Sunday, 3 July 2011

Keeping Things Simple

The Malta Independent on Sunday

When simple things are purposely complicated it inevitably becomes a treacherous road leading to final disaster. Experience, since the financial crisis of 2008, is littered with examples of how obfuscation, complexity and useless complications of things that are basically simple, led to dysfunctional financial markets and the near collapse of the world financial systems.

In the good old days when bankers were bankers making a good living on a hard-earned reputation for honesty and integrity, before bankers turned into traders in search of a quick buck from trading, often against the interests of their own clients, things were simple. For every 100 units of assets, bankers had to have eight units of capital. Assets were assets and capital was capital. That simple!

Then greedy bankers started to persuade regulators that such simplicity was boring and inefficient. They argued that not all assets were equal and, given their risk management skills, assets had to be weighted according to their risk and the capital required should not be calculated on the basis of the gross value of the assets on their balance sheet, but on their risk adjusted value. Applying a low co-efficient of risk to a multitude of assets that were highly rated meant that bankers needed to keep much less capital than used to be the case when life was simple and an asset was an asset, pure and simple. The lower the capital that needs to be held for maintaining a given level of gross assets, the higher the efficiency of the capital and the profit return on such capital. Of course the counter-argument to this is that the lower the capital that needs to be held for maintaining a given level of gross assets, the more susceptible the bank would be to external or unexpected shocks (black swans as they are now technically referred to following N.N. Taleb’s famous book of the same name), with the prospect that while the profits in the good times are privatised the losses in the bad times are socialised through the forced intervention of the regulator to save the system from greedy and irresponsible bankers.

As if this were not enough, banks started playing around with capital by classifying as capital certain liabilities that were not capital at all. In the good old days capital was capital, i.e. paid up share capital and distributable ploughed back reserves. Banks persuaded regulators to include as capital, bonds on which they paid out interest irrespective of profitability purely because these bonds were subordinated to normal bonds. Counting bonds as capital reduces the true capital required and jacks up profitability in the good times but magnifies the risks in the bad times.

When crisis struck in 2008, it was like the proverbial tide that flows out to expose those that were swimming naked. Assets proved much riskier than the high rating allocated by rating agencies and much riskier than the adjusted value given by banks’ VAR (Value at Risk) models. On the other hand, subordinated bonds proved to be no risk capital at all (except in the case of Ireland) and regulators and governments had to work hard pumping liquidity and capital to ensure that banks remained liquid and solvent even when subordinated loans fell due for payment.

Many banks were found swimming naked with too little capital to sustain their bloated balance sheets. Regulators were also blinded by what banks and shadow banks could do beyond the cautious traditional role of taking deposits and lending a margin of them out to borrowers who could put that money to good use to grow their own household or business and in the process contribute to the general well-being of the general economy. Bankers started to dabble in strange products, among which Credit Default Swaps (CDS). What is a CDS and why should we care about them` CDS is a credit insurance, which anybody could buy and many banks can sell, that insures against default in payment by a third party, irrespective of whether or not the buyer of such insurance cover has an insurable interest. It is the financial equivalent of buying life insurance on the life of an unconnected third party, creating a hidden incentive to have the insured kick the bucket before his time so that policy holder can cash in the insurance money.

This practice in and of itself magnifies the risk of default as it creates large speculators who can benefit from default at the expense of the many who invested in good faith, believing in the promise of the borrowers to honour their repayment commitment. The reason why regulators would allow third parties without an insurable interest to buy a CDS to cover the risk of Greek default escapes me.

No wonder markets get rattled by all sorts of rumours meant to damage the ability of the insured to maintain financial solvency when the delicate situation requires silence or at least transparent dispassionate analysis. The same applies for short selling. Short selling is when investors sell an investment they do not own hoping to buy it back later at a lower price. Short sellers profit from a fall in the value of the investment they sell short and therefore have every incentive to denigrate the business or country they sell short. When things were simple, investors used to make money by buying investments they believe could grow over time but things have been allowed to get complicated enough for investors these days to have as much an incentive to profit from failure rather than share in success. My simple mind says if an investor does not like a particular investment he should avoid it, but I find such short selling hard to accept.

The same applies to measurement of the deficit of the public budget. In the good old days things were simple. A deficit was a deficit. In these complicated days, the deficit figure read out in the Budget never tells the true picture. You never know what expenditure is being passed through the Treasury Clearance Fund to be eventually brought back into the Consolidated Fund by spreading it over a number of years. You never know what expenditure is going on through SPV (Special Purpose Vehicles) created for a particular purpose (e.g. to execute the City Gate Piano Project), which borrows money commercially against the guarantee or letter of comfort from Central Government.

You never know how much unpaid bills are accumulating at the Treasury when line budgets are exhausted.

It would really help to solve problems and get out of the financial mess the world got itself into if we were return to the days when things were kept simple.

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