A remarkable feature of the global economy in the last two decades has been the rapid growth of the non regulated part of the financial system. As Jamie Dimon, CEO mentioned in JP Morgan’s 2008 Annual Report. The role of banks in the capital markets has changed considerably. And the change is not well understood – in fact it is fraught with misconceptions. Traditional banks now provide only 20% of the total lending in the economy. Right after World War II, that number was almost 60%. The other lending has been provided by what many call the shadow banking system.”
More importantly, the formal and the shadow banking system are too closely interlinked. Indeed, authorities across the world are realizing that the financial system cannot be managed by dividing it into two segments – core banking institutions that need to be tightly regulated and others such as hedge funds, brokers and structured investment vehicles that can be left to operate on their own since they do not use public money. The “core” and the “shadow banking” segments have become far too interconnected. It is estimated that by the summer of 2007, the assets of the six largest US commercial banks were about $6 trillion while the shadow banking system controlled assets worth $4 trillion. The two systems have become so closely intertwined that the collapse of a shadow banking entity can send ripples across the formally regulated banking world.
The shadow banking system is increasingly coming under scrutiny from regulators across the world. Many European politicians are pressing for curbs on offshore tax centers and hedge funds. The ECB president, Jean Claude Trichet mentioned recently that reforms need to be holistic and regulation must be extended to all important markets that pose fundamental risks to financial stability. The latest round of proposals by the US Treasury in May 2009 seem to echo this sentiment.
But we cannot be too sure whether such an approach represents a long lasting and permanent solution. Curbs on the shadow banking system may allow a new “wild west” to form at the periphery. Moreover, the financial system has always been good at finding loopholes in the existing legal and regulatory framework and moving into segments that bypass regulation. Besides, for a well functioning and liquid market, different participants must have different views towards holding and transferring risk. If all entities try to manage risk and liquidity in the same way, the dynamism of the market will be threatened. The current cyclicality bias in the regulatory system may then be further amplified.
Wednesday 30 December 2009
Why regulation is important in the banking industry
Banks are fundamentally different from other corporations in other industries. Banks lie at the heart of the economy. A large section of the population keeps their money with them. Many businessmen and small entrepreneurs depend heavily on these institutions for their capital requirements. Banks create and sustain markets for financial instruments and help in channelising savings into productive investments. They also facilitate payment flows among customers. It is difficult to conceive of a modern economy working without banks.
When a bank fails, the impact can be disruptive for the economy. For example during a banking crisis, investors may retreat to safe government securities, due to lack of confidence in the financial system. This may lead to a sharp decline in investment spending. Consumers may also postpone purchases. As a result, recessionary pressures will gather strength. Several percentage points of GDP growth may be lost in the process. This is exactly what happened during the recent financial crisis.
Banks are inherently fragile as they use a small amount of capital and leverage it to build huge asset positions. Banks assume that all depositors will not demand their money back at the same time. From time to time, banking crises have been witnessed as panicky depositors have tried to withdraw money in droves.
Since banks are inherently fragile, most countries have a system of deposit insurance, which protects small investors in the event of a bank failure. This guarantee of a “bailout” for small investors helps in maintaining customer confidence and consequently preventing a run on the bank. But deposit insurance can lead to a moral hazard problem. Banks may end up taking more risk than they can handle. Also, because they are protected by insurance, depositors may have little incentive to monitor banks. This is where a strong regulatory framework comes in. Regulation aims at providing a robust risk management framework for financial institutions and checking whether enough capital has been set aside to deal with various eventualities.
In short, the following are the reasons given to justify the existence of banking regulation:
v A bank’s depositors are too small to monitor the performance of the bank.
v Banks facilitate payment against and settlement of transactions. If payment and settlement systems break down, there will be chaos.
v The failure of a bank can have systemic effects because of interlinkages with other financial institutions. The systemic risk must be managed carefully. Otherwise, there will be a crisis in the financial markets.The collapse of a major financial institution can affect industrial investment in the region. Other banks may not be able to step in with substitute offers as they may not have enough information on the clients
When a bank fails, the impact can be disruptive for the economy. For example during a banking crisis, investors may retreat to safe government securities, due to lack of confidence in the financial system. This may lead to a sharp decline in investment spending. Consumers may also postpone purchases. As a result, recessionary pressures will gather strength. Several percentage points of GDP growth may be lost in the process. This is exactly what happened during the recent financial crisis.
Banks are inherently fragile as they use a small amount of capital and leverage it to build huge asset positions. Banks assume that all depositors will not demand their money back at the same time. From time to time, banking crises have been witnessed as panicky depositors have tried to withdraw money in droves.
Since banks are inherently fragile, most countries have a system of deposit insurance, which protects small investors in the event of a bank failure. This guarantee of a “bailout” for small investors helps in maintaining customer confidence and consequently preventing a run on the bank. But deposit insurance can lead to a moral hazard problem. Banks may end up taking more risk than they can handle. Also, because they are protected by insurance, depositors may have little incentive to monitor banks. This is where a strong regulatory framework comes in. Regulation aims at providing a robust risk management framework for financial institutions and checking whether enough capital has been set aside to deal with various eventualities.
In short, the following are the reasons given to justify the existence of banking regulation:
v A bank’s depositors are too small to monitor the performance of the bank.
v Banks facilitate payment against and settlement of transactions. If payment and settlement systems break down, there will be chaos.
v The failure of a bank can have systemic effects because of interlinkages with other financial institutions. The systemic risk must be managed carefully. Otherwise, there will be a crisis in the financial markets.The collapse of a major financial institution can affect industrial investment in the region. Other banks may not be able to step in with substitute offers as they may not have enough information on the clients
The future of derivatives
Derivatives have often been held responsible for various market breakdowns in the past. The sub prime crisis is no exception. At the heart of the current financial crisis have been OTC derivatives, especially Credit Default Swaps (CDS). The CDS market had grown to $62 trillion in notional value by early 2008. To put this figure in perspective, the size of the global economy in 2008 was approximately $55 trillion! It is because of the huge volumes of CDS transactions that insurance giant AIG had entered into, that the US Treasury had no option but to intervene and bail out the insurance giant. If AIG had collapsed resulting in the dishonor of many CDS contracts, these would have been mayhem all around. Similarly Bear Stearns was so deeply entangled in the CDS market that regulators feared its collapse would lead to chaos. That is why it was bailed out in early 2008.
It is because of such concerns that regulators and the industry body, International Swaps and Derivatives Association (ISDA) have had to intervene. And there are some indications that the CDS market has started to cool down. After growing 100 fold from the middle of 2001 to the end of 2007, to a value of $62 trillion, in the first half of 2008, the value of outstanding CDS positions has declined significantly. The decline has been facilitated by netting out trades that offset each other. The next step being discussed is central clearing of OTC trades.
Despite the problems arising out of the indiscriminate use of CDS, one can hardly imagine a world without derivatives. Just because a few players used derivatives indiscriminately is hardly a reason for banning the use of derivatives. Instead what we need are better mechanisms for reducing counterparty and settlement risk. To address the current concerns in the CDS market, some 17 large dealers have come together to launch a clearing house for credit derivatives. A central counterparty backed by a default fund would greatly reduce the probability of the system becoming unstable due to any one player’s failure. Exchange based arrangements may also over time deal with other challenges such as a more precise definition of credit events. More recently, the US Treasury has come out with new guidelines that would call for better disclosure of derivative trades and capital backing and a shift from OTC trades to exchange trades wherever possible.
It is because of such concerns that regulators and the industry body, International Swaps and Derivatives Association (ISDA) have had to intervene. And there are some indications that the CDS market has started to cool down. After growing 100 fold from the middle of 2001 to the end of 2007, to a value of $62 trillion, in the first half of 2008, the value of outstanding CDS positions has declined significantly. The decline has been facilitated by netting out trades that offset each other. The next step being discussed is central clearing of OTC trades.
Despite the problems arising out of the indiscriminate use of CDS, one can hardly imagine a world without derivatives. Just because a few players used derivatives indiscriminately is hardly a reason for banning the use of derivatives. Instead what we need are better mechanisms for reducing counterparty and settlement risk. To address the current concerns in the CDS market, some 17 large dealers have come together to launch a clearing house for credit derivatives. A central counterparty backed by a default fund would greatly reduce the probability of the system becoming unstable due to any one player’s failure. Exchange based arrangements may also over time deal with other challenges such as a more precise definition of credit events. More recently, the US Treasury has come out with new guidelines that would call for better disclosure of derivative trades and capital backing and a shift from OTC trades to exchange trades wherever possible.
Lessons from past financial crises
Here are some useful lessons as captured by Derivatives Guru, John Hull.
Companies and banks must define clearly the limits to the financial risks that can be assumed.
Violations of risk limits must be sternly dealt with.
Even successful traders must be monitored carefully. Luck rather than superior trading skills often explain the success of traders. “Star” traders should not enjoy immunity from audit checks by risk managers.
Diversification benefits should not be over estimated. Concentration risk must be managed carefully.
Scenario analyses and stress testing must back risk measures such as value-at-risk. It is important to think outside the box and consider extreme situations. As Nicholas Nassem Taleb would say, just because we have never seen a black swan, it does not imply that one does not exist.
Models should not be blindly trusted. If large profits result from relatively simple trading strategies, risk managers should become suspicious. Maybe, the profits are being measured in the wrong way.
Getting too much trading business of one type, warrants as much critical examination as getting too little of these businesses.
Traders should not be allowed to book inception profits , i.e., profits at the start of a trade, by marking-to-model. By recognizing inception profits slowly, a longer term, more mature orientation can be inculcated among traders.
Banks must sell clients products that are appropriate for them. Before the sub prime crisis, many wealth management clients seem to have been been sold complex products whose risks they did not fully appreciate.
The possibility of liquidity black holes must not be underestimated. Liquidity problems can crop up more frequently than what models would seem to suggest. Less actively traded instruments will not always sell at close to the theoretical price, as predicted by models. When many market participants are following the same strategy, there might be big market moves leading to a liquidity crisis. So liquidity and market risks should be examined together.
Top management should not approve a trading strategy that they do not fully understand. Otherwise, traders are quite likely to take advantage of the situation.
Caution should be exercised before turning the treasury department of a company into a profit centre. The treasury can become a profit centre only by taking more risk. This implies that hedging will inevitably move towards speculation.
Companies and banks must define clearly the limits to the financial risks that can be assumed.
Violations of risk limits must be sternly dealt with.
Even successful traders must be monitored carefully. Luck rather than superior trading skills often explain the success of traders. “Star” traders should not enjoy immunity from audit checks by risk managers.
Diversification benefits should not be over estimated. Concentration risk must be managed carefully.
Scenario analyses and stress testing must back risk measures such as value-at-risk. It is important to think outside the box and consider extreme situations. As Nicholas Nassem Taleb would say, just because we have never seen a black swan, it does not imply that one does not exist.
Models should not be blindly trusted. If large profits result from relatively simple trading strategies, risk managers should become suspicious. Maybe, the profits are being measured in the wrong way.
Getting too much trading business of one type, warrants as much critical examination as getting too little of these businesses.
Traders should not be allowed to book inception profits , i.e., profits at the start of a trade, by marking-to-model. By recognizing inception profits slowly, a longer term, more mature orientation can be inculcated among traders.
Banks must sell clients products that are appropriate for them. Before the sub prime crisis, many wealth management clients seem to have been been sold complex products whose risks they did not fully appreciate.
The possibility of liquidity black holes must not be underestimated. Liquidity problems can crop up more frequently than what models would seem to suggest. Less actively traded instruments will not always sell at close to the theoretical price, as predicted by models. When many market participants are following the same strategy, there might be big market moves leading to a liquidity crisis. So liquidity and market risks should be examined together.
Top management should not approve a trading strategy that they do not fully understand. Otherwise, traders are quite likely to take advantage of the situation.
Caution should be exercised before turning the treasury department of a company into a profit centre. The treasury can become a profit centre only by taking more risk. This implies that hedging will inevitably move towards speculation.
Why risk management failed
No society can thrive without taking risk. We should not respond to the sub prime crisis by swearing solemnly. “Never again shall we take risk.” Rather, the efforts must be channelized towards finding loopholes in the current risk management framework, and strengthening systems and processes. Such efforts will encourage companies to take risk once again and pave the way for the return of the animal spirits.
But before we gaze into the future, it is a good idea to look at the recent past. In the months before the crisis, many banks claimed to have put in place sophisticated risk management systems. Yet these systems failed to deliver and many a bank landed in a mess after the sub prime crisis started to unfold. Why did this happen?
Risks went out of control for various reasons. To start with, mechanical approaches were followed by many banks with human judgment and intuition being completely ignored. For example, credit ratings were used to justify heavy investments in the super senior tranches of CDOs. In some cases, the top management did not become sufficiently involved while dealing with risk. In the name of delegation, they abdicated their responsibility. We saw this in some detail in the case of UBS in Chapter 10. Sometimes, the top management did raise the right questions. But they did not follow through with appropriate actions. In other cases, traders fooled risk managers into believing that all the rules were being followed. To a large extent they were able to do this by hiding behind technical jargon and sophisticated quantitative models. Only banks like Goldman Sachs, JP Morgan and Toronto Dominion (of Canada) where the top management asked the right questions at the right time and took principled decisions, escaped relatively unscathed.
In short, the ability of the top management to get involved and ask the right questions at the right time will have a crucial influence on the quality of risk management in an organization.
But before we gaze into the future, it is a good idea to look at the recent past. In the months before the crisis, many banks claimed to have put in place sophisticated risk management systems. Yet these systems failed to deliver and many a bank landed in a mess after the sub prime crisis started to unfold. Why did this happen?
Risks went out of control for various reasons. To start with, mechanical approaches were followed by many banks with human judgment and intuition being completely ignored. For example, credit ratings were used to justify heavy investments in the super senior tranches of CDOs. In some cases, the top management did not become sufficiently involved while dealing with risk. In the name of delegation, they abdicated their responsibility. We saw this in some detail in the case of UBS in Chapter 10. Sometimes, the top management did raise the right questions. But they did not follow through with appropriate actions. In other cases, traders fooled risk managers into believing that all the rules were being followed. To a large extent they were able to do this by hiding behind technical jargon and sophisticated quantitative models. Only banks like Goldman Sachs, JP Morgan and Toronto Dominion (of Canada) where the top management asked the right questions at the right time and took principled decisions, escaped relatively unscathed.
In short, the ability of the top management to get involved and ask the right questions at the right time will have a crucial influence on the quality of risk management in an organization.
The future of investment banking
After all the mauling they received, what is the future of banking? Plain vanilla commercial banks can be expected to operate as before. They provide basic functions like mobilizing savings, providing fixed deposits, etc. In many cases, they also provide letters of credit and other forms of trade financing. These functions are well understood. Indeed, these “non glamorous functions,” may regain their importance.
But what about investment banks? A few like Goldman Sachs already seem to have recovered. But many others are still struggling. With the collapse of Bear Stearns and Lehmann and the acquisition of Merrill by Bank of America, the air of invincibility about large financial institutions no longer exists.
Till recently, investment banks remained the dream employers for graduates of most leading Business Schools. The cowboy approach of the investment bankers received admiration and respect from society, even though of a grudging type. They came to be known as “Masters of the Universe.” Under the guise of financial innovation and various quantitative models, the investment bankers succeeded in convincing regulators that they had found ingenious ways to package and disperse risk. But it is now clear that many of these strategies were undesirable from the systemic risk point of view.
Thanks to the sub prime melt down, investment banking will undoubtedly undergo some structural changes in the coming years. Many banks are examining their product lines to determine whether the returns generated justify the risks taken. We saw this in great detail in the case of the investment banking division of the global Swiss bank, UBS in Chapter 13. Banks are also reducing leverage dramatically.
Leverage has traditionally been an integral part of the business model of most investment banks. Indeed, investment banks thrived on leverage to generate adequate returns for shareholders. The leverage ratio (Total assets to equity) for Wall Street banks was in the range 25-30 before the bubble burst. The great thing about leverage is that even a small rise in the value of investments results in a phenomenal return on capital. But the downside is that a small drop in the value of investments can wipe out the equity and raise fundamental concerns about a bank’s viability causing the stock price to plunge. That is why investment banks are reducing leverage. But as leverage reduces and capital goes up, the returns to shareholders are bound to reduce. So investment banks will have to get used to much lower returns on equity than they have been used to delivering in the past. In the early part of 2009, some banks such as Goldman have shown record profits. But that seems to be more due to government support. It is unlikely that these profits can be sustained in the long run.
Investment banks will also have to diversify their fund base. They will have to reduce their dependence on wholesale short term funding. During the sub prime crisis, when this funding dried up, it became difficult to roll over positions. That is how the Structured Investment Vehicles (SIVs) got into trouble. Liquidity dried up and many of the sub prime assets came back to the balance sheets of banks. In future, investment banks are likely to depend on “stickier,” retail deposits for their funding needs.
What kind of shakeout can we expect in the investment banking industry? It is too early to make predictions but already there are some doubts about the future of bulge bracket investment banks. Advisory boutiques with a “partnership,” culture that also give clients good, independent advice, seem to be doing well after the meltdown. These boutiques also have less conflict of interest. For example, they are generally not involved in proprietary trading or market making.
But what about investment banks? A few like Goldman Sachs already seem to have recovered. But many others are still struggling. With the collapse of Bear Stearns and Lehmann and the acquisition of Merrill by Bank of America, the air of invincibility about large financial institutions no longer exists.
Till recently, investment banks remained the dream employers for graduates of most leading Business Schools. The cowboy approach of the investment bankers received admiration and respect from society, even though of a grudging type. They came to be known as “Masters of the Universe.” Under the guise of financial innovation and various quantitative models, the investment bankers succeeded in convincing regulators that they had found ingenious ways to package and disperse risk. But it is now clear that many of these strategies were undesirable from the systemic risk point of view.
Thanks to the sub prime melt down, investment banking will undoubtedly undergo some structural changes in the coming years. Many banks are examining their product lines to determine whether the returns generated justify the risks taken. We saw this in great detail in the case of the investment banking division of the global Swiss bank, UBS in Chapter 13. Banks are also reducing leverage dramatically.
Leverage has traditionally been an integral part of the business model of most investment banks. Indeed, investment banks thrived on leverage to generate adequate returns for shareholders. The leverage ratio (Total assets to equity) for Wall Street banks was in the range 25-30 before the bubble burst. The great thing about leverage is that even a small rise in the value of investments results in a phenomenal return on capital. But the downside is that a small drop in the value of investments can wipe out the equity and raise fundamental concerns about a bank’s viability causing the stock price to plunge. That is why investment banks are reducing leverage. But as leverage reduces and capital goes up, the returns to shareholders are bound to reduce. So investment banks will have to get used to much lower returns on equity than they have been used to delivering in the past. In the early part of 2009, some banks such as Goldman have shown record profits. But that seems to be more due to government support. It is unlikely that these profits can be sustained in the long run.
Investment banks will also have to diversify their fund base. They will have to reduce their dependence on wholesale short term funding. During the sub prime crisis, when this funding dried up, it became difficult to roll over positions. That is how the Structured Investment Vehicles (SIVs) got into trouble. Liquidity dried up and many of the sub prime assets came back to the balance sheets of banks. In future, investment banks are likely to depend on “stickier,” retail deposits for their funding needs.
What kind of shakeout can we expect in the investment banking industry? It is too early to make predictions but already there are some doubts about the future of bulge bracket investment banks. Advisory boutiques with a “partnership,” culture that also give clients good, independent advice, seem to be doing well after the meltdown. These boutiques also have less conflict of interest. For example, they are generally not involved in proprietary trading or market making.
Encouraging the right kind of financial innovation
The experience of the sub prime crisis tells us that, we must encourage the “right” kind of financial innovations. In an interesting paper[1], Joseph R Mason points out that only those financial innovations that facilitate diversification, market completion or capital deepening are useful to society in the long run. Others end up creating more problems than solving them. And this is exactly what seems to have happened during the subprime crisis. Let us understand Mason’s arguments in more detail.
Financial innovations that facilitate diversification are extremely important for investors. A good example is index funds, which allow small investors to hold a portfolio that replicates the index without actually having the money needed to buy all the stocks that make up the index.
Market completion helps to make markets work more efficiently, by removing arbitrage opportunities and financial friction. For example, life settlement products allow life insurance policy holders to sell their policy for the expected present value of the insurance benefits. This value typically exceeds the policy surrender value and the net present value of the premiums contributed to date. If life settlement products succeed, the life insurance industry will have to pay much higher surrender values to compete with life settlement providers. This will remove a financial arbitraging opportunity.
Capital deepening means injecting liquidity by making assets more liquid. A good example is securitization, which enables illiquid loans to be sold. The proceeds of the sale can be used to make more loans. Thus more capital is available in the market.
Why did securitization, positioned as a capital deepening innovation, fail? Mason explains that the key to a capital deepening process is the effective distribution of risk and returns to a wider investor base. But during the sub prime crisis, the risk was either not distributed, i.e., it remained with the banks or was parceled off to unwitting investors without commensurate returns to justify the additional risk involved. Indeed, securitization, during the sub prime crisis became a risk “distillation” rather than a risk “distribution” process. While securitization pooled various loans and made them tradable, it also ended up creating a few very risky securities that ended up bearing all the expected losses in the pool. It was indeed this “toxic waste,” which fuelled the sub prime meltdown.
Regulators must be proactive when it comes to financial innovation. Innovations, when first introduced, may be a black box to many. But as they become popular, they must become more transparent. The features of financial instruments must become standardized so that they can trade freely on OTC markets with adequate liquidity. Commoditized instruments can finally trade on organized exchanges where as we know, the counterparty risk is greatly minimized.
Adequate accounting rules, a proper regulatory framework and widespread understanding of product features are all necessary before an innovation can become broad based. Unfortunately, in the case of complex, opaque instruments like CDOs, the market expansion took off before participants had enough time to understand them and appreciate the risks involved. As Mason sums up, “Recent experience should stand as a lesson that it is important to move financial innovations through those incipient stages of development before they grow large enough to substantially undermine economic performance, should a crisis arise.”
In short, financial innovation must be encouraged within a controlled framework. Giving the financial sector complete freedom to operate in the name of encouraging innovations is a simplistic approach to say the least. Checks and balances are indeed necessary.
Financial innovations that facilitate diversification are extremely important for investors. A good example is index funds, which allow small investors to hold a portfolio that replicates the index without actually having the money needed to buy all the stocks that make up the index.
Market completion helps to make markets work more efficiently, by removing arbitrage opportunities and financial friction. For example, life settlement products allow life insurance policy holders to sell their policy for the expected present value of the insurance benefits. This value typically exceeds the policy surrender value and the net present value of the premiums contributed to date. If life settlement products succeed, the life insurance industry will have to pay much higher surrender values to compete with life settlement providers. This will remove a financial arbitraging opportunity.
Capital deepening means injecting liquidity by making assets more liquid. A good example is securitization, which enables illiquid loans to be sold. The proceeds of the sale can be used to make more loans. Thus more capital is available in the market.
Why did securitization, positioned as a capital deepening innovation, fail? Mason explains that the key to a capital deepening process is the effective distribution of risk and returns to a wider investor base. But during the sub prime crisis, the risk was either not distributed, i.e., it remained with the banks or was parceled off to unwitting investors without commensurate returns to justify the additional risk involved. Indeed, securitization, during the sub prime crisis became a risk “distillation” rather than a risk “distribution” process. While securitization pooled various loans and made them tradable, it also ended up creating a few very risky securities that ended up bearing all the expected losses in the pool. It was indeed this “toxic waste,” which fuelled the sub prime meltdown.
Regulators must be proactive when it comes to financial innovation. Innovations, when first introduced, may be a black box to many. But as they become popular, they must become more transparent. The features of financial instruments must become standardized so that they can trade freely on OTC markets with adequate liquidity. Commoditized instruments can finally trade on organized exchanges where as we know, the counterparty risk is greatly minimized.
Adequate accounting rules, a proper regulatory framework and widespread understanding of product features are all necessary before an innovation can become broad based. Unfortunately, in the case of complex, opaque instruments like CDOs, the market expansion took off before participants had enough time to understand them and appreciate the risks involved. As Mason sums up, “Recent experience should stand as a lesson that it is important to move financial innovations through those incipient stages of development before they grow large enough to substantially undermine economic performance, should a crisis arise.”
In short, financial innovation must be encouraged within a controlled framework. Giving the financial sector complete freedom to operate in the name of encouraging innovations is a simplistic approach to say the least. Checks and balances are indeed necessary.
The future of financial innovation
In the wake of the sub prime meltdown, the rapid pace of financial innovation in the past decade has been criticized. Innovation proceeded so fast that regulators were caught on the wrong foot. But the solution clearly does not lie in throttling innovation. No society can progress without innovation. Innovation creates new possibilities. And by their very nature, new things are risky. But that does not mean we go back to the past. Consider the following:
§ Credit cards, if they are misused can cause considerable problems. Does it mean we must ban credit cards?
§ Online payments can be very risky in a world where hackers abound. Does it mean we must stop online payments?
§ High speed transport can result in major casualties if there is an accident. Does this mean we must go back to primitive modes of transport?
§ Virtual collaboration tools are reducing the personal touch and leading to behavioural dysfunctions such as superficiality, multi tasking, inadequate concentration while doing a job and so on. Does it mean we must stop the use of email and social networking?
§ Derivatives can be and have been used by some unscrupulous individuals. Does it mean we should ban their use and thereby take away an important means of transferring risk?
§ Securitization was used ingeniously by banks to minimize capital backing. Does it mean we should ban securitization and take away an effective means of making illiquid portfolios liquid?
§ Speculators fuelled a housing boom. The boom was partly facilitated by innovative mortgage instruments. Does it mean we must put a blanket ban on these instruments and deny the aspirations of millions of people who want to own a home?
§ Credit cards, if they are misused can cause considerable problems. Does it mean we must ban credit cards?
§ Online payments can be very risky in a world where hackers abound. Does it mean we must stop online payments?
§ High speed transport can result in major casualties if there is an accident. Does this mean we must go back to primitive modes of transport?
§ Virtual collaboration tools are reducing the personal touch and leading to behavioural dysfunctions such as superficiality, multi tasking, inadequate concentration while doing a job and so on. Does it mean we must stop the use of email and social networking?
§ Derivatives can be and have been used by some unscrupulous individuals. Does it mean we should ban their use and thereby take away an important means of transferring risk?
§ Securitization was used ingeniously by banks to minimize capital backing. Does it mean we should ban securitization and take away an effective means of making illiquid portfolios liquid?
§ Speculators fuelled a housing boom. The boom was partly facilitated by innovative mortgage instruments. Does it mean we must put a blanket ban on these instruments and deny the aspirations of millions of people who want to own a home?
The price of the sub prime crisis
The overarching purpose of a sound financial system is to channelise effectively savings into productive investments. When the financial system is characterized by fear and panic, this function cannot be discharged. Investment spending falls and GDP shrinks. This more than anything else, is the real cost of a financial crisis.
Towards the end of 2008, as the crisis peaked, the markets for corporate bonds and commercial paper all but dried up. The spreads between risky and risk free instruments rose to phenomenal heights. Banks stopped lending and instead preferred to hoard cash. Economy after economy began to shrink in size with some countries showing double digit negative growth.
In the past six months, however, things have improved remarkably. The markets seem to be recovering. And global trade is gaining momentum. As we approach the end of 2009, the worst seems to be over, though we still do not know whether the recovery that began in early 2009 will be sustained. During the peak of the crisis, the governments and central banks were the only source of liquidity. Unless this perception goes away completely, recovery will be muted and halting.
Whatever be the nature of the recovery, we do know that we are paying a huge cost for the sub prime crisis and the bill is rising each day. The magnitude of the crisis is reflected in the scale of the government intervention. The value of sovereign credit and guarantees put in place during the crisis, already exceeds $7 trillion. (Estimates of course vary) There is hardly any major country in the world which has not announced a fiscal stimulus to boost spending and restore confidence. And obviously, central banks have been in the thick of things to provide liquidity to the financial system. The US Federal Reserve provided a bailout loan of $30 billion in case of Bear Stearns, a $85 billion credit facility for AIG and guaranteed $424 bn of losses on bad assets in case of Citibank and Bank of America. As of June 2009, the Fed’s total assets had risen to over $2 trillion compared with $852 billion in 2006. Only 29% of these assets were Treasury securities, compared with 91% in 2006.
Towards the end of 2008, as the crisis peaked, the markets for corporate bonds and commercial paper all but dried up. The spreads between risky and risk free instruments rose to phenomenal heights. Banks stopped lending and instead preferred to hoard cash. Economy after economy began to shrink in size with some countries showing double digit negative growth.
In the past six months, however, things have improved remarkably. The markets seem to be recovering. And global trade is gaining momentum. As we approach the end of 2009, the worst seems to be over, though we still do not know whether the recovery that began in early 2009 will be sustained. During the peak of the crisis, the governments and central banks were the only source of liquidity. Unless this perception goes away completely, recovery will be muted and halting.
Whatever be the nature of the recovery, we do know that we are paying a huge cost for the sub prime crisis and the bill is rising each day. The magnitude of the crisis is reflected in the scale of the government intervention. The value of sovereign credit and guarantees put in place during the crisis, already exceeds $7 trillion. (Estimates of course vary) There is hardly any major country in the world which has not announced a fiscal stimulus to boost spending and restore confidence. And obviously, central banks have been in the thick of things to provide liquidity to the financial system. The US Federal Reserve provided a bailout loan of $30 billion in case of Bear Stearns, a $85 billion credit facility for AIG and guaranteed $424 bn of losses on bad assets in case of Citibank and Bank of America. As of June 2009, the Fed’s total assets had risen to over $2 trillion compared with $852 billion in 2006. Only 29% of these assets were Treasury securities, compared with 91% in 2006.
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