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October 31, 2008

Now Showing: Government vs. Free Market

In the aftermath of the financial crisis, the lines between government and free markets are being fundamentally redrawn. As a new world financial order emerges, laying down some objective principles will help.

On November 15th, leaders of the world's top 20 economies will meet in Washington, D.C. to decide what financial regulation will look like in future. The creation of this new world financial order is at once a historic opportunity and a task of immense responsibility. People are already referring to the Nov. 15th summit as Bretton Woods II, thus equating it with the conference that created the post-war world financial order that endures to this day.

With the notable exception of the US, almost all the leaders who will be in attendance have already weighed in in favor of greater regulation of the financial markets (see, for example, here, here, here, here and here ) and so we are inevitably entering an era of increased regulation. In this 2-part essay I will analyze past trends in financial regulation, and outline some principles that a financial regulatory regime must adhere to. I will revisit this topic after mid-Nov. and evaluate the outcomes of the Nov. 15th summit in the light of these principles.

 

By and large, most people agree that government should play a role in reining in the free play of markets, with a view to promoting various social goals. In the world of finance, this translates into the government playing the role of financial regulator, or the overseer of banks and allied financial institutions to ensure systemic stability and to protect the small investor.

Regulatory fervor, and government's role in it, has waxed and waned over the past century or so. Various events that have occurred from time to time have caused the intensity of regulation to increase or decrease. A series of ruinous runs on banks over the centuries, the US panic of 1907 and of course the Great Depression of the 1930s are a few cataclysmic events that brought home the need for greater financial regulation*. Then, in the 1970s, a series of developments including the abolition of the gold standard, the oil shock and stubborn stagflation brought about a reversal in thinking. Led by intellectual gurus such as Milton Friedman and political leaders such as Reagan and Thatcher, a long period of deregulation began that continued into the 21st century riding on the able shoulders of Alan Greenspan. Thus, the winds of financial regulation can be said to have peaked around 1970 and have been in decline ever since.

Until last month. When any system fails, the tide of opinion often turns against whatever that system represents. Sure enough, when the bottom fell out of the world's financial markets in mid-September, there was clamor (much of it an over-reaction) to the effect that this was nothing less than a failure of free markets. As I noted in my post on this blog on Sep 23rd, voices emerged which held that the upheavals prove that the free market system is fundamentally flawed. As the crisis played out, these voices only strengthened, prompting the Economist to write on Oct. 16th that  "economic liberty is under attack and capitalism, the system which embodies it, is at bay". Newsweek in its Oct 13th cover story said, "it's not just bank solvency that's being questioned, but the entire Anglo-Saxon capitalist system". And on Oct. 23rd, Uber-regulator Alan Greenspan acknowledged in congressional testimony that his belief in the "self-correcting power of free markets", and in banks' ability to self-regulate was shaken.

While it was sad to see the man who so recently strode the world of finance as a colossus being reduced to defending his legacy against accusations of laxity in regulatory duties, this was also a sobering lesson that regulation is too important to be left to the banks - government must play a bigger role.

But how much bigger a role? Where do we draw the line between government and free markets? How much regulation is "just right"?

While nobody in the world knows the definitive answer to that question, I believe it is both a necessary and a feasible endeavor to outline some objective principles that can help define what this "right" level of regulation should be. And in Part 2 of this essay, to be published early next week, I will do precisely that.

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* Indeed, much of today's regulatory infrastructure - the Federal Reserve, the FDIC and the SEC in the US, and many similar authorities worldwide - is a product of these cataclysmic events.

October 19, 2008

Do we need Basel III to curb current market dynamics?

Sub-prime led credit crunch, failure of some of the leading players in capitalist market have definitely brought the question back on risk management practiced in financial world. If closely observed the demise of some of these institutions, the root cause points to single major factor - “Too much exposure to single market downplaying consequences of correlation & concentration”. Before I pin-point individuals, let’s look at the market dynamics for last 8 years till culminating to present crisis. It clearly articulates how the risk taking corporations forgot to understand the implications of traps in each step. If we closely observe each of these leading debacles – Lehman, AIG, Bear Stearns, Wachovia, Washington Mutual & plenty more mortgage providers- the reason for crisis stems from the very greed & exuberance portrayed by these players to spike their profit by exposing to unrealistic level of mortgage business & its structured products without entangling the underlying risk. Some pundits might argue that some of these investment banking units have failed due to unbelievable leverage since they do not come under banking regulatory purview and not reined by the risk based regulatory capital regime of central banks,  but the failure of commercial banks at the same time questions that very conjecture. Basel II driven risk management philosophy in banks is the talk of town for last 7 years; however we see so much financial disturbance within banking fraternity globally. What went wrong then? Does that mean Basel II has its inherent weakness or not capable of answering present crisis? 

Before I jump to Basel II, let’s look at the financial market, players and their behavior which rooted the catastrophe. Most of the financial institutions, those failed & those struggling, if minutely analyzed had certain similarities in their market behavior – “tremendous exposure to sub-prime mortgage & structured products having sub-prime mortgage as underlie”. The profitability syndrome in sub-prime zone was so high that players forgot to examine the market concentration & correlation they are canvassing. This is not just US market; Europe & APAC are also lured by the sweetness of the exposure.  Things went fine till end of FY 06 and the calamity engulfed in the very beginning of FY07 when mortgage market bubble pacified with decrease in housing demand & mortgage price in US and thus affected the structured products (CDOs, MBSs, CDSs etc) value enormously. This burst deepened so much that financial markets have already lost billions in write-offs and trillions in market value erosion. That brings one fundamental question to forefront – Is the financial risk management set-up not robust within most players to predict such event? Since most of those are Basel II compliant, finger points to the robustness of this guideline. To me, answer lies in some of the assumptions carried by 2nd edition of Basel credit risk guideline..


-Asymptotic Single Risk Factor (ASRF) : Basel expects that diversification in the portfolio is so granular that every exposure can be evaluated on single risk factor. This clearly articulates, Basel II in present form does not approve concentration risk in credit exposures. Discussions are on in BIS to address that in subsequent edition (read here)
-Portfolio effect on credit contracts : Basel does not believe in portfolio effect on credit risk evaluation though it has addressed minimally for retail credit sector. That means, if any additional credit contract is created, it’s the individual contract’s risk that matters, other risks are assumed to be not present. Basel is clear in undermining the diversification of credit risk.

-Correlation : Basel II is somehow silent on extent of correlation each contract carries due to its inherent characteristics with respect to external market, other sector.

-Liquidity Risk Measure: There is no specific dictum in Basel which addresses the effect of credit, market & operational risks on liquidity, in other words the inter-risk correlation effect. This looks to be a major drawback considering present market scenario.

If one evaluates present market dynamics, above four factors are prominent in creating the contagion in credit market initiated by sub-prime fiasco in US. The ripple effect is so high that credit crunch has decimated some of the biggest financial institutions & even bankrupted the economy of Iceland.


With banks reeling under liquidity pressure, sovereign bail-out being the in-thing in capitalist market and also investment banking behemoths converting to commercial banks, it is inevitable that Basel guideline gets ready in focusing on new edition to curb some of the prominent short-comings (including above four factors). So, do we foresee a Basel III very soon? My take is ‘Yes’, let me know what you perceive!

 

October 15, 2008

Bail Out Blues

I was teaching my 6 year old a new nursery rhyme the other day, in keeping with the times…!

Baa, baa, Paulson, have you any bail out?

Yes Sir, Yes Sir, 700 billion of tax payer loot

Some for the Big Banks, some for Wall Street

And some for the Congressmen (and women)’s gravy train

But none for the poor man (and woman) who foreclosed down the lane!

Seriously speaking, the US Treasury-led bail out has generated very lively debates across academics, economists, columnists and the entire political spectrum. The fact that there is a Presidential election looming in less than 3 weeks adds to the fireworks!

When the Emergency Economic Stabilization Act of 2008 (a.k.a the "bailout plan") was signed into law on October 3rd, reaction was mixed.  Various opinion leaders (notably Warren Buffett and George Soros) had differing viewpoints—many of them critical of the plan’s ability to achieve the intended goals.  The market didn’t react as hoped and what followed was a massacre that the global stock markets had not witnessed (especially, the Dow Jones Industrial Average in the US) in a generation  

Following UK Prime Minister Gordon Brown’s lead, on Tuesday October 14th, the Bush Administration changed course and announced what was tantamount to a partial nationalization of large U.S. banks - essentially forcing nine of America’s largest banks to accept funds in exchange for an equity stake.  The markets around the world anticipated this coordinated action and responded by opening the week with one of the highest single day gains in history.

I think that the biggest conflict facing the implementation of any bail out plan is really the toss-up between protecting tax payers’ interest and the need to thaw the credit markets by freeing up the Banks’ tangle of toxic assets! I am probably reducing the challenge to a very simplistic proposition, hence I am keen to hear your views.

I have also put together a links page, polling opinions of noted economists, columnists and academics.  If you have the time, click to read the extended entry below and let me know what YOU think about the bailout plan, the nationalization of banks around the world and the future of the global economy. Of noteworthy mention is Economics Nobel Prize winner, Paul Krugman’s column in The New York Times on Gordon Brown’s "equity injection" plan.

A number of academics and economists view the revised bailout plan as a major upgrade over the original version. Click here to read more.

Others, such as noted economist Jeffrey Miron, believe a lack of transparency is the root of the problem and that the bailout does nothing to address the problem. Click here to read more.

Luigi Zingales of the Chicago Graduate School of Business reveals his "Plan B" which argues for a market solution to the problem.Contributors at Barron’s argue that declining housing prices lie at the core of economic woes.

John Preston proposes a plan to mitigate problems in the housing market on the popular stock market site, Seeking Alpha.com.

Senators John McCain and Barack Obama have revealed dueling economic plans in the last week.

Prescient economist from New York University, Nouriel Roubini believes the United States will suffer a deep recession regardless of the bailout plan. Click here to read more.

Roubini is not alone. Though many Economists think the bailout is a necessary move, many believe the economy will continue to struggle in the coming quarters.

Plunging retail sales also lend credence to a pessimistic viewpoint.