their exposures to particular exposure classes or understand the level of leverage counterparty may be running. As a result the inter-bank market dried up. Information asymmetry, therefore, would also appear to be a relevant market failure.

Market power is exercised when prices are changed solely by the decision of a few market players. This in itself is less of an issue within the financial sector.

C. Regulatory Proposals

In particular, what risks do the proposed reforms pose both to banks individually and to the economy as a whole? Let’s examine the proposed regulatory reform under the following main themes:

1. Raising the quality, consistency and transparency of the capital base - The key changes with respect to the capital structure in the proposed regulations are:
• Most regulatory deductions (like goodwill and intangibles, minority interests, deferred tax assets, shortfall of EL vs. provisions) to come from Core tier 1 as opposed to Tier 1 and/or Total capital currently;
• Tighter conditions for hybrid capital (relating to discretion on cumulative coupons/ dividends, permanence, no incentive to redeem and loss absorption capacity) to qualify as Tier 1 capital; and
• Leverage ratio limit

The impact of the changes will undoubtedly lead to a significant increase in the requirement of maintaining core equity and hence would increase the cost of capital for banks and hence the cost of credit to the industry.

Hybrid capital - The changes proposed to the hybrid capital make sense. I strongly believe that write-downs should be temporary and capable of being written back up upon liquidation. A permanent write down would mean that the non-Core Tier 1 capital was subordinate to Common equity and that holders could not share in the recovery of the bank or any liquidation proceeds.

Deductions from capital- It is not necessary that all of the regulatory adjustments applied to regulatory capital should be made from Core Tier 1 capital. A number of the deductions considered in the consultation paper do have value on a going concern basis but arguably less so on a gone concern basis. The Committee should re-consider this particularly bearing in mind the possibility that application of the proposed deductions could exacerbate cyclicality.

Leverage Ratio - Leverage built up for a number of reasons, in particular, the availability of cheap money over a sustained period of time. Leverage then amplified the downward pressure on asset prices as liquidity dried up, thereby puncturing the asset bubble. This led to increased margin calls, which in turn amplified the downward pressure on asset prices as sales were required to meet margin calls.

However, there are serious concerns over its potential design. There is no recognition for credit risk mitigation in exposures and recognition of other netting arrangements. It also ignores business model, risk appetite, structure, governance and risk management practices and at best is a blunt instrument.

2. Enhancing the risk coverage

Counterparty credit risk - The credit valuation adjustment (CVA) charge, among the many overlapping counterparty risk measures raises more questions. The charge appears to be highly disproportionate and fails to recognise hedging practices. Instead, the focus should be on
1. management and regulation of the Central Clearing House - to ensure the security of collateral/margin;
2. computational ability and capacity to appropriately determine market liquidity and margin levels plus default-fund backing for the products that are to be cleared;
3. the operational capacity and connectivity to manage the business in an automated fashion.

Moreover, the current proposals follow on from significant changes to the Trading Book.

3. Supplementary measures – Large exposures and Concentration risk

The objective of the regime is to provide an appropriate degree of protection against firm failure arising from single name concentration risk in the credit portfolio. As a result the large exposure framework is a preventative measure and therefore it could be argued that the use of a going concern measure is appropriate. However, it is not appropriate to make the definition of capital for large exposures a priority for change at this juncture as this issue is already addressed through Pillar 2 currently.

4. Pro cyclicality and promoting countercyclical buffers- Two areas have been identified as countercyclical measures viz. through the cycle provisioning for expected losses and contingent capital.

Through-the-cycle provisioning for expected credit losses - The regulatory proposals comes up with a requirement for through-the cycle expected loss provisioning over and above the accounting provisions. This effectively leads to forward looking provisioning regime which will not sit with the current accounting regime. In summary the recommended approach is that of expected loss over the life of the portfolio.

Capital buffers and the cyclicality of minimum requirements - The Pillar 1 credit risk framework already includes stress test, which can potentially result in a buffer to cater for an economic downturn. On top of this in Pillar 2, many countries operate on a more severe stress scenario, which further informs the buffer level to be held. It would be inappropriate to create a situation where buffers sit upon buffers trapping capital from its efficient use in the real economy.

At first appealing – surely banks should hold more capital – the efficacy of such a general idea will inevitably lead to sub optimal deployment of capital and hence result in either poorer returns or increased cost to customers. Somebody has to pick up the slack! This is where the contingent capital provides considerable appeal.

Contingent capital - The efficacy of contingent capital as a source of funds in distress has had a lukewarm acceptance from the industry. However, this is an effective and economic way of maintaining ‘capital buffers’ to deal with extreme forms of economic or idiosyncratic stress.

Greater acceptance from the industry is required with respect to the notion of contingent capital and these can come in many forms:
• Contingent convertible bonds – these instruments convert to equity at a pre-determined share price that is at a discount to market price at the time of issue upon the triggering of threshold conditions, usually, core Tier 1 ratio breaching a pre-established level;
• Sub-ordinated bonds with write-down features that have fixed hair cut upon triggering of threshold conditions; these may or may not have write up features

The criticism that is levied for the former is that it might exacerbate the short selling activity at times of distress and cause additional erosion of market confidence. This in my view is a very weak argument as in the event of distress the focus is on survival and if capital is available at a pre-determined price, it provides stability and may in fact mute the market nervousness.

5. Liquidity - The introduction of a short term ratio that focuses on the adequacy of a financial institution’s liquidity buffer in times of stress and a long term ratio that focuses on the structure of its funding is welcome. The development of a harmonised menu of liquidity measures that would be available for regulators to choose from when considering a cross border group is essential as a ‘one size fit all’ approach will fail.

Net Stable Funding Ratio (NSFR) - The objective of encouraging more medium and long term funding is laudable. It is recommended that an approach that recognises that the NSFR is only one of the several measures that needs to be used by supervisors in the evaluation of a firm’s liquidity.

6. Financial stability or ‘Moral Hazard’ ? - The identification, measurement and monitoring of these ‘Significantly Important Financial Institutions’ (SIFIs) is being debated in global, European and national fora. Agreed, large and diverse banks or those whose operations include a high degree of interconnectivity, require careful oversight, given their systemic importance.

However, it is vital to recognise that large and diverse firms bring social, economic, and market benefits, through their capacity to intermediate between borrowers and investors across a range of markets. These firms perform a risk taking function, which is necessary for economic vitality. Large global firms can deliver economies of scale, scope, and improve market efficiency and support global trade.

Addressing systemic importance - There is no ‘silver bullet’ for dealing with SIFIs, and a multi-pronged approach is needed. There is potentially a trade-off between enhancing financial stability and stimulating economic growth so a thorough assessment of the cumulative impact of the proposed measures, in line with changes already in train, is required.

Capital or liquidity surcharges for SIFIs - Additional capital or liquidity surcharges should not be the immediate choice of regulators. As noted, across the board prudential capital and liquidity changes in train will serve to protect against probability of failure.

Placing restrictions on activities or ‘Volcker Rule’ - In the recent crisis diversified firms were able to cope with the crisis better than the monolines. The focus should be on risk management and governance. However, what would be more effective would be a closer review of conflicts of interest within a business model. Also the regulatory approach of higher capital charge for trading activities is appropriate rather than driving these activities into unregulated entities.

Resolution Fund - The creation of a resolution fund to bail out financial institutions would in itself create a moral hazard. It would result in encouraging the kind risk practices that regulations are seeking to rein in. It is appropriate for supervisors to have a common regulatory toolkit and to continue to develop convergence of understanding and approach.

Pillar 2 is the right place to address firm-specific issues but the approach to Pillar 2 requires new thinking from supervisors. Improvements should be made in the Pillar 2 supervisory review and evaluation process with a greater focus on understanding banks’ businesses models and the risks that they could create, individually and collectively, for the financial system.

D. Appropriateness and proportionality

Whilst some of the regulatory developments are necessary, the collective impact of the regulations will result in a significant increase in capital requirements. The current thought process that capital is a panacea for all evils is unpalatable. As a starting point to the debate would like to make the following points:

1. Regulatory oversight - The significant reason for the large scale failure can be attributed to the ‘light touch’ regulation and the collective failure of regulators, rating agencies, bank’s risk management standards. Unabated growth in loans and asset prices should raised enough warning signals for regulators to initiate action to dampen credit.

2. Regulate ‘high risk’ activities - Stipulate higher levels of capital and notional limits for highly risky activities like correlation trading, leveraged financing transaction, underwritten M&A trades, private equity, etc. so that these are supported with capital commensurate with its risk. Sectoral exposure caps or significantly higher capital charge to non regulated entities (like hedge funds, private equity etc.)

3. Address conflicts of interests - Eliminate activities that pose conflicts of interests. For e.g. Investment Banking combined with Asset / Fund management business poses significant conflicts of interest as the entity in lure of fees may originate assets and transfer to managed funds.

Conclusion

The current set of proposed regulations will deliver onerous levels of capital and liquidity buffers and act like a ‘millstone around the neck’. The higher price for capital, as well as the fact that more capital is required, implies a higher cost of credit. This in turn will slow economic growth.

The trade-off between financial stability vs. economic growth has begun! Will it be too much to hope for a balanced result?

The Coming Fall of €uro

The Market is heaving a sigh of relief over the rescue package announced for Greece. The euro-area governments themselves (so this doesn't include Britain) have pledged €440bn in loans or guarantees. A further €60bn in loans comes from the European Union's budget (includes UK). And there could be as much as €250bn from the IMF (which includes UK, as well as all the American and Canadian taxpayers who might be wondering what did they do to deserve this).
On top of all this, the European Central Bank (ECB) has said, effectively, that it'll step in as a lender of last resort, buying government and corporate bonds where it feels it's necessary. This is not the same as the quantitative easing (i.e. printing money) that the US and Britain have undertaken as it is not financed by printing more currency. The purchases are will be financed by selling for e.g. German bunds.

This deal won't save the euro

“We shall defend the euro whatever it takes,” EU Commissioner Olli Rehn said after the 11-hour meeting (meaning EU taxpayer´ last cent). But in the longer run, this deal is not a solution. And it's not good news for the euro.

All of these moves, assuming they work, do not make for a 'strong' currency. Europe has now decided that "member countries have to jointly put their resources at stake to support the weaker members." In other words, the euro can now only ever be as strong as its weakest member.
And that will be pretty weak. Austerity programmes might be necessary, but they tend to stifle economic growth. Meanwhile, the ECB is likely to have to keep interest rates low for the long term as it shepherds all these weak economies through their hard times. That's not a great recipe for currency strength, the euro will still fall, and any bounce now is a good opportunity to get short.
The trouble for Greece is that there is limited scope to boost growth. And thus it cannot really boost its tax revenues immediately. In particular, as Greece is in the euro area, it cannot devalue in the way that, say, the UK has, to correct the major loss of competitiveness it has suffered in recent years. Of course, devaluation would only partially help Greece. The reality is that Greece, like a number of other smaller European countries, has deep structural problems and probably should not have been allowed into the euro in the first place.

Effectively, it has to deflate its economy. The trouble is that this does not reduce the deficit as much as one might think: cutting spending when the economy is already suffering weakens it further. It is like chasing one’s tail. Moreover, as we are seeing in Greece, this austerity message is not going down well locally, as evidenced by strikes and riots. Thus, the economic crisis is already becoming a political and social crisis.

Greece is in a debt trap. Its debt is greater than the size of its economy, at 126% of GDP, and the interest it pays on its debt is higher than its rate of economic growth. Even with this bailout, its debt-to-GDP ratio is expected to rise, peaking at 149.1% in 2013, according to officials. It might even be worse. Greece may still default. The 'contagion' risk remains.

How big is the problem?

Who are the weak countries? They are called the PIIGS: Portugal, Italy, Ireland, Greece and Spain. Yet Ireland is taking the tough medicine that Greece is resisting, and politically, it does not want to leave the euro. The worries are centred on Spain – a much bigger economy and one that is in trouble, where one in five is unemployed and prospects for growth are minimal, as economic growth before the crisis was driven by a construction boom which is unlikely to return. Let’s take look at the Europe’s web of debt.



[Source: NY Times, May 1, 2010]

The bail-out package is big, but it's not that big: "€750bn is just over one-year's new borrowing by eurozone members and a bit more than 10% of eurozone government debt. So it's certainly not enough if investors were to start losing confidence in the ability of some big countries – such as Spain or Italy – to honour their debts."
Europe has bought some time. The best bet now is for it to look for realistic ways to restructure the debt of troubled eurozone nations, and get ahead of the problem, before the issue rears its ugly head again.

Is monetary union sustainable without the political union?

The arguments are the same now as they were then. Monetary union requires labour mobility and fiscal flexibility in the form of a single Treasury. Rich regions need to bail out poor areas when needed. This is easier to implement if they are part of the same country. It is much harder to justify across a monetary union. Asking hard working German tax payer to pay for the laid back early retired pensioner in Greece is not likely to go down well!

The basic problem with the euro is that one interest rate does not suit all the countries. The economies are so different that they need their own monetary policy and the ability to set interest rates in line with their economic cycle. One size does not fit all. So ahead of the recent financial crisis, the euro contributed to an even bigger boom in the smaller European economies. Hence, they have seen a bigger bust.

All of this demonstrates the fragile underpinnings of the euro area. A monetary union makes sense for Germany and its satellite economies, including France. But the PIIGS need a competitive boost. They need devaluation and structural change. But because they cannot leave, the markets are pushing yields up, creating domestic problems. A bailout does not solve the problem. It just gets us by, with some hope and prayer, until the world economy is stronger and the markets are better able to cope, even if Greece eventually defaults.

The European economic and monetary union (Emu) may need to become a political union to survive. This is one lesson from a historical analysis of monetary union in the 19th and 20th centuries. Monetary unions of large sovereign nations which do not have political union eventually fail, sometimes after a long time.

Monetary unions have succeeded where there has been a political union. The German unification is a good example of this. Monetary unions of small countries can survive without political union, provided there has been economic convergence. Two examples are the Union between Belgium and Luxembourg and the CFA franc zone in West Africa, which have survived..

Once the political system binding it together collapses, the monetary union fails e.g. the collapse of the Soviet system.

The lesson is monetary unions of politically independent, large sovereign nations can fail, particularly when there is an external shock, causing the economic environment to change. It is easier for unions to survive when the economic cycle is favourable.

The Exchange Rate Mechanism (ERM) worked well in its first phase, from 1979-87 because the system was flexible, with 11 frequent realignments. The second phase, between1987-92, appeared to work well. There was only one realignment, when the Italian lira moved to a narrow band. Yet all that happened was that problems built up below the surface. Nominal exchange rates did not change, but real rates moved badly out of line, providing the catalyst for the system’s near collapse in September 1992. Flexibility is important for any currency system.

In Summary

Previous experience of monetary unions in Europe is that they can last for some time, but ultimately Emu must become a political union to survive.

With such diverse socio-cultural, economic and politically independent sovereigns, that may remain a distant dream. Meanwhile, the coming fall of €uro is getting increasingly forceful……this story is beginning to read like the ‘Tower of Babel’.

How to Stop Relatives Meddling in your Personal Affairs?

Every family has a few of these types, those who stake their right to every bit of information! They are the eager beavers or the frequent busybodies present almost in every family. Many a times these intrusive individuals are not overly concerned because they are altruistic or want to see harmony in the family; it is usually because they are meddlers.

Believe it or not, some relatives get a thrill out of meddling in your personal affairs. This seems to give them some sort of joy for the moment. It can even turn into gossip where the whole family has a gossip line going about, you from Auckland to California.

Don’t get me wrong. Family can be one of life's greatest blessings when they are supportive, understanding and caring. However, there are times, when some of your relatives cross the line of caring to enter the zone of meddling, it is no longer a blessing, it usually feels more like a curse. Your relatives may have an irresistible urge to expound some of their wisdom to "help" your situation. The counsel or advice quickly turns into a meddling in your affairs. So-called concerned relatives may feel the need to dabble into situations in your life that they have nothing to do with; neither do they have any control over it nor any real interest in resolving it albeit get a thrill out of it.

Often people make the mistake of succumbing to the outwardly friendly approach of these busy bodies and succumb to their wily ways for the purpose of being liked. By the time they realize, it is too late as they may have established habits and practices that are not only irritating, but also interfering.
It's a fact in most extended families’, relatives feel they have a right to all information and assume an active central role. The thought is that since you are related, you should share every intimate detail of your life with each other, and give commentary and suggestions. In large families, this takes the form of gossip about other family members providing entertainment value.

But why does this happen? It probably emerges from the early impressions that people form with respect to the members of the family. The early impression we all had in their minds about us boxes us into a stereotype. Some of us were average, some bright, some lucky, some underachievers and some of us were even the black sheep. Whatever the stereotype in your family of origin, chances are that those notions have continued. Meanwhile you might have moved on in life and probably shaping yourself for better things but if that is at odds with those early impressions, it gives enough reasons for them to discredit you.

As you begin to get ahead and show the new you, some of your family members will feel uncomfortable. They will not know how to deal with you, the way you are now, so inevitably, they will try to push you back into the stereotype role you had before or start malicious campaign against you.

Just as in the childhood game of reling messages on an imaginary "Telephone," the story changes as it's passed between family members and ends up as garbled. You, as a member of this family, fall into two categories; you either feel your life is an open book or you choose to have certain aspects of your life private. So what do you do if you fall into the latter category? The more you try to retain your privacy, the harder they will work to pry information from you or gang up to annoy you.

One must set limits with them and its never too late to do this, because the longer they are allowed to interfere, the greater the influence these meddling types will have on your relationships with others. It is important to speak up when asked to do or say something with which you do not agree. Do not sacrifice your opinions or what you know to be right simply for the sake of getting along with your relatives. When they do something you do not like, tell them in a civilized manner what they did and why it upsets you. Try and be conciliatory by explaining what is acceptable, but again, not at the expense of your beliefs or self-esteem. If you have reconnected with any of the family member, be on alert. Old patterns will most likely remain in waiting to thrust you into the same old position.

With this said keep in mind that you have to do what is best for yourself, regardless of how your family may respond. The choice of making a change is something that you are doing for your benefit, and not for anyone else’s harm. You should not feel guilty for doing what is right for you.

To prevent your relatives from meddling in your personal affairs here are a few tips you may want to try:

1. Do not talk too much about your business.

2. Keep your business out of the street.

3. Just say nothing. If someone in your family comes to you meddling. Just tell them you don't wish to talk about it.

4. Tell your kids to keep their tongue. Sometimes conniving relatives will go so far as to ask your children questions about your life. If some of their relatives want to know about you, tell your children to say, "you have to ask my mother or father about that.”

5. Change the conversation. If a family member wants to meddle in your affairs, try changing the subject.

6. Flip the question around on them. Most times people like to meddle in your affairs, but they do not like for you to meddle in their's.

7. Another tactic is to answer their questions with one of your own. When the meddling relative begins to inquire about your personal life in a way that you aren't comfortable with, here is your answer: "Why do you ask?". The question makes them uncomfortable and forces them to assess their true motives, as well.

Lay new ground rules for your relationship, and stick by them, even when it hurts. It will pay off in the long run. Eventually your family will get used to the new you, and learn how to relate to you.

Family is what you are born into, there is no choice about it. Do all that you can to keep these relationships healthy and intact. They are important, but always remember that you are in control of your life and how you choose to live it. Don't allow yourself to be run over or exhausted by meddlesome relatives.

You can put a stop to it, at best by questioning their intent and at worst by severing the relations.

The bottom line is that it is your life. Stopping meddlers takes assertiveness, setting boundaries, and understanding the dynamics. Setting boundaries takes clear communication. Chances are that if you originate from a family that is enmeshed, there is more than one meddler. If you are determined to stop the meddlers, you will need to gain great skills in assertiveness and setting limits.

Ultimately, it is important to realise that the only person you can change is yourself. It is wise not to waste too much time and energy trying to change another person. Simply change the way you deal with them.

Good luck….

“We do God’s work”....hmmm….but do the Greek Gods agree?

If I asked you to think of someone who did God’s work, I would imagine, you are probably thinking of a high priest, Mother Teresa, Pope or someone of that esteem. You could not have been more off the mark!! Well, that is according to one Wall Street Banker!

In an interview with the Times of London in November 2009, Lloyd Blankfein, Chairman & Chief Executive of Goldman Sachs, is quoted to have said “We do God’s Work”, with much hubris and smile!

As per him, modern banking performed a vital function and he described himself as a just banker 'doing God's work'. We're very important. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. We have a social purpose.”

All very noble, indeed. But even as the dust has barely settled on their role in the sub-prime crisis, they now find themselves under fire following the escalation of Greece’s fiscal woes. Greece’s entry to Euro zone is said to have been facilitated by the complex currency swap undertaken with Goldman Sachs in 2001.

The transaction consisted of cross-currency swaps of about $10 billion of debt issued by Greece in dollars and yen. That was swapped into Euros using a historical exchange rate (read off-market rates), a mechanism that implied a reduction in debt and generated about $1 billion of funding up front.

The swaps allowed Greece to delay payments and shrink its reported budget deficit and are now fueling questions about whether Greece used the contracts to mask the fact it was struggling to comply with the currency’s membership criteria from the early days of its entry into the Euro zone.

Legal ‘At the Time’

It is claimed that EU regulators had blessed the use of derivatives to let some countries curb their deficits. Italy had swapped fixed payments on a three-year, yen-denominated bond in 1996, for a floating rate, enabling it to cut the amount of interest paid on the debt.

The use of derivatives helped Greece manage fiscal deficit by pushing the interest obligations into the future. While this may have been blessed by the EU, the fact remains that Goldman’s helped Greece to disguise its deficit. Probably at Goldman’s when one’s engaged in a "social cause", small things like ethics are not allowed to come in the way.

Apparently, it was all ‘Greek’ to the EU officials when they allowed it! They have since changed the rules on deficit accounting for off-balance sheet items. Eurostat (the EU’s statistics office) has now ordered Greece to hand over information on the swaps transactions in an investigation that may extend to other EU countries.

Bond sales

If you thought that was all to it, well it does not stop there! Goldman Sachs further managed several bond sales amounting to US$15 billion for Greece. No mention of the swap was made in prospectus for the securities in at least six of the 10 sales the bank arranged for Greece since the transaction, according to a review of the by Bloomberg.

Goldman Sachs earned about €735 million (US$1 billion) for its “God’s work” of underwriting the Greek government bonds since 2002 (data compiled by Bloomberg). Small fee for God’s work!!…but large enough to get the Greek Gods seething…

Fall from grace?

The firm has a long established reputation and was seen as the “Gold Standard” for Investment Banking. It now finds itself suddenly equated to the ‘toxic’ financial instruments it sold to its clients.

Politicians and commentators are now competing to denounce Goldman in ever more robust terms — "robber barons", "economic vandals", "vulture capitalists". Rolling Stone magazine ran a story that described Goldman as "a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money".

Direct line to the “Gods”!

A firm that claims to do God’s work, of course, are close to the Gods in seat of Power!! The list of Goldmanites who have held key posts in the US administration and vital global institutions in New York and Washington alone is mind-boggling. Here’s a sample list:

§ Robert Rubin (the treasury secretary under Bill Clinton);
§ Hank Paulson (the treasury secretary under George Bush);
§ William Dudley and Stephen Friedman (the current president and former chairman of the New York Federal Reserve);
§ Mark Patterson (the chief of staff to the treasury secretary Timothy Geithner);
§ Joshua Bolten (the chief of staff under President Bush);
§ Robert Hormats (the economic adviser to the secretary of state, Hillary Clinton);
§ Gary Gensler (the chairman of the US Commodity Futures Trading Commission);
§ John Thain and Duncan Niederauer (the past and current heads of the New York Stock Exchange)
§ Adam Storch (the chief operating officer of the Securities and Exchange Commission’s enforcement division).
§ Michael Paese, lobbyist for Goldman used to work for Barney Frank, the congressman who chairs the House Financial Services Committee.

As in the US, the bank is closely linked to the government in the U.K. too. Goldman has been s a key banking adviser to the government on the sale of Northern Rock.

It’s no small wonder that another of Goldman’s nicknames is "Government Sachs". The Apostles of God serving the financial world are certainly well entrenched with the God’s in the Government!

President Obama, just last week said in defense of Goldman CEO Lloyd Blankfein and Jamie Dimon, his old Chicago buddy who heads JPMorgan Chase, "I know both those guys; they are very savvy businessmen." The Greeks, of course, have a different view! Incidentally, both were big campaign donors for Obama.

With such a glowing endorsement from the President, the fall from grace, I reckon, will only be temporary......What the heck do I know about God’s work?

Its the Jobs, Stupid!!

In plain Clinton Speak - "It's the Jobs, stupid!" One in five families in the US is struggling to make ends meet and mood is increasingly getting despondent as the job market continues to show weakness.

The crying need of the hour is "Confidence" and that is fragile at the moment. The last thing we need is knee jerk actions from politicians that can threaten the fragile confidence that is so essential for the business to resume hiring.

The combination fiscal stimulus, quantitative easing and low interest rates have managed to hold the economy from sliding deeply into a pit but it has had its run and has even helped in recording a strong growth of 5.7% in Q4. The United States economy grew at its fastest pace in more than six years at the end of 2009, even as businesses resisted hiring and continued to do more with less.

However, the growth is a lot more feeble than the headline number suggests if we strip the effect of inventory build up. The biggest factor in the strong growth rate during the last quarter was not driven by consumers spending, but by businesses building up inventories. The change in inventories added 3.4 percentage points to the growth rate.

Obviously inventory changes alone cannot sustain growth over an extended period of time, unless of course these are consumed. Interestingly the economy has been able to grow even without adding workers because of productivity gains.

There isn't much more ammunition left to pursue this steroid infused growth any further without threatening to fall into a debt trap, risking ratings downgrades and fuelling future asset bubbles.

The biggest challenge in the near term is the job market. On a net basis, the economy lost 208,000 nonfarm payroll jobs last quarter, and the unemployment rate rose to 10 percent, from 9.7 percent. As long as the labor market remains weak, consumers — whose purchases make up the bulk of economic output each quarter — will be reluctant to spend money. That means businesses will need to look for other sources of demand, like exports (read weak US Dollar policy).

Larry Summers commented at Davos that US "appears to be out of statistical recession, but remains in a human recession". Across the world, unemployment looks set to remain high despite GDP growth. This will have a huge impact on politics, and thus on policy. The risk is that concerns about "protecting jobs" lead to protectionism. That may well endanger trade and retaliatory actions all around.

The West has been profligate for far too long and it is time now to tighten the belt. And tighten the belt it must by several slots! President Obama unveiled a budget that projects a deficit of US$ 1.6 trillion for Fiscal year 2011 and the cumulative deficit to reach US$ 5 trillion over the next 5 years. US is postponing the problem in the hope that they can rein in deficits in the future. It is a ticking time bomb!

Alternatives are tough and its time for some radical action. Actions to eliminate waste, productivity gains in administration to fund investments, innovation through research (tax breaks for research spend), creating business climate that encourages capital investment (stable tax policies), investment in green energy and private sector job creation (reduce corporate tax and support self employment programmes).

I think the administration is turning its focus on the critical issue i.e. job creation. The Obama administration seized on news of the latest upturn as an opportunity to push its proposal to encourage hiring. Companies would receive a tax credit of up to $5,000 for each new hire, and an additional credit on Social Security payroll taxes for raising wages — by increasing hourly pay or work hours, for example — in excess of inflation. Some of the new initiatives are being funded by taxing earners with income > US$250,000.

A lot more needs to be done and some additional measures such as the following would help:

- lowering corporate taxes thereby encourage foreign capital investment

- supporting investment in new technologies through tax breaks;

- investment in education to improve skills linked to business needs

- support research for innovation mainly in green energy,

- focus on improving productivity, eliminating waste in public sector and stricter conditions for doles and

- lastly, sensible regulation that does not limit credit growth from banks; bashing bankers, however, appealing it is must stop and focus should be on developing a framework that makes the system safer;

There is a great need for public-private partnership with focus on equipping the youth with appropriate skills through sustained training and development programmes. If only part of the fiscal stimulus or the QE was spent to set up a Venture Capital fund to support entrepreneurship and self employment programmes, it might have had potentially much more lasting and positive impact.

Time for some concerted, coordinated and well thought out measures. Can we expect it from our Leaders ?