Wednesday, June 24, 2009

What I asked the Commission of UN experts chaired by Professor Joseph Stiglitz

My question:

Strong and rich borrowers in developed countries are more prone to be considered as having a low-risk of default and will therefore in general have to pay lower interest rates than the weak and poor clients in developing countries. That we know, c’est la vie!

But, in June 2004, ministers of the G10 countries, poured salt on the wounds when they endorsed the minimum capital requirements for banks proposed by the Basel Committee and which are solely based on vaguely defined default risks, as measured by the credit rating agencies.

The above signified, for instance, that if a bank lends to a corporation without a credit rating it has to put up 8 percent in capital (12 to 1 leverage) but, if lending to a corporation that has managed to obtain a credit rating of AAA to AA- then only 1.6 percent of equity is required; and which by the way also implies authorizing an astonishing leverage of 62.5 to 1.

With this, the regulators, in a highly discriminatory way, arbitrarily imposed on the financial markets a de-facto subsidy on anything that could dress up as a low risk, and a de-facto tax on anything that could not.

This regulation gave way to a crazy race after the triple-As; which in just a couple of years and though many insist in calling it “excessive risk taking” (even the experts here present) diverted, by means of misguiding risk-adverse capital, around 2 trillion dollars to the finance of the “safest” assets, mortgages on houses, in the “safest” country, the US and in the “safest” instruments, those rated AAA, in a very haphazard way. These funds, an amount in the range of what the World Bank and the IMF have lent since their creation, could have been put to better use all over the world, had it not been for these regulations that, astonishingly, are still in place.

The current draft of the “Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System” opines something on the issue of the oligopoly of the credit rating agencies that resulted from the “additional boost with Basel II, which incorporates the CRAs’ ratings into the rules for assessing credit risk” but does not say a single word about the much more vital issue of the regulators playing God and toying around with risks they know nothing about. How come Mr Stiglitz? Does this not tell us something about how little prepared we, “experts” included, really are to confront the challenges of globalization and development?

And of course, from what we see, in the final resolution of the conference, again, not a single word will be said about this which in essence constitutes a regulatory subsidy of status quo and a tax on development, as well as a fatal and arbitrary intromission in the risk allocation mechanisms of the market. What a shame! Risk is the oxygen of life and development!

The answer: Professor Stiglitz did not personally answer this question but Mr. Yaga Venugopal Reddy, an expert on the panel, replied that in India these Basel regulations only apply to the larger banks that are internationally active and so they do not discriminate against smaller banks.

My comment to that answer: Yes the discrimination in favor of the “too large to fail banks” that the capital requirements established by the Basel Committee is also a problem, but what I was referring to in my question was to the so much worse discrimination among borrowers.

PS. I have personally and also as a former Executive Director of the World Bank been arguing about this issue for years but the profound respect that the Basel Committee has enjoyed and a misguided peer solidarity among the regulators have made it difficult for any outsider to have a voice. In 2007 at a conference of Finance for Development at the UN I was allowed to intervene in a round table and also to post a document on the issue. Unfortunately, this time, in 2009, the sole chance I had was in the NGO meeting with the panel of experts.

In May 2003, the Financial Times published the following letter I wrote

“Just a new breed of systemic error”

“Sir, except for regulations relative to money laundering, the developing countries have been told to keep the capital markets open and to give free access to all investors, no matter what their intentions are, and no matter for how long or short they intend to stay. Simultaneously the developed countries have, through the use of credit-rating agencies, imposed restrictions as to what developing countries are allowed to be visited by their banks and investors.

That two-faced Janus syndrome, “you must trust the market while we must distrust it,” has created serious problems, not the least by leveraging the rate differentials between those liked and those rejected by our financial censors. Today, whenever a country loses its investment-grade rating, many investors are prohibited from investing in its debt, effectively curtailing demand for those debt instruments, just when that country might need it the most, just when that country can afford it the least. Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

A small note: In the dialogue with the Commission a NGO representative argued for more presence of women in finance since they were more “prudent”. Though I do definitely not oppose more representation of women in finance (how could I with a wife and three daughters one of whom is already in banking) I am not so sure the argument is valid… since that could have led even more capital to pursue the “safe and prudent” AAA ratings.

Psst! Why don’t we just throw out some of the dinosaurs so that we can do some good thinking inside the box instead of us always being shown having to go outside to think?

Wednesday, June 3, 2009

The financial discrimination of development

What would the world say if besides the costs of getting water to the driest areas in the world the driest area would have to pay a tax for the water being shipped there? That is exactly what is happening in the financial world with a de-facto arbitrary regulatory taxation of risk. Yet, not a single word on it appears in any pre-statements or background papers to the United Nation´s conference on the world financial and economic crisis and its impact on development, now re-scheduled June 24-26, 2009.

The Basel II: International Convergence of Capital Measurement and Capital Standards of June 2006 in its Standardised Approach requires a bank to hold the following minimum $ equity for each 100 dollars lent by a bank to a sovereign country, depending on the credit rating of that sovereign.

AAA to AA- = $0
A+ to A- = $1.6
BBB + to BBB- = $4
BB + to B = $8
Unrated = $8
Below B- = $12

And I guess you all know how expensive bank equity is, especially now.

Since clearly the lower rated sovereigns will anyhow have to pay a market rates which are considerably higher than what the better rated sovereigns need to pay, it is clear that these differences in capital requirements imply an additional arbitrary tax on capital and that subsidizes anything better able to dress up as risk-free and penalizes anything expected to be perceived as more risky.

Some could argue that this does not amount to any discriminatory protectionism since these criteria are applied across the whole globe but that argument ignores the fact of how the perceived riskiness is unequally distributed around the globe.

This financial arbitrary discrimination against risk and that is present in the minimum capital requirement for bank established by the Basel Committee and that cover all public and private bank finance makes it not only more expensive for capital to go where they could are most needed but they also falsely induce them to go where they should not.

As an example of the above suffices to see how two trillions of dollars, over a period of less than three years, was because of its AAA ratings diverted to the useless financing of a housing boom in the US, instead of for instance financing the creation of sustainable decent jobs; the elimination of many infrastructure bottlenecks that exists in developing countries; or the adaptation and mitigation efforts that climate change threat requires. Two trillion dollars is most certainly more than all the financing provided by all the development banks over all the years.

In fact the current crisis from which so much suffering will result is a direct consequence of the regulatory authorities arbitrary intervening in the risk allocation mechanism of the market… in favor of what a small and incestuous group of bank regulators from some developed countries felt like favoring. Well now those developed countries are not so developed… but this is clearly not the way we should go in order to reduce inequalities.

Friends in the development community, I ask, how long will you ignore this fundamental issue?