Think Flat

Interesting to see comments from Infosys on this topic. But all said and done, Basel norms only cover the Banking sector and to that extent does not include Hedge Funds (you can also count Hybrid/ Private Equity funds in, but at least these funds focus on private against listed investments). It would be interesting to see where new capital flows (is it banks/hedge funds/private equity, etc.) post this crisis. I believe the 80:20 rule applies here or will apply in the future - 20% of the unregulated capital flows/ transactions will contribute to 80% of problems in the global financial system. The 20% is where 'financial innovation to achieve super-normal returns' will be the aim and that is what will cause armageddon, not the 80% that Basel tries to regulate.

The problems with Basel norms are actual implementation-related (theory can only help so much), pinpointing where the risks lie within the system (a lot of the banks are not where the current problems occured, it is more the derivatives traders, 'politically-inspired' institutions like Fannie/ Freddie, etc.) and again the impetus (artificial) provided by politicians/central bankers, etc. to growing economies through capital inputs in an unregulated form. So I think whether there is Basel III or even IV for that matter, the current issue runs deeper than just trying to regulate Banks - and remember in the future (post the I-banks being converted into 'normal' deposit-taking banks), the world's most sophisticated/ advanced investors will not even be in the banks, but in more and more unregulated and often unregistered hedge funds and investment management firms. Greed cannot be controlled/ regulated. And I don't think the people setting the norms on a global level know what they are doing, primarily because if you think about the problems of regulating at a micro-level, the problem of monitoring a single financial transaction (and derivatives compound that problem exponentially), then it is apparent a global remedy is probably pass-time for some regulatory freaks.

I agree to comments from Atul. Greed can't be regulated and controlled. Theory is one side of the coin, honestly implementing it is another side.

Let's go back to what 'greatest (not sure)' central banker of era, Mr. Alan Greenspan said on record. He accepted laxity in banking regulations.

Further, the financial institution has to realize potential risk for its business, measure it and have provision for such risks. Clealry, the bankers innovated too complicated financial products and couldn't identify risk properly. Forget about mitigation.

Liquidity issue is a fall-out of this financial tsunami. If you are not doing maths correct at first step, this mistake will keep on adding and you never know how much it will deviate from final figure.

See, it's like this: you can't make a law that will cover all future crimes. The law follows the crime and I don't think it can be other way around. The cat-and-mouse game will continue till the human race is greedy.

We should also take a look at Indian Banking Regulation system which keeps a fine balance between growth and regulation. Agreed, it is on conservative side, however, the system has inherent caution to not even allow a financial tsunami to start taking shape.

Atul,

Basel norms are defintely only for banks where the regulatory doctrines are both for lending and trading (including those dangerous credit derivative instruments) side of business. However, I agree with you that implementation is the key and onus remains with the banks and central bankers. So, oversight norms stands out at this juncture and again, if I listen closely to Mr Greenspan, he was expecting institutions to regulate themselves than any regulations externally which never succeeded. Well, that proves the very fate of internal regulatory assumption and we need external stipulations definitely. For that, rules got to be revised for banks (under Basel guideline since there is serious flaws to answer impending loopholes) and there has to have serious thoughts to regulate the 20% crowd, as you mentioned, the hedge funds & PEs. In my view, they are going to be small in number, but large with respect to market maneuverability and those need to be reined in soon. How do you sense that Atul, being a pro from that industry? Will be nice to see some more comments from your end.

Santosh,

Greed definitely can not be controlled, but can be contained with external regulations like the way you mentioned Indian banking system works. And suprisingly the bail-out syndrome has definitely answered that part. We can't depend on liquidity as a fallout of any crisis as a reactive measure. This has to be managed. Risk professionals and academia have already thinking hard how to measure that for each instrument, scenario etc. Financial engineering will thrive again on the subject of liquidity risk. That's how I foresee the future, let's debate more on liquidity Santosh.

Well, the Madoff scandal is proof of my comments above, although a very sad and depressing event, coming as it does on top of the general economic downturn. The Ponzi-type scheme that he ran is a well known tool, used often in the underdeveloped and developing world countries to con poor, uneducated, unsophisticated and unsuspecting investors. But for something like this to happen in the USA and the guy managing to fool HSBC, Santander, amongst others is not only a failure of regulatory frameworks which are broader in scope (like Basel), but a failure to regulate internally within the banks that got fooled as well. Shockingly, Geneva and Zurich banks (the much revered Swiss Banking industry) was fooled as well and it is interesting to read comments from some of the top-most bankers in the world. The bankers who did not invest in Madoff had simplistic reasons like 'not understanding Madoff's investment strategy' or 'lack of a external custodian for the assets', which are basic, not complicated regulatory mechanisms. For e.g. Madoff claimed to trade in S&P 100 options, but that specific options market was small enough not to accomodate his large scheme (USD 50 bn, wow!!), and this fact was recognized by just about a couple of your quant analytic firms. And ahem, Madoff started off as a hedge fund con-artist, morphed into a fund-of-funds, etc...and you bet Basel would be scratching its head bald (and possibly tearing their hair out) as to what they need to do for similar guys. Like I said, what Basel sets out to achieve is not where the problems in the future will come from (and indeed are starting to come from). While Madoff was detected (after he embezzled and fooled people to the tune of USD 50 bn), there are other Madoff's out there to be sure, only undetected and pushed by greed, they march on, safe in the knowledge that white-collar crime like this is detected too late and only when the overall markets crash/ some 'black swan' event happens. Taleb must be really happy about the black swan, there seem to be lots of them breeding these days around the world.

Atul,

Madoff scandal has definitely brought the attention to hedge fund, PE industries who are super-free in this market and can create havoc if miss-managed or crooked. That's how Mr Madoff's story turned out to be. You are absolutely right that some of the top banking players are stumped in this scandal who are already Basel complied. My personal take is the word "disclosure". Basel or any future compliance can't do much unless we have information to analyze the transaction and the risk underlie. Disclosure norms on their investments and risk management functions are rarely under regulatory lense. I presume time is ripe to reinforce these regulations on them. I am discussing in detail the Madoff story and possible repercussion in following blog section. This might interest you and wish to see some critical views from your end.