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Aggressive Banking and Passive Regulation

Securitisation of loans has emerged as the driving force in financial markets, transforming radically the way assets in different sectors of the economy are being created and marketed, but this carries the seeds of a crisis which is what has erupted in global markets. It is time we realise that standard conservative banking principles should not be given the go-by in the name of the new fangled, exotic kind of banking. But will this ever happen?

Off the Shelf

Aggressive Banking andPassive Regulation

Securitisation of loans has emerged as the driving force in financial markets, transforming radically the way assets in different sectors of the economy are being created and marketed, but this carries the seeds of a crisis which is what has erupted in global markets. It is time we realise that standard conservative banking principles should not be given the go-by in the name of the new fangled, exotic kind of banking. But will this ever happen?


For it is not at all pleasant to rail at incurable practices and errors that are far developed, though sometimes it is necessary.

– Plato, Laws

ears ago, in the late 1970s, Walter Wriston, the then chief of Citibank, doyen among commercial bankers and the great defender of commercial bank loans to sovereign countries, asserted nonchalantly: “Sovereigns can never default”. We know of the financial quake in the 1980s – sovereign defaults by many Latin American countries in which several leading banks were heavily exposed. Today the context is different and the players have changed, but the game goes on in the same old spirit – the craze for a larger market share, for more profits and more shareholder value at any cost and irrespective of the consequences. No surprise then that Chuck Price, the present chief of Citibank, put up a brave front in the face of the troubles surfacing in several markets and exhibited the same unconcern that his distinguished predecessor had displayed three decades ago. “As long as the music is playing”, he said, “you have got to get up and dance”.

“Aggressive Banking” is what we have to learn to live with. An oxymoron to those nurtured on traditional banking, but a guiding mantra for today’s bankers. Any lending carries with it some risks and traditional bankers are always cautious in taking assets on to their books, evaluating the impact on their balance sheet under different probabilistic considerations. If they wish to lighten the burden, they syndicate the assets among different members of their fraternity, each according to its need and capacity. Today’s creative bankers scoff at the traditionalists and claim that with exotic financial instruments they have entered a new world of banking. Loans are tradeable securities, to be packaged, sold and forgotten about. It is this financial engine – securitisation of loans – that has emerged as the driving force in financial markets, transforming radically the way assets in the different sectors of the economy are being created and marketed. In the housing sector, the push in the US to raise home ownership mortgage credit reached its peak in 2004 and 2005, supported by a wide array of investors across the globe who picked up securitised credit instruments, which had been evaluated and rated by the leading global rating agencies. This had been hailed by many as the era of great democratisation of credit! But hardly had the party begun to warm up when the air turned thick with charges of misguided and culpable bungling.


Why are we in a crisis situation today? What lies at the heart of the problem is the rupture between decisions on credit from credit risk bearing? The originator of the loan thinks that with the new credit instruments he is in the fortunate position of being able to pass on the risk to other investors and thus escape capital adequacy requirements, linked as these are to the level of credit assets held in his books. But the risk does not vanish from the system. In mortgage lending, the investing institutions that have become active in supporting the secondary market, mainly private equity players and the hedge funds, which play on arbitrage in asset markets to make extraordinary profits, have to depend for their kind of business on extensive lines of credit from banks. So, ironically, it is commercial banks that are again driven by profit to support the highly leveraged and extremely risky positions of some of these players. The commercial banks, the originators of these risks, have the smug satisfaction that with the new fangled instruments, they have passed on the credit risks to unknown investors, but if they have been careless in the evaluation of risks then the consequences will, sooner or later, come back to haunt them. All that has happened through global trading desks is that a risk, traditionally borne by a single institution or shared among a group of syndicated lenders, has got converted into a systemic one. That is, risks not merely in mortgage lending but in any kind of financial institutions, have become generalised.

Mortgage lenders could not escape from the speculative craze. With the rise in asset prices, mortgage lenders encouraged sub-prime borrowers to get loans and buy houses, a clever strategy to stimulate sanguine and ardent borrowers. The appreciation of house prices dilutes risk perception and more leverage is of no consequence; asset books get built up with hardly any margin requirement. Subprime mortgage borrowing nearly tripled during the housing boom years of 2004 and 2005. Risk management standards lay buried in that ambience.

What about the investors who trade in these securities? As long as the assumptions in the quantitative risk modelling system move with the expected variances, it is roses and roses all the way, but, then, quantitative risk modelling that assumes some constancy in the structure and fundamentals of the market cannot find any answer to the woes of the traders when randomness hits the market. To quote from The Economist: “Goldman Sachs admitted

Economic and Political Weekly September 1, 2007

as much when it said that its funds had been hit by moves that its models suggested were 25 standard deviations away from normal. In terms of probability (where 1 is a certainty and 0 an impossibility), that translates into a likelihood of 0. 0006…0006, where there are 138 zeros before the six. That is silly” (August 18, 2007). The mortgage market was affected by some changes in the macroeconomy, house prices deteriorated because of the large inventory of unsold houses, higher interest rates and slower economic growth. The apple cart got upset.


The inevitable has happened. In the subprime sector, the delinquency rates have risen sharply, to about 12 per cent, roughly double the recent low seen in mid-2005. The rate among the prime borrowers has also risen somewhat. Interestingly, these payment defaults occurred very early in the credit cycle, within a few months of mortgage origination. US Federal Reserve chairman Ben Bernanke has placed the estimated loss between $ 50 and 100 billion, roughly about 1 per cent of the US GDP. We would not have landed in such a situation if the originators of the loans had not loosened their standards. Were they worried? No, for, at the worst, they must have argued, the regulatory authorities would come to their rescue, as they have indeed been doing in recent years.

This is not, in any way, an unfounded perception. Look at the late-night rescue efforts mounted by the Federal Reserve when, in 1998, the US hedge fund Long-Term Capital Management (LTCM) imploded. As the hedge funds operate with hardly any regulatory control and supervision, they maintain high leveraged positions with funding from banks. And as the major banks in the US were involved in lending to LTCM and this lending posed a systemic threat, the Federal Reserve intervened. In the current crisis too, central banks did what everyone expected them to do: intervene in the market in a big way. In mid-August, the Federal Reserve injected, on two successive days, $ 28 billion and $ 38 billion. The European Central Bank also joined in, pumping in liquidity into the euro zone money market, with two weekly injections totalling euro 204 billion. The global market has received a temporary respite.

What lessons have this crisis thrown up? Nothing that we were not aware of.

Financial and monetary experts cannot be faulted for not having forewarned us about the crisis that was building up. They have been consistently asking: are the regulatory authorities fully geared to meet such recurring hiccups in global finance? With the financial market getting increasingly integrated and with seamless interconnectivity achieved through information technology, can we expect mitigation and management of risks to be addressed exclusively by domestic regulatory authorities? What we have been experiencing are now matters of global concern. Political and monetary leaders have to imaginatively address some of these global concerns at the global level. They need to bridge the yawning gap that exists today between governance capability and limitations of the existing national and international institutions, on the one hand and the risk breeding and risk multiplying potential, on the other, that are fast becoming inherent in the global financial system.

There are several interrelated concerns. At the point of credit generation itself, laxity in credit assessment seems to have become all pervasive, cutting across many institutions. The eruption of crisis in the LTCM hedge fund could be traced broadly to three factors: little or no regulation of hedge funds by the US Securities Exchange Commission, lack of credit discipline on the part of some of the world’s largest bankers in supporting highly risky leveraged positions in the hedge funds, and inadequacy of monitoring by the regulatory institutions concerned. Little seems to have changed since then. The presidential commission that was set up in the wake of the crisis stopped short of grappling with the global implications of an LTCM type of debacle; it restricted itself to a set of recommendations intended to improve, within the US, the supervisory oversight over banks. The premise underlying the approach is that in the ultimate analysis, the play of market forces will enforce discipline and improve the functioning of the institutions – the time worn moral hazard principle that if you do not discipline yourself, you run the risk of extinction and no regulatory institution will come to your rescue.

This is fine in principle. Recall that when the Savings and Loan (S&Ls) crisis of the 1980s erupted, Ben Bernanke, the then governor of Federal Reserve Bank of New York, described it as “…a situation… in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net – the classic ‘heads I win, tails you lose’ situation.” After an intellectual and political battle of more than a decade, the deposit insurance was sealed. Today there are reasons to believe that given the way the global financial market is behaving and operating, we have to look at the moral hazard principle somewhat differently.

Let me elaborate on this. In the subprime crisis, though the problem started in the US, it seemed to have become most acute in Europe. BNP-Paribas, the largest bank in France, had to suspend the operation of three of it largest funds because it was unable to value the US mortgaged-backed securities and was facing liquidity problems. In Germany, a little known bank, IKB Deutsche Industrie Bank AG, that lent to small and mid-size German companies, wanted to grow at a fast rate. In pursuit of that strategy (Moody’s Investors Service endorsed the move, crediting the bank last year with “successfully diversifying”), it started buying complex bonds invented in the US, of which a large chunk was in US mortgaged-backed securities. In the case of this bank, it was the German government that organised the rescue. The psychology of nervousness spread to Asia, even though investors in the region are not overexposed to the US sub-prime market. Australia’s Macquaire Bank announced recently that two of its debt funds have lost 25 per cent of their value, a loss of about 1 per cent of the total assets under management. Central banks all over the region would be willing, so it appears, to step in at a moment’s notice. More corpses are likely to surface, but no one can say exactly when and where. It would be no surprise if major problems of this kind show up in the below-investment grade corporate bond market once corporate profits begin to decline.


The authorities can be blamed for fostering moral hazard, but in the globalised financial market that is growing at a terrific pace, would it be realistic to take the view that the regulatory authorities should sit back, watch and allow market forces to have full play? However, if the distress signals threaten to be ominous, would the national regulatory authorities be aware of the dimension of the problem, and

Economic and Political Weekly September 1, 2007 even if they are, would they have the resources to counter any threat to their own system? The successive crises and the costly bailouts that have been taking place over the past several years have made one thing clear: in a market that is getting globally integrated, any crisis that has its roots in financial market behaviour can in no way be countered by any single country acting in isolation. As we know to our cost, laxity on the part of any regulatory institution in any major country would have ripple effects all over the world. In particular, the US has its own standards of regulatory governance, too market friendly for the comfort of many other nations; they are always deeply worried about their own capacity to absorb shocks and counter effectively any possible contagion effects. The players in the US market – bankers, investors, hedge funds and private equity investors – are historically and culturally dominant and aggressive. They drive the global market in the way they would like it to run and seem to have little regard for the consequences of their decisions: quick to come in and quick to get out. The emerging countries are left on their own to face the consequences of the speculative decisions of these players. In their home countries. These global players have, however, never been let down in the recent past; the enormous resources of the authorities, as we have seen in some of the major US market crises, have readily come to their rescue.

We have to accept that such issues can be addressed only at the global level. But the institutions that are needed to tackle these issues at the global level are missing. The integrity of the global financial market can be protected only through a global regulating agency that is constituted and governed in a democratic manner. We cannot however wait till then. It has therefore become critical for global financial stability that every country initiates effective measures for mitigation of risks. As Henry Kaufman has put it: “If competition is not allowed to enforce market discipline, the most viable alternative is increased supervision over financial institutions and markets” (‘Financial Quakes’, The Wall Street Journal, Asian edition, August 16, 2007).

We must look at where risks are originating. The US must take the lead in this respect; as the epicentre of the global financial market it must put its own house in order. Soon after the crisis erupted, Fed chairman Ben Bernanke mentioned in his remarks to the 2007 International Monetary Conference in Cape Town on June 5, 2007, that the Federal Reserve would focus on better implementation of four types of instruments available with it for promoting safe and sound underwriting practices: “required disclosure by lenders, prohibition of abusive and deceptive lending practices, principles-based guidance with supervisory oversight and less-formal efforts to work with industry participants to promote best practices”. These are standard principles and practices that have been in the armoury of central bankers for decades. Is it that the Fed chairman is implicitly accepting that there has been a failure in implementation of these time tested principles? Perhaps so. To some extent, self-defensively, he says, “Last year, together with other federal banking regulators, we issued guidance concerning so-called nontraditional mortgages. We have also issued draft supervisory guidance concerning underwriting standards and disclosures for sub-prime mortgages. The agencies are now reviewing the many responses to the draft proposals.” Too late and too little! They could not have been unaware that a mess was in the making. Many market observers were expressing deep concern about the developing situation. The former chairman of Salomon Brothers echoed these sentiments in a forthright manner: “We’re not really sure what the guy’s income is and we’re not sure what the house is worth. So you can understand why some of us become a little nervous” (The Wall Street Journal, Asian edition, August 13, 2007).

In the 1980s the defaults on these loans would have led to a run on the local bank, but today, the loans have been securitised, repackaged in a consolidated debt obligation bond and sold to a hedge fund that bought it on leverage. Clearly, the Federal Reserve has been behaving far too passively. Why did the authorities turn a blind eye to the quality of the portfolio of the bankers when the loans were being originated and also when the market was seething with rumours that hedge funds have taken a big chunk of them. There is another worrying aspect about the efficacy of the regulatory structure that has often been discussed in the context of the US, but what is significant is that the Fed chairman has chosen to make a specific mention of this in the context of the current crisis: “The patchwork nature of enforcement authority in sub-prime lending poses a special challenge. For example, rules issued by the Board under Home Ownership Equity Protection Act apply to all lenders but are enforced – depending on the lender – by the Federal Trade Commission, state regulators or one of the five regulators of depository institutions. To achieve uniform and effective enforcement, cooperation and coordination are essential” (emphasis added).

For several years many commentators have been stressing that the regulatory standards and their surveillance and enforcement have to be much tighter than what obtains within and between the regulatory institutions. Talking of the sub-prime mess, it is often asked: Why is it that banks could get away by requiring no margin stipulation? Why is it that no steps could be taken to mitigate the risk at the source itself? If, for example, it is made strictly compulsory for banks to hold the bulk of the loans on their own books, only a small portion would be securitised, and in that event the banks would be extremely careful in screening the antecedents of the borrowers and their net worth. It is time we realise that standard conservative banking principles should not be given the go-by in the name of the new fangled, exotic kind of banking. But will that ever happen? After every crisis, we wake up with all good intentions and resolve to give teeth to our regulatory institutions, but the enthusiasm evaporates soon thereafter. Have we forgotten that we are still confused and clueless as to how we should enforce the simple requirement of registration of hedge funds, not to speak of their submitting to the discipline of the regulators? Are we waiting for the wholesale collapse of the global market till we come to our senses?



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