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Professor Paul De Grauwe


Professor De Grauwe can you express your opinions about the different measures proposed in order to better control the financial system?




Paul De Grauwe
Paul De Grauwe
What do you think about the different measures taken to better control the financial system?
Regulatory reform of the financial system is becoming a painful thing to watch. The main object, never that clear to start with, is disappearing under a mass of suffocating detail. Perhaps policy makers should turn for guidance to an unlikely source-health and safety. In two centuries, since the industrial revolution, it had developed the kind of intellectual clarity that bank regulators are groping for. For example hazard represent s the amount of damage if a chemical plant, says, blows up or spews poison. Risk represents the odds of that actually happening. Hazard must be identified, risk measured. If we want chemicals – or indeed banks- risk cannot be done away with. So the concept has developed of “tolerable risk “. That represents the amount of risk society is prepared to live with. That varies enormously- large in the case of driving along highways, vanishingly small for nuclear reactors. But it can be defined, if in a rough and ready way. The trick is then to take the risk below that level.

With all this in mind; consider the issue of macro-prudential supervision for the banks. This is much touted at present as the answer to the failings of micro-regulation. The concept is not new, having been devised by the B.I.S. in the 1970s. Nor has been it is been neglected since, with Central Banks round the world turning out 200- page financial stability reports at regulars intervals. But in the run-up to the crisis, those reports were generally ignored. This was not because they irrelevant: the Bank of England ‘reports furnished a hair-raising account of the risks building up in the credit systems. But there were no real attempts to draw conclusions or set priorities. So the system managed to identify the hazards, but not to measure the risks.

How did bank creates the financial crisis?
When the financial crisis among financial institutions erupted they were almost engulfed by it. Banks borrow short and lend long. In doing so they create a liquidity risk. This risk is special because it is a “tail risk”. It occurs infrequently, but when it does, it has devastating effects. It is nearly impossible to quantify because it occurs as a result of collective movements of distrust and panic, therefore we have no scientific basis to predict liquidity crisis. It would be more appropriate to talk about uncertainty the distinction has been introduced by Knight: risk is quantifiable; uncertainty is not. Bank produces uncertainty.

Second banks are at the center of the payment system. This interbank network market has the effect of creating an interconnectedness of risk, i.e. when one bank fails, the other banks are in trouble. Risks in the banking system are likely to be correlated. This contrasts with what is happening in the non-banking sector; for example in the automobile sector if a company goes bankrupt this is good news for the other automobile companies.

Securitization which became popular in the 1980 onwards was thought to reduce systemic risk because it would spread the risk concentrated in one bank over many more institutions. In fact it did the opposite; it increased systemic risk. When a bank in the US Midwest bundled mortgages via investment banks like the defunct Lehman Brothers or the so called Master of the Universe, Goldman Sachs, into an asset backed security it passed it over many more institutions. If this was in Germany, the interconnectedness and the correlation of risks in the banking system increased. Thus, securitization amplified the inherent problem of the banking system which is that shocks occurring in one place are quickly transmitted to the rest of the system. On top of the liquidity risk the sudden emergence of correlated risks is close to impossible to quantify.

How is it possible to tackle this problem?
In the first way banks maintains a business model that allows them to securitize their loans in different sophisticated ways, be it that they are subject to tighter regulation and supervision than before. This is the approach towards which policymakers gravitate today. The problem of this approach is that we do not have a science of liquidity and interconnection risk, which is the risk or uncertainty created by banks. All we have is a science of independent risks. This is the risk which arises in one place and that can be isolated, because it is not propagated to the rest of the system. This science of independent risks which has been very powerful in developing and pricing derivatives and other sophisticated financial products , is useless as a tool to manage the uncertainties created in the banking system. It is even dangerous because it will lead to a new complacency. When the new regulatory environment will be in place it will create the illusion that things are under control, while underneath the time bomb of liquidity and correlated risk that can be triggered by collective movements of panics will continue to tick.

The second approach starts from the admission that we do not have the tools to quantify the uncertainties created by the banking system. All we can do is to limit these uncertainties by restricting the activities of banks. This is the idea behind narrow banking. In this approach banks are told that activities that increase the interconnectedness of risk shall not be allowed. Since securitization of loans increases the interconnectedness, it will not be allowed. Thus narrow banking aims at minimizing the potential of the banking system to create correlated risks. These risks of course cannot be eliminated, but they can certainly be reduced.

Objections to this approach must have been raised?
The first objection, popular among bankers, says that narrow banking will reduce credit and thus will negatively affect economic growth. The empirical evidence is not favorable for this view. Securitization has led to an explosion of bank credit that has fueled the latest asset bubbles. The economic growth observed in the US, the UK and many other countries during the decade prior to the crash was artificially high, sustained as it was by excessive unproductive credit, like the subprime loans, made possible by securitization. Countries like China, India, Brazil and other far eastern countries have had a much higher economic growth without resorting to securitization. Financial innovation will still occur in a narrow banking landscape. Investment banks will still be able to develop new sophisticated assets. The limitation they will face, however, is that they will not be able to finance these (most often illiquid) assets by short-term funding. This might necessitate the reintroduction of a type of galas Steagall Act, whereby investment banks will not at the same time be able to operate as commercial banks, as unfortunately some as Goldman Sachs ( GS) and Morgan Stanley can do today awkwardly handled to them during the fall of 2008 by US Treasury Hank Paulson a former CEO of G.S .
The second objection to narrow banking is a more serious one. It has been formulated by Charles Goodhart among others. It says that in good times there will be a tendency towards disintermediation, i.e. it will be more attractive to expand credit through the less regulated part of the banking system ( ( the investments banks or other “ shadow banks “like hedge funds ) at the expenses of the more regulated narrow banks. When crisis erupt the reverse will happen, when agents fly to safety towards the more regulated part of the banking system like what happened during the fall and winter of 2008/2209.

Will this objection not be applied to any kind of regulation?
The regulatory reforms that are now considered and that imply that bank can keep their business model of securitization also face this problem. Banks will be subjected to tighter capital and liquidity ratios. They will then also try to move activities in such a way as to evade these restrictions, much in the same way as they have done in the past with the Basle regulations. This will create movements of credits from the tightly regulated activities and asset holding of the same institutions to the less regulated ones. It also implies that the supervisors will have to do a lot of micro-supervision at the level of the internal management of the financial institutions. It is therefore not clear a-priori whether this approach will be more successful in preventing the evasions and distortions in the financial system than the approach based on separating commercial from investment banking activities. Bankers and their many lobbyists protest that narrow banking is terrible and will reduce innovation and growth. The authorities should not believe them. The protests of bankers against narrow banking are self-serving. When Bankers make pleas to keep their business models unchanged they are not concerned at all with general welfare. Their only concern is to go back to the situation prior to the crisis that allowed them to generate extremely high profits while making sure that most of the risk was borne by the rest of the society in other word at the end by the taxpayer.

There are other initiatives being considered by the Governments and Financial regulators could you please detail the resurgence of the Tobin tax?
The controversy started in August when Adair Turner, Britain‘s top financial regulator, called for a tax on financial transactions as a way to discourage “socially useless “activities.

The proposal is a modern version of an idea originally floated in 1972 by the late James Tobin, the 1981 Nobel-winning Yale economist. Tobin argued that currency speculation was having a disrupting effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies. Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a disincentive for people trying to make a speculative profit by outguessing the markets over the course of a few days or weeks. Tobin’s idea went nowhere at the time. But the new “Tobin Tax “is now considered to be applied to all financial transactions; not just involving foreign exchange. It would be a trivial expense for long term investors, but it would deter some of the churning that now takes place in our hyperactive financial markets. It would be a bad thing if financial hyperactivity were productive. But after the debacle of the past two years there is broad agreement (even acknowledged by the e CEO of Goldman Sachs) that a lot of what Wall Street and the City do is “socially useless “. And a transaction tax could generate substantial revenue, helping alleviate fears about government deficits

Is such a tax workable ?
The main argument against the tax is that traders would find ways to avoid it. Some also argue that it wouldn’t do anything to deter the socially damaging behavior that caused our current crisis. Part of it is true because some of the profits expected from the speculators are so much larger than the tax that it would not deter the speculators who expect returns of 10 %, 20 % or more on a yearly basis. In another vain there are large taxes to be paid when acquiring a house ( it varies from 1 % in the UK to close to 16 % in Belgium ) and this did not stopped speculators to enter into a frenzy of real estate loans in the US ( the catastrophic sub-prime loans ) , the UK, Ireland and Spain for example .

However on the claim that financial transactions can’t be taxed: Modern trading is a highly centralized affair. Take for example Tobin ‘original proposal to tax foreign exchange trades. How can you do when currency traders are located all over the world? The answer is, while traders are all over the place, a majority of their transactions are settled at a single London or New York based institution. This centralization keeps the costs of transaction low, which is what makes the huge volume of wheeling and dealing possible. It also, however, makes it relatively easy to identify and tax.

But what about the claim that a financial transaction tax doesn’t address the real problem?
It’s true that a transaction tax wouldn’t have stopped lenders from baking bad loans , or gullible investors from buying toxic waste like all ABS, CDO, CDS etc… backed by those loans . But bad investments aren’t the whole story of the crisis. As indicated above what turned those bad investments into catastrophe was the financial system’s excessive reliance on short-term money. The USA banking system has become crucially dependant on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period-often a single day. As said before losses in subprime and other assets triggered a banking crisis because they undermined this system- there was a run on repo. A financial tax, by discouraging reliance on ultra short –run financing, would have made such a run less likely.

Can the “new Tobin tax “be used for other purposes?
Instead of seeing the “ Tobin tax “ as a way to stabilize the financial sector it can be used as a way to generate substantial revenue given the enormous number of financial transactions handled by all type f institutions be it in the exchange traded way or in the “ shadow banking “ system . It could generate billions of US $ for governments. The use of this new source of revenue can be used for varying purposes; either to boost the reserve for a countercyclical fund or for funding developing countries growth as suggested by many NGO’s . Other uses could be the financing of renewable energy, boosting education and R & D. In other word a worldwide based tax which can be used, like the Tobin tax, to finance socially acceptable projects is a good tax.

Are they other ways to bring more stability to the system besides narrow banking?
A better way to tax financial institutions would be to tax their balance sheet. It is what the IMF is studying presently. Commercial banks benefit from an implicit State guarantee. When they come into problems the governments have to save them at the cost of the taxpayer. The larger the bank failing; the greater the losses and the cost to the people. This tax would be computed on the total assets of the bank. The tax could progressively be increased with regards to the turnover of the bank. In this way banks would be encouraged not to become too big. As we have learned from the crisis big banks are the most risky because they are “ too big to fail “ and cause systemic risk.

What kind of other alternatives are the regulators and the IMF following?
The thread that runs through the IMF and other regulators is how to preserve the core financial services provided to the economy through periods of extreme stress without bailing out banks ‘equity holders or uninsured wholesale creditors. While banks ‘management might not consciously take undue risk, wholesale fund might be so cheap and available , like in the last decade, that they could , like they did, be tempted to borrow for risky pursuits with higher returns than the cost of funds .In the financial crisis , some bank shareholders were wiped out or forced to take big losses . But wholesale creditors, such as those who bought bank debt had not been as damaged because governments intervened. Without tougher regulations, the balance off risk would continue to fall on taxpayers. One idea to minimize the need for banks to use central bank facilities is that they should be required to hold inalienably liquid instruments such as Treasury bills, UK government gilts or government bonds. Another idea is for banks to pay an annual 10 % profits tax in exchange for the taxpayer support they have received. This tax could raise about 2 bn £ a year in the UK and be used to pay down the structural deficit.

The IMF is s studying for the G20 different ways to tax banks like: taxation on their trading profits, of their risky assets and even on their past financial transactions. Of course this tax should not hinder the giving of credit to the economy. These tracks would allow Governments to recover part of the trillions of US $ provided by the governments and thus the taxpayer to save the “too big to fail “banks. The IMF is also studying the possibility to require banks to pay an insurance premium in order to create a reserve fund or “contingent capital “which would allow financing potential new crisis.

This is in fact already in use in the USA by the Federal Deposit Insurance Corporation (FDIC); all US banks must pay an annual insurance premium in order to back the FDIC fund. This fund is used in order to pay the guaranteed deposits of failed bank clients. Presently, due to the large number of small to medium bank failures in the USA the FDIC fund is negative. The FDIC has thus required a couple of weeks ago all US banks to pay three years of insurance upfront in order to replenish the fund . This system of insurance premium, which does not exist in Europe, could be applied on a worldwide basis and collected by the ECB or the Bank of England for example.

The US bank lobby is fiercely resisting to keep the sale of Over the Counter derivatives out of an open clearing system. Why is that so?
Every catastrophe brings calls for restrictions on derivatives. This year Nobel economic laureate Joseph Stiglitz has said that their use by the world‘s largest bank should be outlawed. But derivatives have defenders too. Used carefully, they are an excellent – some would say indispensable – tool of risk management. Myron Scholes, another Nobel Prize winner says a ban would be like a “luddite response” that takes financial markets back decades. About 95 % of the world’s 500 biggest companies use derivatives according to the International Swap and Derivatives Association (ISDA). But what is at stake is not their adequate use as a tool of risk management but their lack of transparency and therefore their escape to potential taxation if a type of “ Tobin tax “ was implemented . The OTC markets for derivatives dwarfs exchange trading. Estimating it size, however demand caution. In figures published by the Bank for International Settlement (BIS), the Central bankers’ central bank puts its “notional” value at 604.6 trillion US $. But those numbers don’t appear on anyone balance sheet.
Opaque markets breed insiders profits, and abuse of investor in the “shadow banking system “. One of the most profitable franchises of maximum ten banks in the world is the sale of customized derivatives to corporate customers. Remarkably, the banks have persuaded customers that keeping the markets for those products secret is in their interest. Those markets allow companies to bet on or hedge themselves against losses from –changing interest rates and commodity prices. They also allow investors to use credit default swaps (CDS) to bet on whether a company will go broke. The US Future Trading Commission (FTC) and the SEC wants to standardize those products when possible and require their trading to be done on exchanges when possible. Banks wants to whittle away the changes promoted by the FTC and the SEC and leave it to the banking regulators to oversee the dealers, something regulators totally failed to do in the past.

Unless US Secretary of the Treasury Mr. Geithner can persuade legislators otherwise, one of the great banks lobbying campaign will have succeeded. This is due in large part because some companies that buy derivatives have been persuaded that their costs would rise if needed changes were the opposite is probably true. The history of nearly all markets is that customers suffer if dealers are able to keep them ignorant of what is actually going on.

It is now time to promote the similar transparency of the corporate bond market, where actual trades were kept confidential until the beginning of this decade, to this relatively new marketplace for derivatives presently traded OTC. In the listed markets for derivatives securities, like futures, there are margins that must be posted everyday if markets move against the buyer of the derivative. Corporate customers of the OTC derivatives fears that they might face similar margin requirements if their contacts were to be traded on exchanges, and they have persuaded some legislators that would be horrible. Of course because prices are not made public we can only hope that these banks are pricing the credit at reasonable levels. The powerful International Swaps and Derivatives Association (ISDA), has assured that the cost of credit is taken into account in the collateral relationships and in the bid-ask spread. In layman‘s terms, that means that customers with worse credit would ISDA face different prices than customers with excellent credit in other words according to the making price disclosure is of limited value.

What is the position of the FTC and the SEC relative to this squabble?
The two institutions say that customers would be better off if the two markets – for the derivatives and for the credit- were separated and had clear pricing. Otherwise how else can customers know if they are getting fair prices?

What is remarkable in the OTC derivatives market s is that big companies like Boeing, Caterpillar and many others that use derivatives to hedge risk have been persuaded by bankers that they should not worry about the lack of transparency? It appears most likely that the bank lobby might convince the US Congress to eliminate or minimize the disclosure of customer trades , and if it allows custom derivatives to remain almost completely opaque and without visible pricing of credit , that will encourage some corporate customers to prefer customized contracts. Such contracts will most likely cost them more but the cost of credit will be hidden, and they may not have to post collateral immediately if they are losing money. The lack of enticement among US legislators to push for such a transparency system might be because the efforts of the administration and the FED to save the banking system worked too well. The fears of collapse that were present early this year have faded away and have been replaced by a general feeling of resentment. The US banks seem to be on the verge of harnessing that feeling of resentment to preserve a major profit center. On the other hand the US government might miss out on collecting substantial taxes if these transactions were carried out on open exchanges.

Michel-François Clerin
524 Av. Louise
B-1050 Brussels - Belgium
michel_clerin@yahoo.fr

Mercredi 16 Décembre 2009
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