…Underlying Tenet of Banking
ost students of economics will recall the history of banking and basic concept on which capital-formation was built - that through mobilizing deposits and advancing portion of it as loans, which in turn is partly utilized or re-deposited and re-disbursed by other institutions to customers, and so forth… you can create financial marketplace that amplifies level of economic activity and amount of goods and services produced in any given society.
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In other words, communities are more prone to advance and meet their needs if they can fashion seamless mode for mobilizing and utilizing this magic power of numbers. Indeed some countries like the United States have mastered this philosophy and over time perfected the art of operating and regulating highly efficient financial platforms resulting in emergence of robust capital and money market architecture.
Beyond the mundane process of deposit-mobilization and lending, financial systems have advanced so rapidly (especially in the post-war decades), to encompass plethora of complex products/services – equities, bonds, mortgage loans, consumer loans, credit cards, mortgage/asset-backed, options/derivatives etc. To the extent that it has assumed global dimension whereby activities in one country extends to various industries and nations.
Thanks to such crucial elements like multilateral agencies - World Bank/IMF and regional institutions (in Europe, America’s Asia and Africa) as well as advancement in technology, combined with local financial authorities and regulations we have come to experience phenomenal growth and relative tranquility in domestic and international financial markets, as never before since the great depression – is that about to change?
…Growing Sophistication
Our reality is that both on national and international levels there has evolved sophisticated network of financial structures that are fast, highly efficient, robust yet fragile due to increasing reliance on the power of leverage and deregulation. Hence our system is currently at the brink of serious peril unless fundamentally reformed. This is calling to question principles of free-market, as we know it. According to Nouriel Roubini, (Professor of Economics at New York University) who is widely credited with predicting the current crises – the Anglo-Saxon model of supervision and regulation of financial systems has failed.
As he put it while answering questions on FT.com recently – “the supervisory system relied on self-regulation that, in effect, meant no regulation; on market discipline that does not exist when there is euphoria and irrational exuberance; on internal risk management models that fail because – as a former chief executive of Citi put it – when the music is playing you gotta stand up and dance”. This begs the questions whether financial managers and regulators have somehow outdone themselves?
Clearly there are standards of risk management and financial ratios that conventional banks must follow such as reserve ratios, capital adequacy ratios and other benchmarks and disclosure requirements usually handed down and strictly monitored by central banks around the world. Such strict policies and disciplined approach have for long been the saving-grace and main reason why banking infrastructure in some sense have remained resilient – does that absolutely immune individual banks from cyclical downturns? Not at all, as we saw countless times both here in the US and abroad – the Savings and Loan crisis in 1980s or Asian contagion in late 1990s quickly comes to mind.
In addition, confidence is reinforced by existence of deposit insurance scheme and central banking institutions (US Federal Reserve for instance) that act as buffers to sudden shocks, by protecting average depositors, investors or entities and when necessary stepping up as “lender of last resort”. In the securities industry we have government agencies like Securities and Exchange Commission (SEC) or self-regulatory agencies like Financial Industry Regulatory Authority - FINRA (formerly NASD) and Securities Investors Protection Corporation (SIPC). All of these combined provide the right environment in which financial institutions and customers interact.
Hence, even with episodic economic dislocations around the world over last few decades, none have risen to the level seen today or straddled multiple facets of economic life, jolting several industries; finance, housing, manufacturing and retail all at the same time.
…Not Time For Blame Game?
The gloomy picture of current crisis re-echoed loudly at the recent World Economic Forum in Davos, Switzerland and buttressed by grim statistics here in US – staggering job-losses (estimated at over 2,5 million that has pushed unemployment beyond 7% last year), decline in productivity (that hit over 3,5% last quarter on annualized basis) and growing foreclosure that surpassed 2,3 million in 2008.
Many foreign political leaders like Prime Minister Putin of Russia or Chinese Premier Wen Jiaboa as well as leading intellectuals lay most of the blame squarely at the doorsteps of United States. Repeal of Glass Steagal Act by US congress in 1999 was an epochal moment that ushered financial de-regulation when institutions became free to operate across various sub-sectors of the industry. This helped dismantle hindrances for cross-border mergers and acquisitions.
Soon other countries were to follow suite by liberalizing their regulatory regime, which in a way fostered competition and stimulated creation of new financial products, mostly built around “leverage” – which by definition simply means you can execute transactions for more money than you are investing in the deal (depending on the product). This scenario is the case with transactions in foreign exchange market where leverage averages 1 to 5 times or more and options/derivatives contracts, as well as equity trading where individual margin accounts (leverage) is typically 1 to 2. Practically all forms of financial products today or transactions operate with some leverage. In the opinion of hedge fund manager George Soros, writing in Financial Times recently, ratio of outstanding credit has grown from 160% of GDP in 1929 to 260% in 1932 and 365% as we entered the crash of 2008. He predicts that number could soon hit 500% in the near future.
As major attributes of current system remain the dizzying array of products, services, technology and voluminous transactions, in an atmosphere of fewer regulations key question is whether or not these products/services are matched with safeguards that could provide required confidence and sustain integrity. When everything is going well, maybe that doesn’t seem to matter, but when the chips are down, as might occur ones in a while this question is called to sharp focus.
Unlike real estate market where physical property is the underlying asset for leveraged transactions, the bitter truth unfortunately is that most leveraged deals are built around products and services that are quite often not secured by any form of traditional guarantees or collateral whatsoever. The underlying premise was that when due, the transaction will settle and counter-parties will make good on their obligations – all things being equal. That said it is fair to add; upside potential of leveraged transactions can be quite substantial just as the downside could be cataclysmic. With this in mind, institutional investors have devised various models and strategies to hedge their bets.
…Demystifying Credit Default Swaps
The most recent manifestation of leverage strategies is in so-called credit default swaps (CDS) – a relatively novel financial instrument developed to hedge (insure) against possible default in mortgage-backed securities. Much like you will purchase “put” (right to sell at an agreed price at a future date) or “call” (right to buy) option contract on stocks or commodities. On the surface the idea makes lot of sense in perfect market environment, however that might not exactly the case in “real-world” situation with multitude of players and unforeseen market dynamics.
Even in best of circumstances were all possible scenarios have been factored with help of financial modeling techniques, unfettered trading in these instruments was fraught with possible pit-falls, which even the most astute banker, talk less of regulators can’t possibly forestall. For starters, CDS instruments were purchased and traded with huge leverages. Data by Financial Times revealed that total value of outstanding credit default swap contracts is now about $62 trillion, up from $34,5 trillion a year ago.
This colossal sum far exceeds aggregate market-capitalization or asset-base of all major global banks combined. The deeper involved banks were in CDS market the more exposed to losses they are today, and the higher amount of so-called toxic assets on their balance sheet. In an unpredictable panic-situation like we had late in 2008, how are counter-parties on both sides of a transaction likely to behave – stick it out or cut and run?
Any slightest malfunction, such as mortgage payment default by homeowners, (which is the underlying instrument for CDS) was bound to cascade across the industry and worldwide, given that most of the instruments are distributed around the global market. Even modest 1% loss on these CDS contracts could lead to serious contraction in bottom-line for institutional underwriters or investors as we saw last year with Merrill Lynch, Citi Group, AIG etc, posting huge losses in 2008.
…Untangling the Web
To untangle the seeming intractable web, former US Treasury Secretary Henry Paulson and New York Federal Reserve Chief (current Treasury Secretary Tim Geithner) understood the gravity of the problem and quickly unveiled the TARP (Troubled Asset Relief Program) bailout plan estimated at $700 billion to purchase or insure so-called toxic assets from banks. Within less than a month of the legislative approval about half of the money was disbursed to banks with no clear result in thawing the credit market. Given the amount of leverage, the idea of direct bailout didn’t make much sense unless the banks could be supported in off-loading toxic assets completely and write-down huge losses on their balance sheet.
Mandating banks to channel any new money to credit market in light of this circumstance also falls short, as long as they sit on poor performing assets and losses that exceed their overall earnings. Any new money obtained will simply be deployed to strengthening their financial status first, which indeed underscores the unprecedented scope of the quagmire.
With the new strategy for disbursing the second half of the bailout money, it is expected that the government can strike squarely at the heart of the problem and begin to de-freeze the market then face more long-term measures of radically restructuring the industry to curb excessive leverage.
Recent history should remind us of very ugly incidences like collapse of Barings Bank of UK that was wiped out by flawed derivatives transactions on Tokyo stock market initiated by head-trader - Nick Leeson in February 1995. His trading positions were highly leveraged miscalculations just as losses of $1,4 billion amounted to double the operating capital of the bank. Barings Bank had to be bought-out by Dutch financial powerhouse - ING for one pound. The same situation was repeated in Paris in summer of 2007 with Credit Lyonnais that might have collapsed, after losing $7,2 billion from bad leveraged trades initiated by an employee.
We must recollect also 1998 here in US the predicament of Long-Term Capital Management (LTCM) of Greenwich, CT that was bailed-out by the Federal Reserve Bank after losing over $4,0 billion in less than four months, on highly leveraged exposures to Russian government bonds – GKO.
So instances abound of how unmitigated leverage can be tricky and detrimental to institutions and even whole markets. In each previous instance the situation had been within single institutions and was quickly remedied by regulators working in tandem with private investors.
The difference today is that the turmoil is widespread both in terms of industries affected and geographical reach, thereby creating risk of massive systemic failure. Much as that will be utterly catastrophic to global economy the solution should include combination of aggressive and far-reaching measures on national scale and in the international arena. As the leading economy, US have shown proven ability of helping the world ride-out storms through taking the right steps.
…Call For New Architecture
The proposed stimulus plan of over $800 billion is a good first step to calibrate the financial markets and domestic economy, but not without consequences on national debt therefore concerted effort in the regulatory reform front is necessary as Obama himself agrees but that must be multi-pronged, encompassing the following broad steps:
- Dismantle the Securities and Exchange Commission (SEC) and replace it with twenty first century financial regulatory authority. Then conduct bottom-up overhauling of the regulatory mechanism, first to forestall repetition of such despicable grandiose financial scandals like Enron, WorldCom, Bernard Madoff and several other scams all occurring within the last decade. New regulatory authority must redefine operating framework of financial institutions to complement the Sarbanes-Oxley Act of 2002, bearing in mind the following questions; what should be reasonable level of permissible leverage and disclosure guidelines for various financial institutions and transactions in exotic products? Evaluate if these new types of financial instruments should be regulated or not, how strictly and under what parameters should activities be conducted and disclosed, who should be held accountable for any serious violations? This can help rebuild investor-confidence, sustain integrity of the market while fostering competition, without stifling innovation. Experiences of equity and bond market regulations are instructive in this regard for developing new regulatory tools for modern financial instruments. A succession of securities and trust indenture acts (1993, 1934, 1939 and 1940) since formation of SEC and strict guidelines on full-disclosure in issuing equity and fixed-income instruments have helped support these markets to the extent that there hasn’t been an all-out meltdown such as we experienced in 1929.
- Curb excesses and recklessness in financial risk management; streamline executive pay-package and check corporate malfeasance through oversight functions of independent board of directors, third-party shareholder/consumer advocacy groups, as well as rating agencies and regulatory authorities. Enhance and enforce modern corporate governance standards by standardizing accounting rules/principles on an international scale. Pegging executive compensation (above and beyond base-salary) to merit, performance and corporate results will be fair and equitable to employees, shareholders and senior executives. There currently a raging debate on “mark to market” principle for valuing assets of financial institutions, because in reality price of such assets might be worth far less than is reflected on the balance sheet. Unless that is rectified soon it could remain a time-bomb and misleading to investors and consumers.
- Dissolve World Bank/International Monetary Fund (IMF) or at the minimum fundamentally re-organize current global financial system as we have often heard lately from leaders around the world. This is imperative and timely to address realities of new world-order in the twenty first century. The world is essentially evolving into a global marketplace with new players that have more clout and financial muscle. They should be ready to step-up and take on increased responsibility for maintaining sanctity of international financial system. The so-called BRIC nations and wealthy oil exporting countries in OPEC on combined basis have in excess of $4,0 trillion of foreign reserves, part of which can be deployed to fund new global financial regulatory authority (similar to World Trade Organization - WTO) and international lender of last resort. By so doing, some of the countries might end up with higher voting rights – so be it, which wouldn’t necessarily be detrimental to US. At least it could then re-focus energy and resources on rebuilding and de-leveraging faltering domestic economy as it advance into new areas of technology.
- Revert to gold-standard as mechanism for determining exchange rate regime as well as measure of value for international settlement in global trade. US dollar has played that pivotal role for well over half century, however through emergence of “Euro” and if recent squabbles with China on its currency manipulation is anything to judge by, I doubt if any single country or region can provide the dominant currency moving forward. Based on existing status-quo, unnecessary fluctuation of major currencies against US dollar cheapens its imports, while increasing price of US exports. Whereas low import-prices fosters higher living standard and encourages consumerism in the US, the protracted imbalance between US imports and exports is major culprit for mounting trade/budget deficit and soaring national/consumer debt, which compels US to continuously borrow to make up for the shortfall – that must stop. At the minimum President Obama’s administration should set the stage for new paradigm where “combo of three currencies” – US dollar, Euro and Chinese Renmimbi are pegged and aligned to become alternative instruments for settling international transactions. So US dollar can swing synchronically with currencies of its major trading partners, especially China. That should enable Chinese exports to US and US exports abroad find realistic balance and price-parity.
There is no denying the fact that current financial crisis will ultimately reshape the global economy in ways we haven’t seen before. So, not withstanding how unorthodox some of our ideas might seem, my goal is to set the stage for deep introspection and policy discourse. It behooves President Barack Obama to take “bigger-picture” view of emerging world order and understand things differently - not as they were or how they ought to be, but how things might turn out. Then only can US seek to drive the process by enacting “outside-the-box” measures in repositioning its financial market and society.
