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.....
Monday, 21 June 2010
Monday, 14 June 2010
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?
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?
Friday, 14 May 2010
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’.
Sunday, 9 May 2010
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.
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.
Friday, 19 February 2010
“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?
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?
Monday, 1 February 2010
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.
- 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 ?
Saturday, 23 January 2010
Obama's Volker Rule - Panacea or wrong medicine ?
OBAMA PLAN - Is it panacea or wrong medicine?
The outline of President Obama’s proposals or Volcker Rule as it is labeled, aims to introduce limits on bank size and to restrict proprietary trading. The proposals lack any link to the current financial crisis and will hardly have the desired effect of making the banking system safer.
The core causes of the current crisis viz. poor risk management practices, weak regulatory oversight, loose monetary policies, excess liquidity, investor greed, and rising consumerism will not get addressed with these proposals.
It’s overly simplistic to blame the banks entirely for the current financial crisis. The Central banks around the world kept interest rates too low for too long and topped it with lax regulatory oversight. This was most responsible for the carefree risk taking and desperate hunt for yield that brought the global banking system to its knees. The poison that brought the system down (too much liquidity and lax regulation) has ironically become the cure. The real question is governments are willing to be austere and make individuals / companies face the realities of a deleveraging. If the current low interest rates / weakened currency rates end up driving inflation which it will, it will be too late to rein in the Frankenstein. So the combined impact of deleveraging, higher taxes and higher interest rates would be a real cause of economic pain for some time.
Limiting a bank’s size and its scope of activities will not be a panacea for preventing a systemic failure in the future. The current measures seem like knee jerk reaction to election set backs and misdirected with little likelihood of achieving the intended objective of securing the banking system.
Impact of current proposals
While the devil is in the detail and details are yet to be worked out, here is a quick analysis of potential fall out of current proposals.
Proprietary trading curbs
While what precisely constitutes proprietary trading is still to be defined, it is widely believed that the market making activities to facilitate client business would continue to be allowed.
The plan aims to restrict banks from owning, sponsoring or investing in hedge funds and private equity groups. Whilst these investments were not the reasons for the current financial crisis nevertheless this measure is unlikely to make the system any safer. Banks may still be able to finance these entities and be exposed to the performance risk of these entities. These loans can be structured to give participation linked to performance of the underlying exposure. Hence, this is likely to have a very limited impact.
Restriction on size
The proposal aims to restrict the size of the banks based on market share of retail deposits. While this may limit the extent of the cost of a bail out of an individual financial institution, when there is a market failure, all market participants will be vulnerable to such events. Hence, the overall cost of any future bailout resulting from failure of many smaller institutions will not be any different.
Unintended consequences
The risk of unintended consequences of the current proposals could mean a large part of the financial activity may go into unregulated entities.
Where should the focus be?
Lawmakers’ and regulators efforts will be better served if their focus is directed towards the following issues would yield better results:
- Greater transparency and disclosure of risk positions of banks;
- Overhaul of risk measurement, monitoring and management within financial institutions; most financial institutions cannot monitor risks on an integrated real time basis of all their exposures to a counterparty, this is a major weakness within the financial system;
- Enhance underwriting standards through appropriate regulatory guidelines / oversight; For e.g. Setting income based overall indebtedness limits for individual borrowers and thin capitalization rules for businesses etc.
- Limits on trading activity as a percentage of overall business;
- Conflict of interests with respect to advisory and own positions to be eliminated;
- Asset management business should be divorced from commercial banking as there is a natural conflict of interest; this was the primary cause of origination of assets with poor underwriting standards as banks collected origination fees and transferred the risks to these funds and marketed them to investors; proposed rules on securitization addresses some of these issues;
- Setting appropriate capital measures for trading activities that fully captures stress volatility; as a minimum, trading book capital requirements should be higher than a similar asset in the banking book;
- Focus on Asset Liability management to ensure liquidity, price and Fx risks are appropriately managed;
- Greater transparency on performance based rewards with focus on realised profits rather than a fluctuating unrealized mark to market based results with focus on long term performance of the institution; regulatory developments in this area are progressing along right lines;
- Pro-cyclicality of impairment provisioning and capital requirements to be appropriately addressed;
- Accounting – Simplification of hedge accounting norms.
Conclusion
The Obama plan / Volcker Rule is misdirected and is unlikely to make the system any safer but is certain to yield more than a few filibustering sessions in the Capitol Hill.
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