Friday, September 19, 2008

Is Basel II dead?

At the start of the credit crunch crisis banks suddenly woke up to the extreme realities of banking regulation, of Basel II, Solvency II, IAS/IFRS-7 where stress testing scenarios come into play to prepare captal reserves for a 1 in 25 years series of crashes - only this was no longer abstract about some indeterminate future, but happening around us today, now! Then there was a period of everyone scrambling to restore their capital adequacy ratios - to be able to say they are stable and solvent, sometimes selling anything not nailed down, and then whatever was nailed down too, turning off the lights, cancelling air trips and credit card lunches, and the office leaseholds too.
Long before its collapse, Lehman was offloading landbank acreage for mouth watering discounts. ABCP and other AAA securitised assets were sold by banks (only if they could be sold at all) for up to as little as 23c on the $ along with first loss agreements and fat loans for the buyers, margin collateral grabbed by Citibank and sold off in firesale prices, or by Merril Lynch, or auctioned for 40c on the $ by Goldman Sachs. Some who-should-have-known-better banks dumped sub-prime total return funds into retail customers' pension funds wiping out years of millions of pensioners' savings and income at a heartstroke! Sometimes it was enough just to deem that Trading Book assets for sale would be "held to maturity!" Or, SIV conduits fully funded as a way of maintaining that these are fully back on balance sheet? Creepy minuses crept in to the balance sheets called "adjustments to reflect market turbulence", no not writedowns or losses, not exactly, not really that! And the calls on shareholders for funds with assurances about prudence alongside dividend cuts. No surprise that these were discounted and disbelieved.
In writing this I have a modicum of sympathy for the bankers in charge. They had being losing moral authority for years (for reasons not to be gone into now). The adage applies here "be nice to everyone you pass on the way up or you risk them not being nice to you on the way down!" And, anyway, meanwhile, the interbank credit markets, despite all the central bank liquidity injections, did not free up! There was a dog bites dog bites tail vicious circle of every bank upping margins on all other banks and being squeezed in turn. Maybe the LiBOR was not up to the job in such a crisis? What confidence could there be if banks could not bring themselves to have confidence in each other even when it was in their collective self interest to do so?
Banks herd like fat bovines normally, what the FT is calling "the blundering herd", but they have also fought with a 'devil take the hindmost' attitude, or like starving wild dogs, . A systemic crisis can only be solved systemically, collectively, not by every bank for itself! The central banks and treasuries and governments acted in the collective interest, but the banks, for all their professional bodies & associations, could not get together and hammer out some mutual emergency agreements.
I think, in part this is because the banks, the really big ones, had long ceased to be able to exert a common integrated strategy across the totality of their businesses. They are not 'holistically' managed according to some understanding of their economic capital. The culture of big banks had migrated too far in the direction of letting each line of business chase its own p/l targets independently of the rest, right down to individual traders and fee earners. Lehman bought 40,000 buy to lets because the fees were good. UBS's securitisation unit refused to let the rest of the bank see its trading book until the writedowns wiped the unit's capital. AIG and JPM and many others woke up to the impossibility of fair value valuations of structured products and so on and on. The ratings agencies stung by political attack started downgrading everything in sight triggering tsunami waves of monthly asset and liability adjustments. Recession loomed into the ratings agencies models and, as banks stocks ran off the cliff edge, the banks could see they might have to replace their total own capital reserves not once but twice over! They had to cover off balance sheet exposures, replace equity and ramp up for recession's usual loan loss provisions. Basel II Pillar I capital ratios plus Pillar II buffers imposed by regulators became increasingly remote targets, harder and harder to achieve or maintain over the last year.
In the years leading up to the implementation of Basel II etc., banks maxed out on securitisations and other credit derivatives precisely to optimise their balance sheets as aggressively as possible, to win competitive edge under the new regime, fully anticipating for example a rash of banking mergers in Europe and among medium and small US banks, plus buying into Asian banks. The banking world of the future, it was thought, would divide into three classes, global financiers, product packagers, and retail marketing distributors.
More time was needed, but time is an expensive commodity when the regulators say so, and then IASB insists on fair value taking the short not the medium term view of values, wherever possible marked to market, even if in inefficient disorderly markets in free fall! The politicians started demanding to know why regulation did not prevent this catastrophe and continue to insist on the need for entirely new regulations! They may have voted Basel II into law (in the EU as the Capital Reuirements Directive) only 2 years ago, but this seems to be generally overlooked.
With the nationalisations (or should I say "taking into public administration") of Northern Rock, Fannie Mae, Freddy Mac, and AIG, plus hundreds of billions of toxic financial assets, plus money market liquidity windows of hundreds of billions more, are Basel II, Solvency II and IFRS-7 going to survive. Is Basel II dead. Is Basel III dead. Can the banks and others place some of the blame on these prudential regulations? Might we then end up with a much cruder regulatory regime, more like that applying to utilities? The new rules may proscribe various off balance sheet and credit derivatives activities and place a sever cap on proprietary trading, insisting that banks stick to serving their customers, not over-charging, with various % thresholds for the sectoral diversifiaction of lending, if so much to consumer, then so much to industry and never letting assets exceed deposits, and deposits no more than x% financial and y% retail and business customers, and reserve capital = minimum 4% of gross assets?
Applying such rules globally would be near impossible. Already, however, we read analyst notes suggesting banks generally will have to reduce their assets even now by a further 30%. Banks may take a long long time to ever again see the profits of the years before 2007.
Meanwhile, the non-banks and near-banks, hedge funds, other AI, vulture and private equity funds may, because they are not serving households, the ordinary voters, will find themselves poised to fill the huge gap that has opened up in investment banking. Some of these will become the bulge bracket blue chip investment banks or "near investment banks" of the future, much like a new generation of property developers are created after every property crash has wiped out their predecessors. A lot of investment banking capacity has been lost this year. Those left standing sheltering under the wings of full service commercial banks will not be able to leverage capital as before. The general class called hedge funds are so far under no such obvious regulatory constraints, though perhaps that too is only a matter of time?

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