Beginning 1985, Bank for International Settlements (BIS) imposed two chaos-preventive global regulatory regimes in succession viz. Basel Accord-I and II. Shortly, BIS will impose a third accord, but the fact that Basel Accord-I could not prevent the global crisis of the 1990s, and Basel Accord-II the current crisis, proves that these regulatory regimes lacked the requisite controls.
Although it is unrealistic to assume that any regulatory system can prove effective for extended periods given the fact that that the only ever-lasting reality is change, the Basel accords didn't serve their purpose for realistic timeframes. As BIS struggles to draft the third version of its accords, it is worth examining why they failed to deliver.
The regulations reposed excessive confidence in the screening abilities of the credit-rating agencies by not requiring their being regulated, and agencies whose ratings repeatedly proved wrong (in some cases reflecting on their integrity) stayed in business. Rumour is that these agencies may remain unregulated while bank capital adequacy will remain tied to their ratings.
The Basel accords failed to prioritise regulations (and their credible implementation) that rewarded quality in risk assets and investment portfolios. Instead, like central banks with make-believe autonomy, these accords placed a price on every distortion in these portfolios because imposing exemplary penalties on bad bankers was left to the central banks.
But the key flaw of the regulations was to assume that the vast majority of bankers were prudent although, for years, universities around the world had been turning out graduates with confused ideas about what truly reflected growth and profit - a fact proved by the current (largely self-inflicted) recession. University professors now accept that text books diluted the quality aspect of these indicators.
The repentant university professors were joined by World Bank president Robert Zoellick who recently said that, even before the current crisis, traditional paradigms had become questionable and that development economics needed rethinking since experience had shown that what works for one country doesn't necessarily work for others [the failed IMF/WB one-size-fits-all formula].
Because Basel Accords' failed to emphasise the reflection of quality (real growth and its equitable transmission) as the outcome of bank lending, we now confront the reality that it is quality, not numbers that eventually counts. Proof: economies that registered high GDP growth rates on the one hand now confront rising poverty, and on the other, too-big-to-fail businesses.
While it is imperative that banking must remain reasonably profitable to expand for meeting the economic challenges that surface with rising global population, should banks turn into outfits that profit at the expense of the economy rather than play their inter-mediatory role? What's the future of economies whose financial services become more profitable than all other businesses?
The role of innovation in genuinely improving the productivity of any effort is deniable but one shouldn't overlook its side effects, and the possibility of some market players benefiting from it at the expense of the rest. The fear of stifling innovation kept BIS regulations overly permissive, which was their serious weakness.
Unregulated trading in derivatives and lax oversight of agencies that bundled together weak assets to issue asset-backed securities (ABS) there against, and shift the risk on to ABS buyers are two examples of how innovation-friendly flexibilities back-fired; banks everywhere suffered due to them because Basel Accords were soft on regulating these activities.
A credible assessment of counter-party risk mandated that derivative trading must be through regulated exchanges to accurately determine this risk. Lack of knowledge about the quantum of risk counter-parties were already burdened with duped banks into dealing with and, after systemic market failures these counter-parties defaulted on their contractual commitments.
Banks weren't obliged by BIS regulations to transparently disclose the risks and rewards built into complex hedge instruments. Nor was it mandatory that ABS packagers must invest in a significant part of the ABSs, and payment of their fees be staggered over time and reclaimed if the packaged loans turned sour; mandating this would have encouraged sound ABS packaging.
Regulation also didn't require on-balance sheet disclosure of liabilities, like capital leases whereby lessees undertake to eventually acquire leased assets from the lessors at pre-agreed prices. Such commitments amounted to acquiring term loans but borrowers were permitted to report them as off-balance sheet rather than on-balance sheet liabilities.
Such flexibilities encouraged over-leveraging and reckless business owners (corporate and non-corporate) played with saver funds without injecting proportionate equities to share the risks arising out of their business ventures. Had larger equity funds too been at risk, the owner/managers wouldn't have acted as recklessly as they did.
Ironically, for 'adequacy' purposes, Basel Accord-II allowed banks' capital to consist of a mix including perpetual debt up to 50 percent and subordinated debt up to 33.3 percent of the shareholder equity. Besides, imposing asset-deposit ratios (ADRs) was left to central banks. Not surprisingly, many banks ended up with ADRs as high as 132 percent, reflecting dangerous over-leveraging.
Nor did Basel Accords curb suicidal 'expansion' in financial institutions overlooking the fact that, despite all claims (real-time consolidation of activity courtesy computers and the internet), supervisory weaknesses expand in direct proportion to organisational expansion. Admitting this reality after making everyone suffer from it doesn't justify acclaimed global regulatory expertise.
What BIS must do now is to strictly regulate all these areas, especially requirement of higher shareholder equity for capital adequacy to automatically curb reckless expansion, encourage quality lending and investment, and confine banks' role to intermediation between savers and businesses, and these measures must clearly upgrade the importance of 'quality' over numbers.
BIS must insist on global regulation of auditing firms, and credit-rating and asset valuation agencies, specifying clear yardsticks for their 'capacity' for carrying out the checks based on which they certify the health of businesses and their assets. These agencies must also radically improve the quality of their reporting to help banks assess the future health of businesses for prudent lending - right now the key missing link.
Finally, the tussle between Financial Accounting Standards Board and the International Accounting Standards Board on asset valuation must be resolved. While value of tradable (inventories, securities, etc) assets must be marked to market, the seldom traded assets (fixed assets, long term investments, etc) must stay at their historical cost. Flawed asset valuation bases were the biggest drivers of market volatility in the current chaos.
Comments
Comments are closed.