x Abu Dhabi, UAEThursday 27 July 2017

Chain reaction, but the song remains the same

Binod Shankar: The devastating financial crisis has sparked determination among leaders to reform their banking regulations, but so far it seems little has really changed.

The classic song by Diana Ross, on stage above in 1986, seems to mirror aspects of the recent banking crisis.
The classic song by Diana Ross, on stage above in 1986, seems to mirror aspects of the recent banking crisis.

The huge financial reform bill is slowly navigating its way through the labyrinth of the US Congress, British politicians are vowing to impose stricter regulations and their EU counterparts are debating what sanctions to take.

At such a moment, it is perhaps appropriate to consider some home truths for regulators and policy makers, set to the theme of a few popular rock and pop hits: Genie in a Bottle (Christina Aguilera) Credit derivatives almost brought the financial world to its heels. The whole mess started when JPMorgan in the 1990s wanted to release itself from the shackles of strict capital adequacy requirements wherein each bank had to have at least US$8 (Dh29.38) of equity for every $100 of risky assets (that is, loans and investments). Less risk meant freeing up capital for more lending and increased profits. Thus was born synthetic collateralised debt obligations (CDOs), the biggest cause of the financial crisis.

Banks started feverishly creating rated CDOs and a range of structured investment vehicles so they wouldn't have to carry the risky assets on their balance sheets and did not need to carry more capital. Regulators allowed the first few transactions, which then opened the gates of hell. Dancing in the Dark (Bruce Springsteen) Over the past 15 years, an enormous "shadow" financial system came into being - a multitrillion-dollar system that comprised numerous structured investment vehicles, conduits, hedge funds, etc.

Incredibly, none of these were regulated. Over-the -counter derivatives such as swaps and options were also outside the scope of any regulator. As a result, no one kept tabs and no one knew the scale of the problem. The fact was that by 2005, the total value of collateralised default swaps (CDS) had touched $12 trillion. The problem with this shadow system was that unlike commercial banks, officially they had no lender of last resort and therefore no safety net. And what is worse is they were inextricably bound with the real, regulated system through large, complicated deals. So a fire in that sector inevitably raced through to the banks as well, and hence bailouts became essential. No regulator understood either the size or the implications of this parallel system.

Everybody Wants to Rule the World (Tears for Fears) In the UK, self or light-touch regulation became the norm after Tony Blair took office in 1997. This meant the Bank of England (BoE) was stripped of its supervisory powers and a new agency - the Financial Services Authority - set up. Unfortunately, the FSA never saw the big picture but just inspected individual banks and the BoE was mostly a helpless spectator, which is exactly why the chancellor of the exchequer George Osborne recently decided to scrap the FSA and return all powers to the BoE.

Problems tend to slip between the cracks when multiple agencies manage one giant system, much like the US law enforcement authorities' inability to share information over 9/11. America specialises in these things. The three main federal financial "watchdogs" were the Federal Reserve, the office of the comptroller of the currency and the office of thrift supervision, and there were the usual huge empire building and co-ordination issues.

Strangely enough, the big brokers who caused most of the mess (Lehman Brothers, Bear Stearns, Merrill Lynch) were not monitored by the Fed but by the Securities and Exchange Commission (SEC), which didn't have the financial firepower to bail them out. Learning to Fly (Pink Floyd) Regulators simply didn't have the bandwidth or the financial incentive to be as alert or smart as the regulated. Thanks to the low-profile, clubby nature of the large and complex world of finance, regulators are almost always clueless and the last ones to know of any fire.

Throw in the fact that the brightest would prefer JPMorgan to a low-paid job at the SEC or the Fed and you have a shortage of financial expertise among regulators. Regulators were perennially behind the curve. One consequence is regulations quickly become outdated. Rules issued by the Bank for International Settlements (BIS), such as Basel 1 (1988) and Basel 2 (2004), were obsolete probably even before the ink dried on the paper. Bankers used to sneer that the "Bistro" CDO dreamt up by JPMorgan stood for BIS Totally Ripped Off.

Lose Yourself (Eminem) In their ignorance, regulators from the Fed to the FSA to the BIS took comfort and solace in the sanctity of the ratings issued by the triumvirate of the credit rating agencies - Moody's, Standard & Poor's and Fitch. It became such that the higher the rating on the investment, the lower the risk and hence lower capital requirements. An "AAA" rating was taken as bulletproof, absolutely default free.

The reality? Moody's had no better idea of the likelihood of default on a mortgage bond than Joe Bloggs because the US housing market had never seen a downturn since the 1930s. Which explains why thousands of "AAA" instruments got suddenly and sharply downgraded during the crisis. Chain Reaction (Diana Ross) Most big banks took huge hits to their bottom lines due to write-downs on mortgage related securities.

When JPMorgan, say, sold $10bn of their loans to investors through a CDO, the CDO investors actually only put in a small amount, say $700 million, which was also the "cushion". Because the CDO was "AAA" rated, the regulators never asked banks to keep aside more capital. They never expected losses to eat through the cushion (as they did) since the regulators never expected contagion and failure. They thought US banks had enough capital to absorb any losses.

The whole idea of stress-testing of banks only became fashionable when the crisis became full-blown, by which time it was too late. Walk Away (Kelly Clarkson) The biggest gaffe during the crisis was letting Lehman Brothers die. The official story? That any bailout would just be rewarding the risk takers, thus leading to moral hazard. It was also against the free-market thinking of the administration of the US president George W Bush.

Well, this doctrinaire approach by Hank Paulson and company (including Timothy Geithner, who was promoted to Treasury secretary for his incompetence) turned what was a purely American crisis into a global crisis. Investors fled the markets and within weeks banks across the world had to be nationalised, taken over or recapitalised. Paradoxically, the Republicans effectively created a bigger government.

Across the pond, Mervyn King at Threadneedle Street in the City of London similarly dug in his heels and wasted valuable time during the UK's Northern Rock crisis but relented when the mood of the crowds (and I suppose his temperamental boss Gordon Brown at 10 Downing Street) turned dangerously ugly. The stark truth is that banking is not just another business, like hawking soap or selling property. It has a huge effect on the real economy and is just too critical a sector to be unregulated.

To modify a quotation, banking is far too important to leave to the bankers. Binod Shankar is a UAE-based CFA charterholder. He is a writer and consultant and runs Genesis, a financial training company business@thenational.ae