CURRENCY WARS

Barely two years ago, even as the financial system was staring into abyss, there was an overwhelming desire from major countries to act in concert.  The fear of a global financial meltdown was too powerful a motivation that propelled the G20 towards a unanimous agreement for a coordinated policy action. This now seems like a distant memory as countries are pursuing their domestic goals as such fears have dissipated.

This is further accentuated by a divergence in economic outlook between the East & the West and the effects of policies pursued in some regions are having adverse impact on others.

In the West growth is faltering as the effects of fiscal stimulus fades. A double-dip is possible if there is a policy misstep, a further shock or a loss of confidence. With this backdrop, timing of policy tightening is the big fear for the Central Bankers’ in the West.

Basle 3 regulations imposes increased requirements for bank capital and liquidity.  The mood was “never waste a good crisis”. It seemingly assumes capital and funding will be available cheaply and in abundance to meet the new requirements.  The reality cannot be farther from this.  It will neither cheap nor will it be limitless.  Any increased cost of raising capital and liquidity by banks will be passed onto customers.  To the extend demand for capital and funding cannot be met banks will limit lending.  

Regulatory actions to appease the public now seems likely as politicians force draconian measures on banks, that will most likely lead them to shrink balance sheets and restrain lending.  This will herald a new credit crunch.  Although a global deal, the reality is the US never adopted its predecessor Basle 2 and some countries may implement different measures now. With change in political scene in the U.S. it remains to be seen whether some the measures may soften as high unemployment in the west continues to be the major political issue.

The monetary and fiscal policies pursued by the West is driving asset prices through the roof in Asia and is leading to the heightened risk of asset bubbles in most Asian markets.

Low interest rates, quantitative easing and loose fiscal policies in the west has encouraged the classic “carry trade” as money flows in search of higher returns to emerging economies. The combination of cheap money, one-way expectations, and the ability to borrow creates the environment in which asset price inflation occurs unabated  and bubbles are created, destabilising economies.

Hence in the west, interest rates will have to stay low to limit the pain. This will feed flows to the east, adding to bubbles and inflation across much of Asia. Thus, currency policy has come to centre-stage. Intervention by China and others to keep foreign exchange competitive for their exports is adding to trade tensions. Consequently, there is an increase in decibel levels around exchange controls, the fear of protectionism and talk of currency wars.

Intervening to stop a currency appreciating is easier than trying to stop one weakening. If a currency is overvalued and the markets decide to sell then it is just a matter of time before it falls. In contrast, governments and central banks can stop a currency appreciating.   

Thus it has become popular to consider exchange controls. Recently Brazil doubled the tax on bond inflows. Thailand re-introduced withholding tax for foreign investors. But if a country has been liberalising, controls may be less effective, being easier to circumvent. Also, any tax will have to be high enough to deter investors if they still think a country's prospects are good. Despite this, such controls are welcome, even if they just deter currency speculators.

In the near-term other measures may be needed. Hong Kong and Singapore have used specific measures to cap their property markets.

Some have opted for currency appreciation, although it has an adverse impact on export competitiveness. Thailand, Malaysia and Singapore, have allowed their currencies to strengthen. Although many Asian currencies are undervalued the big problem is the Chinese renminbi. Thus recent talk of currency wars needs to be kept in perspective.

An important thing to remember is that currency moves alone will not guarantee a stronger global growth. They are only part of the puzzle.  To rebalance the global economy there is a need for the west to save, the east to spend and currencies to adjust.

China, by keeping a strong economic growth, feels it is doing its bit. Hence it is unlikely to shift policy dramatically and as reiterated by them prefer gradualism. Ahead of the G20 meeting in Seoul next week it is always possible that there may be token moves  of appreciation. But may not be enough.

Across Asia, stronger currencies, higher interest rates and macro-prudential measures to curb asset prices with exchange controls to curb speculative inflows may all be needed. However, progress may be gradual. That is a big challenge.

In the west, fragile economies mean a failure to resolve the currency issue could lead to trade protectionism, led by the US. This is why global policy coordination is crucial.

Recent weeks have continued to see mixed data from around the world on the economic outlook. This has added to the air of uncertainty. In addition, uncertainty about future policy stances has increased.

What about Double-dip?

The biggest concern at the moment is - whether there will be a double-dip in the West. Across much of the emerging world, economic conditions are broadly stabilising.  In the West, however, there are enough uncertainties that could trigger a double dip:

§         an external shock e.g. sovereign default by one of the bigger euro zone countries;

§         rising food and commodity prices leading to domestic pressures;

§         a policy misstep;

§         or a loss of confidence.  

Any of these or a combination of these have the potential to derail the fragile economic recovery.  Deleveraging and the overhang of debt take time to work their way through an economy.

As the policy stimulus of the last year wears off, and as some of the Western banks that received aid face the need to roll over borrowings, it is important to be aware of downside risks.  

In the US, big corporates’ appear to be in far better shape than smaller ones, and although credit conditions for small firms appear to be past the worst, they are tough. The situation is the same in the UK. Hence, there is a need for both the Fed and the Bank of England not only to keep rates low, but to do more through quantitative easing. This is particularly so in the UK, where fiscal policy is to be tightened. The UK Comprehensive Spending Review is another reminder to the world of the challenges of unsustainable fiscal deficits facing governments in the West.

Europe has its own set of complexities. Should the European Central Bank (ECB)  tighten in response to the stronger growth in northern Europe – particularly Germany – or ease or stay accommodative to ease the pain in the south and the fringes. Any action will add to tensions. The likely concession may be that the ECB withdraw stimulus but hold off from interest rate hikes. None of this will prevent southern Europe, plus Ireland, from suffering a recession.  But in Germany, rising house prices are seen as an inflationary concern. This is the downside of a one-size-fits-all monetary policy.

Challenges faced by the emerging economies

The consequences of continued low US interest rates have taken its toll on some of the Middle East economies.  Due to the exchange rate peg to the USD in the Middle East, interest rates stayed far lower than where they needed to be for domestic reasons. This fed the boom there. Yet many emerging markets are not pegged to the USD and have chosen to intervene in their currencies.

The Asian economies have the ability to change set monetary and fiscal policy to suit domestic needs.  The lethal combination of cheap money, access to debt or ability to leverage, and one-way expectations is bad news. It fed asset bubbles in parts of the West. It now threatens to do likewise across emerging countries. Bubbles, of course, take time to develop.  The house prices in Tier 1 cities across Asia have all the hallmarks of a bubble. These countries have to act now before it is too late, as experience has shown that the bigger the bubble, the louder the thud!

Currencies do matter

This brings us the biggest topic currently in discussion – Currency Wars. China has started to allow its currency to appreciate gradually.  Yet from a domestic perspective, there may still be some unease about the possible impact on low-value-added exporters, many of which fear increased competition.  Within China, this will add to pressure for industry to move inland to take advantage of lower costs. But it still does not erase the fact that China's currency is cheaper than it should be.

China will, if not already, commence its diversification away from the dollar through its reserves management actions. They are investing increasing proportion of their new reserves into non-dollar assets.

Many countries would like to diversify into the Chinese yuan (CNY) itself. The growth of the offshore CNY (or CNH) market this summer in Hong Kong is perhaps a prelude to China paving the way for internationalisation of its currency in the future – not just for trade, but for more active use in investment and other decisions.

While it is necessary to view the issue of currency adjustment from all sides, the overwhelming view is that the Chinese currency needs to appreciate. Not only does this seem justified on domestic grounds for China, but it is also needed as part of global rebalancing. It would also take the pressure off of others who are intervening to keep their currencies competitive versus China’s.

But such arguments are not helped when the West engages in actively devaluing its currencies by pursuing policies such as “Quantitative Easing” (read printing money)! The latest is the Fed announcing a USD 600bn for QE2.

This crisis was triggered by a combination of factors: a failure to heed warning signs, particularly those associated with large deficits or cheap money; a systemic failure in the financial system itself; and an imbalanced global economy.

Restoring global balance requires a change in the behaviour of how countries operate.  The West (with the exception of Germany) needs to save more; East and Germany needs to spend more and the currencies be allowed to adjust to its NEER co-oefficient of 1 (Nominal effective exchange rate).

Germany manages to export considerably and has done so for some time because of the quality, not the price, of its goods. It should also recognised that China has made a huge contribution to the post-crisis recovery through its domestic policy boost, and through its impact on world trade.

Currency wars are a reflection of uncertain economic times. The fear is that unemployment in the West will remain stubbornly high. Protectionism is always a risk. There have been signs of this in the financial sector over the last couple of years, and the threat of trade protectionism is now resurfacing. How the currency war evolves will have a huge bearing on the global economic recovery.

QE2 is likely to raise the hackles for China and it is giving a legitimate concern for them as the impact this will be felt on the Chinese economy.

Overall, currency is needed not just to prevent a move towards a trade war, but also as part of the process of preventing bubbles across the emerging world. That is why domestic monetary policy such as appropriate interest rates, macro-prudential measures to curb domestic asset prices, and targeted exchange controls to curb speculative inflows may all be needed.

The imminent G20 summit in Seoul next week may not be the forum at which this issue will come to a head. France has put currencies, commodities and even capitalism itself, amongst the topics to be addressed in the G20 next year, when it holds the presidency.  

It remains to be seen whether this may yet blow out into an all out trade war and protectionist actions.  I hope not, as in that scenario every one would be a loser! Will wise heads agree to coordinated action in the coming weeks? Watch this space!

The Order of Fenix

The rescue mission capsule was aptly named as "Phoenix" (albeit with a Spanish slant - "Fenix"). The Chilean Miners’ saga captured the attention of almost the entire world as it unfolded culminating with the final rescue mission after 69 days of confinement.  It was probably the best reality TV one could have witnessed with most of the major news channels covering the rescue effort 24X7.  

In the end, it was a triumph of courage, unflinching faith and above all unwavering hope. Chilean President Sebastian Pinera said "We have done what the entire world was waiting for.” The president told Urzua, the shift Supervisor (No. 33^rd to emerge):  "You are not the same, and the country is not the same after this. You were an inspiration. Go hug your wife and your daughter."  With Urzua by his side, he led the crowd in singing the national anthem. U.S. President Barack Obama said the rescue had "inspired the world."

It is very hard to even imagine how the 33 men survived the initial 17 days when they had no interaction with the external world and had only 2 days of food supply. They only had 10 cans of tuna to share, and that the only water they could drink tasted of oil. And when they were eventually contacted they were informed that it could take several months to get them out.

The miners said it felt like an earthquake when the shaft finally collapsed above them, filling the lower reaches of the mine with suffocating dust. It took hours before they could even begin to see.

Just getting trapped in an elevator for a few hours can be daunting for many of us and here we are talking of getting trapped 650 mts. below the ground in a humid environment with no communication to the outside world for 17 days!.

Once their news of survival reached, even NASA was called upon to offer advice on how to best care for the miners in their state of isolation and confinement, their mental health is obviously being the main concern.

Knowing that a huge rescue effort is underway must offer a certain degree of comfort but how will the men come to terms with the fact they will not see daylight for weeks to come? And what mental resilience will they require?

There are a lot of parallels with space missions, which can sometimes leave astronauts stranded for unexpectedly long periods of time, says Dr Kevin Fong from the Centre for Altitude, Space and Extreme Environment Medicine at University College London. "This is as extreme as it gets and actually far more austere than for astronauts - I can't even begin to imagine it. They are isolated in a hazardous environment and the psychological stress will be quite impressive."

I am eager to find out about their mental state when they were trapped and staring almost a certain death in its face on what their thoughts were during those dark days when they little survival prospect, if any.  It makes one to contemplate the extremes - whether they would have turned into cannibals to extend their life?  Or would they have gracefully accepted death?

The question keeps coming back - What kept them going? How did they draw their strength? It will be a fascinating read when their memoirs are eventually published.

Mining industry is prone with accidents and the previous record of longest period of ordeal before their eventual rescue was 25 days.

Among the most compelling stories from the ordeal will be Urzua's (33^rd to exit - a true leader!!). He was the shift foreman when 700,000 tons of rock sealed them in. It was his strict rationing of the 48-hour food supply that helped them stay alive until help arrived. He was a fundamental pillar that enabled them to keep discipline.

There were critical moments, but at the end they never lost their hope because they had very positive leaders who kept the group unified. None of the miners are suffering from shock despite their harrowing entrapment, a reflection of the daily care and feeding sent through a narrow bore hole by a team of hundreds, and the team of psychologists that helped keep them sane. The men certainly have an extraordinary story to tell. No one before them had been trapped so long and survived.

The rescue exceeded expectations every step of the way. Officials first said it might be four months before they could get the men out; it turned out to be 69 days and about 8 hours. That got faster as the operation went along, and all the miners were safely above ground in 22 hours, 37 minutes.

The miners made the smooth ascent inside a capsule called Fenix 2– 13 feet tall, barely wider than their shoulders and painted in the white, blue and red of the Chilean flag. It had a door that stuck occasionally, and some wheels had to be replaced, but it worked exactly as planned.

"We were completely surprised," added Health Minister Jaime Manalich. "Any effort we could have made doesn't explain the health condition these people have today."

If this is not miracle, then what is it? Miracles are experienced by those who keep an unwavering faith and belief. Their triumph was cheered right through the world and rightfully so.

Unity helped the men, known as "los 33," survive for 69 days underground, including more than two weeks when no one knew whether they were alive.  Pictures of the miners as they emerged from the Fenix Capsule shows it all.

The Chilean miners’ story has all the elements of Drama, Love, Betrayal, Hope, Courage, Despair et al.  the ingredients for the making of an epic Hollywood / Bollywood movie…

Let’s take a peek at some of the key characters as compiled from the various press reports (and it is indeed fascinating):

THE YOUNGSTER – Jimmy Sanchez [No. 5]

Jimmy Sanchez, the youngest at 19, proposed to his 17-year-old girlfriend while he was trapped below, though his father urged him to reconsider. The couple have a 4-month-old baby girl,.  "You are just 19, and have so much life ahead of you, to enjoy, to know people," read the letter Eugenio Sanchez sent to his son. "It cannot be that because you are now closed up in the mine that you are going to throw away all your plans."

"It's fine that you want to be with Helencita and everything... but get married? Well, marriage is a really serious thing." But girlfriend Helen Avalos said she was sure they would be wed.  "He has to keep his word," she said. But first, "We'll have an enormous party. I think we'll have almost 500 people."

THE MEDIC or “Dil ka Rogi (a.k.a Love Rat)” – Johnny Barrios Rojas [No. 21]

Dubbed "el enfermero" – the nurse – Barrios, 50, served as the miners' medic during the ordeal, dispensing medication sent in by health officials, passing out nicotine patches and photographing wounds. He reportedly ended all his letters this way: "Get me out of this hole, dead or alive."

Johnny Barrios Rojas' rescue was among the most anticipated – if only to see who would be there to greet him.  Order No. 21 of the men pulled from the collapsed mine, Barrios gained notoriety as the man who had two women at Camp Hope – his wife of 28 years, Marta Salinas, and his mistress of four, Susana Valenzuela.

Salinas apparently knew nothing of the affair until the two women ran into each other amid the tents pitched by family members anxiously holding vigil – and a very public spat ensued. The 50-year-old Barrios looked around sheepishly Wednesday as he emerged from the rescue tube that elevated him to the Earth's surface, peering through dark glasses as mining officials in red shirts applauded loudly.

Behind him, smiling widely and waiting for him to notice her stood Valenzuela. When he didn't, the round-faced strawberry blonde walked around to face Barrios and gave him a long kiss and hug, weeping into the shoulder of his jumpsuit as he whispered into her ear.

Salinas was nowhere to be seen and had indicated that she would not be present to greet him. Weeks earlier, Barrios' wife had ripped down a poster of her husband put up by his mistress. Defiant, the mistress taped the poster back up, and beneath several poems and prayers she had dedicated to him, she signed it, "Your Wife."

THE ORGANIZER – Omar Reygadas [No. 17]

Omar Reygadas became a great-grandfather – for the fourth time – while trapped underground. The 56-year-old electrician had survived other mine collapses and was said to have exclaimed "Not again!" when he and the others were trapped by the Aug. 5 collapse. Reygadas later helped organize life below the surface, calming others when they got nervous and helping them get what they needed from authorities outside.

"He is in charge of ensuring that we are well," one miner wrote to his wife.

THE EVANGELIST – Jose Henriquez [No. 24]

Jose Henriquez turned to his Christian faith while he was underground, forming a prayer group that met several times a day, and asking to have 33 Bibles sent down the narrow supply passage.

Nevertheless, the 56-year-old father of twin daughters had one vice he hoped the time underground would cure.  Herniquez' wife Hettiz Berrios was said to be happy when her husband asked authorities to send him food rather than cigarettes. "He's trying to stop puffing. ... Hopefully he'll do it," she said.

THE FOOTBALLER – Franklin Lobos [No. 27]

Former Chilean national soccer player Franklin Lobos has never seen a bigger victory. Lobos briefly bounced a soccer ball on his foot and knee as he stepped from the capsule that carried him from the mine where he was trapped with 32 other men. Then he embraced relatives and President Pinera.

The 53-year-old is the only rescued man whose name was widely known in Chile before the disaster. He played for the Chilean team that qualified for the 1984 Los Angeles Olympics. He was the driver of a truck that takes miners to and from the mine. He was in the mine with the group he drives when the collapse occurred – leaving them alive but cut off from the outside world.

THE LEADER – Luiz Urzua [No 33]

Luis Urzua, 54 The shift foreman, known as Don Lucho by other miners, took a leading role while they were trapped and made maps of their cave.

Speaking from a hospital bed at the San José mine, shift foreman Luis Urzúa – the man who kept the Chilean miners alive for two months – said his secret for keeping the men bonded and focused on survival was majority decision-making.

"You just have to speak the truth and believe in democracy," said Urzúa, his eyes hidden behind black glasses. President Sebastián Piñera greeted him with tears in his eyes. "You're not the same after this and neither are we,"  President Piñera told him. "We will never forget this."

THE ORDER OF FENIX

Finally, the order of Fenix was determined by the psychologists and the Ministry of Health officials based on an assessment of physical and mental strength of the miners.  The initial few were chosen for their physical and mental strength and also to provide a morale booster for the rest – providing them with the belief that “It can be done”!

1. Florencio Avalos, 2. Mario Sepulveda, 3. Juan Illanes, 4. Carlos Mamani, 5. Jimmy Sanchez, 6. Osman Araya, 7. Jose Ojeda, 8. Claudio Yanez, 9. Mario Gomez, 10. Alex Vega, 11. Jorge Galleguillos, 12. Edison Pena, 13. Carlos Barrios, 14. Victor Zamora, 15. Víctor Segovia, 16. Daniel Herrera, 17. Omar Reygadas, 18. Esteban Rojas, 19. Pablo Rojas, 20.Dario Segovia, 21. Yonni Barrios, 22. Samuel Avalos, 23.Carlos Bugueno, 24. Jose Henriquez, 25. Renan Avalos, 26. Claudio Acuna, 27. Franklin Lobos, 28. Richard Villarroel, 29. Juan Aguilar, 30. Raul Bustos, 31. Pedro Cortez, 32. Ariel Ticona, 33. Luis Urzua.

What Next?

• A Greek mining company wants to bring them to the sunny Aegean islands, competing with rainy Chiloe in the country's southern archipelago, whose tourism bureau wants them to stay for a week.
• Soccer teams in Madrid, Manchester and Buenos Aires want them in their stadiums. Bolivia's president wants them at his palace. TV host Don Francisco wants them all on his popular "Sabado Gigante" show in Miami.
• Hearing that miner Edison Pena jogged regularly in the tunnels below the collapsed rock, the New York City marathon invited him to participate in next month's race.

• The rescue team even asked Guinness World Records to honor all 33 with the record for longest time trapped underground, rather than the last miner out, Luis Urzua. Guinness spokeswoman Jamie Panas said the organization was studying the question.

Mining is Chile's lifeblood, providing 40 percent of state earnings, and Pinera put his mining minister and the operations chief of state-owned Codelco, the country's biggest company, in charge of the rescue.

Psychiatrists and other experts in surviving extreme situations predict their lives will be anything but normal. Rejoining a world intensely curious about their ordeal, they have been invited to presidential palaces, to take all-expenses-paid vacations and to appear on countless TV shows. Book and movie deals are pending, along with job offers. Their life is guaranteed to be anything but normal for many reasons!!!

The fascinating story of the Chilean Miners will continue to interest social psychologists and the entertainment industry.  This has many more twists and turns and this is just the beginning!!!.

Ultimately, I end this story with this thought:

“Faith is a sounder guide than reason. Reason can only go so far, but faith has no limits”.    ~Blaise Pascal~

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!!