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Monday, 27 October 2008

Gordon Brown's Basel II haircut or hairshirt?

Willem Buiter in the FT (today, 27 October) has issued a long and damning indictment of Gordon brown and of Basel II banking regulation. My equally ex-cathedra response (also posted in the FT) follows:
The Basel II accord did not permit banks to "skimp on capital in exchange for better risk management and market discipline". Basel II has not yet been fully implemented and was only half-way complete by the time the credit crunch struck. Reliance on banks’ internal risk models (something Buiter is angered about) never happened, and in any case all internal models overwhelmingly continued to rely on external ratings agency data. All that internal models could do that marking-to-market could not was risk assess loan collateral and haircuts, and again those tasks use external ratings. One major problem in this was that the external ratings models of CDOs were spectacularly wrong (see blog below "Ratings agencies: the smoking gun" and "protecting Assets like a junk-yard dog" and "B2 or not B2? - another long essay"! Market discipline may be inversely proportional to the degree of euphoria in the market, but Basel II is specifically designed to address this, especially in its Pillar II stress testing and scenario modelling for extreme shocks. It was this aspect that all banks struggled with a failed at. But that was an intellectual as well as a management failure. And the lack of involvement of macro-economists and poverty of academic treatises on the subject are also very much to blame.Basel II did not introduce “vulnerabilities” in what banks knew about risks; they were already there. Basel II and IFRS, when fully implemented, will mean that senior managements of banks cannot be blind-sided on excessive risks - as many have claimed in their hairshirt defence; that they only knew what was in their conventionally audited accounts. No bankers have blamed Basel II for not knowing their true positions!
It is a dilemma to insist on mark-to-market valuations when these depend on ratings agencies errors. Banks and other CDO investors were misled and need time (over the next 5-6 years) to work their way out of current m2m losses in CDOs until actual economic losses are realised, when they will be considerably lesser by about half. Spreading losses over time also reduces those losses and this is what central bank support aims to achieve, to win more time for the banks. Strict mark-to-market principles invite the danger that banks act severely pro-cyclically. Systemic stability may be best served by banks publishing under Basel II Pillar III both m2m and hold-to-maturity values with a strategy for getting from one to the other. There should not be an obstacle in the way of banks taking assets underlying their originated CDOs back on banking book balance sheet, at least the equity and mezzanine tranches. There is no official global relaxation of constraints on bank balance sheet reporting, not yet.
It seems mistaken to blame Gordon Brown as Chancellor of the Exchequer, for encouraging “self-regulation wherever conceivable for banks and other highly leveraged institutions.” That has obviously been led by repeal of Glass-Steagal and other measures including a hands- off de-regulation by SEC and stock exchanges regarding quality of market issues, and decades of tolerance of OTC fixed income markets. Basel II is absolutely not “light-touch regulation” neither does it represent any less than a “strengthening of the global coordination of national financial regulatory regimes”. The cross-border rights of regulators and their coordination and agreement to all sing from the same hymn sheet in risk and accounting standards is clearly defined and operating even as the Basel II edifice is only half-built and only in its first-version implementations. No bank has passed muster in Basel II Pillar I without major issues being spotted by regulators and penalties threatened and imposed including cancelling banking licenses (e.g. Fortis Netherlands). Brown accepted FSA’s membership of C-ebs and opposed EU alignment of tax rates and fiscal stance (via Euro membership), but remained fully aware of the competitive pressures pushing for this as well as good arguments for opposing. A question of optimal balance. Does Willem think all this was wrong? The idea of a regulatory race to the bottom in the face of Sarbanes Oxley, Basel II and IFRS seems much exaggerated. Market euphoria is hard to iron out. In any case a good dose of cyclical experience from time to time is good for the soul of capitalism.
If Brown deemed it advisable to be a devoted disciple of Alan Greenspan, he was in good company and it must have seemed confidence-building politically. But, I am quite unaware of Greenspan having personally diluted Basel II or IFRS or Sarbanes-Oxley, even if he did oppose CDS regulation and trusted too much in the banks. But the banks were not the sole problem. The question of CDS is also the question of unregulated OTC markets and that has a history stretching back long before Greenspan. He flip-flopped less on regulation than Christopher Cox at the SEC, and let’s not forget that market values were for most of Greenspan’s tenure patently cyclical and then still in recovery upturn from 2001 when he vacated his throne. And yes, “Mr. Greenspan, much to his credit, has the intellectual honesty to admit that he was wrong.” Though he is wrong to say, “The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.“ The fact is, as Moody’s admitted, key historical data was not updated after 2003 by ratings agencies, if we accept that what Moody’s did was true of S&P and Fitch? And, let’s not neglect just how ubiquitous the ratings agencies’ data (and commission services) were and are to the business of commercial as well as investment banking!
Willem says, “The day you hear a political figure say: ‘I am sorry; I made a mistake because I had the wrong understanding of how the world works’ is the day we will be skating in hell on natural ice.” Politicians are in power because they at least know how democratic politics works, what we pay them for. Anything else is up to other professionals like Willem! And we (if I may count in myself with him) have to politically and intellectually win our war of ideas and policy prescriptions. We are mandarins of banking economics. Where are our mea culpas?
Describing Brown’s relentlessly expansionary fiscal policy in New Labour’s second term as”pro-cyclical” is interesting, even Keynesian, but GDP rates were close to or below the so-called long term non-inflationary growth rates. He was wedded to long term stability. The criticism should be that he did not act firmly enough to balance the external account while welcoming FDI inflows bigger than China’s, and certainly should have succeeded better in cooling the property market. But, were there votes in that? Are our intelligent chattering class property investors not also blame-worthy? And, what would have been the media or public response to reviving public sector house-building or raising stamp duty further? In any case, our economy is tied to the US so closely that we are forced to either ride with, or use the lag of 2 quarters to try and actively cushion the UK economy against, the US cycles. Boosting public spending seemed a solution for the latter, one that worked a few years ago at the end of New Labour’s first term picking up on similar deficit spending boosts that Ken Clark employed to climb out of the ‘92 recession and again in ‘95 when growth suddenly faltered (due to severe winter weather in the US and the US budget sign-off crisis), as it was faltering again (led by falling US property prices) leading into the credit crunch of ‘07. The very sound point has been made in the FT by Gillian Tett, that governments have been racing to save the banks in order to try and out-run recession and ensure banks have some part to play in acting counting-cyclically, however marginal compared to what governments will do, and are doing, as the economy’s main counter-cyclical pedalist. In that regard, Gordon Brown’s taking the lead globally has much to be said for it as Willem no doubt agrees. [for more see comment]

1 comment:


Willem Buiter’s blast that the UK “economy is faced, right at the onset of the recession, with an unsustainable structural fiscal deficit” trips lightly off the tongue, but I fail to understand the logic? It is to do with the “level “ (ratio to GDP) “of the debt (gross and net)” that is only lower than other European countries if one excludes the debt of part-nationalised banks, which Willem says would, however, be to greatly overstate matters. His concern is that cyclical automatic fiscal stabilisers will increase the budget deficit plus further discretionary fiscal stimuli, expected and appropriate. This he says risks “the confidence that the domestic and international capital markets have in the capacity of the British government to cut spending and raise taxes in the future, when the economy starts to recover” and opines, “Based on the experience of the past 7 years, that confidence level should be close to nil”, which seems remarkably harsh, and “Default risk premia on (UK) government’s debt (will) increase and credit default swaps on (UK) government’s debt will become more expensive.” This sounds suddenly trivial, and I’m not thinking that government can now dictate to the banks what price they should underwrite and buy government paper, although something like that is surely happening already at the Bank of England’s SLS swap window. Willem is right enough about CDS spreads. We can see it in the case of Ireland, UK and others already that CDS spreads on government debt has risen sharply. But, if GDP growth is jump-started thereby that is hardly a cause for concern. Of course, a rise in government debt CDS spreads is inevitable as toxic bank risk is transferred to governments via SARP, and this is happening world-wide. But Buiter’s comparison of UK potential default risk with Iceland is incredible. Iceland has a population only that of Scotland’s Highland region! Oh that Scottish crofters had debt 5 times their income and could demand a bail-out - maybe they do. Highlanders like Icelanders probably believe the whole world is against them and they deserve every penny they can get.
Paul Krugman, the latest Nobel prize winner for economics titled his October 12 New York Times column, “Gordon Does Good”. Willem rails back an emphatic Not so!; “He is one of the fathers of the crisis” and Willem seeks instead to pin the medal for services to the globe on Chancellor Darling. I’m amazed if anyone in politics does not know how intensely Brown and Darling are the closest of colleagues and dear personal friends, unable to do anything the other would not first approve of.
Buiter says Darling’s SARP was however, “late and is still too little, but it was better than what had been achieved till then in many countries - certainly better than what was on offer in the US through TARP as then construed.” How much would be enough? And yet too, he says that in “recapitalisation matters, the UK too was playing catch-up,” citing the antecedence of Benelux countries’ action over Fortis. I know the Fortis case well. It is not suited to this argument. Dexia perhaps, but there are hidden reefs in that case too. The Irish moves are more appropriate as leading edge examples for all the others to follow beginning with the UK. Willem’s cartoonish characterisation of Brown stealing Darling’s thunder is uncharitable and misunderstands both men entirely, insofar as I know them to be in more informal circumstances.
There follows a ‘golden rule’ style warning that the Bank of England’s MPC’s ordering of the bank rate must continue to be entirely inflation-target focused. “A looming recession, however deep and long-lasting, is no excuse to subvert the Bank of England’s price stability mandate.” This heartfelt bugle call loses its clarity as Willem considers the matter more deeply. When bank rate cuts are least likely to feed through to consumer spending and most of world trade is price-discounting faster than the exchange rate is falling, any upward inflation pressure will be among retailers and wholesalers striving to prise open profit margins as investment is cut and inventories run down. Willem sees this as an output gap that temporarily increases inflation while lower commodity prices temporarily lowers prices - not an urgent cause for concern then, and Willem agrees and suggests an immediate bank rate cut of 100-150bp to stop inflation undershooting its 2% target rate! He worries only that an immediate cut of this size may weaken sterling. Interest rates are also indicators of exchange rate risk and, in the present international context, when other countries are likely to make sizable rate cuts, a large cut, or series of cuts over the next months for better signaling effect, is unlikely to have a marked impact on the exchange rate. Markets take views based on medium term treasury yields, which are flat and low just as M2 velocity is negative and unlikely to turn up soon.
My over the horizon view (into the gloaming) is that while sterling may fall further, it will recover next year against the Euro and sometime soon after against the US$ by end 2009 / early 2010 (and as UK trade gap narrows and GNP starts rising, while US trade gap widens again slightly and the $ falls moderately).
As for Brown, I’m with Krugman. The prospect of an IMF audit team arriving anytime in the present UK government’s political lifetime is so extremely remote, that I think Buiter might consider a nod of apology in No.10’s direction, as I willingly do for having in the recent past feared that Brown and Darling might recoil fearfully from accepting the necessity of an “unsustainable structural fiscal stance.” And I apologise to Willem unreservedly for the fact that I don’t understand what makes the UK’s fiscal stance ’structurally unsustainable’. I view almost everything in economics and finance as unsustainable.