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?

Comments on the Draft Outcome Document dated May 8, 2009 for the United Nations Conference “World Financial and Economic Crisis and its impact on Deve

Comments on the Draft Outcome Document dated May 8, 2009 for the United Nations Conference “World Financial and Economic Crisis and its impact on Development”

H.E. Mr. Miguel d'Escoto Brockmann
President of the 63rd session of the United Nations General Assembly

1. Sir, what is going on? The Basel Committee officially endorsed the capabilities of the credit rating agencies’ to identify for the whole world the whereabouts of “risk-free” investments and then, through their minimum capital requirements for the banks, they provided additional incentives for those “risk-free” AAA signs to be followed… and there, right in front of our eyes, over just a couple of years, about 2 trillion dollars were diverted to finance an almost useless and clearly risky housing and consumption boom in the USA, instead of financing the creation of sustainable decent jobs; the elimination of many infrastructure bottlenecks that exists especially in developing countries; or the adaptation and mitigation efforts that the climate change threat requests...and the Draft Outcome Document says basically nothing at all about that!

2. I am one of the very few who can evidence a track record of having in a timely fashion criticized the current financial regulatory framework that originated with the Basel Accord, both in terms of that it doomed the world to a horrendous financial crisis and in relation to the negative impact it has on development. In fact, on the latter issue, I might even be the only voice. Just as an example the following is a letter to the editor titled “Credit ratings for developing nations are just a new breed of systemic error” that I wrote and that was published in Financial Times, January 11, 2003

“Sir, Except for regulations relative to money-laundering, the developing countries have been told to keep their capital markets open and to give free access to all investors, no matter what their intentions are and no matter for how long they intend to stay. Simultaneously, the developed countries have, through the use of credit-rating agencies, imposed restrictions as to which developing countries are allowed to be visited.
This 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 modern-day financial censors. Today, whenever a country loses its investment grade rating, many investors are prohibited from investing in its debt, effectively curtailing the demand for it just when that country might need it the most.
Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friends, please consider that the world is tough enough as it is.”

3. In this respect and notwithstanding that I agree with much of what is said therein I wish hereby to record some fundamental objections to the Draft Outcome Document dated May 8, 2009 (the Draft) and which relates to the G192 Conference on World Economic Crisis and its impact on Development. Many of these comments are extensive to the Recommendations of the Commission of experts of the President of the General Assembly on Reforms of the International Monetary and Financial System (the Recommendations).

Regulation

4. Paragraph 55 of the Draft states “The collapse in confidence in the financial sector is widely recognized as central in the economic crisis; restoration of confidence will be central in the recovery. But it will be hard to restore confidence without changing the incentives and constraints facing the financial crisis”

5. Of course restoration of confidence is central for economic recovery but for the recovery of confidence to happen a full understanding of what happened is a must. That a Bernard Madoff can cheat does not affect confidence in the markets because the markets are much aware that cheaters have always been around and are in fact themselves a part of the market.

6. But, if the credit rating agencies who were so recently officially bestowed with so much power in the surveillance of risks, and therefore must be the best, sort of an “Appointed Risk Surveyor to the Majesty” managed to fail so miserably, then that is of course a tremendous blow to confidence. That loss of confidence can only be cured by fully acknowledging that the mistake was in the creation of an oligopoly in risk surveillance and that this oligopoly will now be eliminated… not strengthened.

7. Paragraph 55 also states “It is imperative that the regulatory reforms be real and substantive, and go beyond the financial sector to address underlying problems in corporate governance and competition policy, and in tax structures, giving preferential treatment to capital gains, that may provide incentives for excessive leverage.”

8. The above says that not taxing the profits is at fault and so that presumably we now must tax profits? Not really so, the problem is not that the profits had tax incentives but that the profits proved to not be profits at all. The “incentives for excessive leverage” those were in fact provided by the regulators and thank God the maximum authorized financial leverages were never even reached by any bank before the crisis. This does of course not preclude that there might be many other valid reasons to tax profits, but that is a quite different matter.

9. Paragraph 55 also states “Even if there had been full disclosure of derivative positions, their complexity was so great as to make an evaluation of the balance sheet position of the financial institutions extraordinarily difficult”.

10. First the crisis was not caused by “derivative positions” and second, the “complexity” argument is irrelevant because the instruments that were so complex that they were not even understood by those who generated them, would never even have reached the balance sheet of a bank, or an investor, had they not been granted the triple-A rating which substituted for the understanding, unfortunately in a much imperfect way. There is of course a need for a better management of the exposures though central clearing houses but that is a quite different matter.

Purpose and objectives of the Financial System

11. Paragraph 57 of the Draft states: “Financial policies, including regulation, have as their objective not only ensuring the safety and soundness of financial institutions and stability of the financial system, but protection of bank depositors, consumers and investors and ensuring financial inclusion - such as access to all banking services including credit, and the provision of financial products which help individuals and families manage the risks they face and gain access to credit at reasonable terms. It is also imperative to make sure that the sector is competitive and innovative.”

12. First, the world needs to set as an explicit objective that individuals should be sufficiently gainfully employed so as not having to use debt except for the acquisition of long term capital goods or in the case of very special emergencies. Most current consumer debt does only help to advance current consumption, at interest rates higher than the risk-free rate and therefore, as a norm, only help to impoverish even more the poor consumers.

13. Second the real purpose of our financial policies should be to advance growth, the creation of decent jobs and to help society to confront special challenges such as climate change. If, in doing so, the financial sector remains stable that is of course a much welcome result, but little is gained from making stability per se the ex ante overriding objective, such as is currently the case. In fact I have even argued that a regulatory system that is much more “trigger-happy” and therefore allows financial institutions to fold much faster, would lead to more satisfactory and stable results.

14. Third, it is of course imperative that the financial sector remains competitive, but this only as long as the competition is carried out in a competitive way and not by assigning special favorable treatment to any parties. That said there is absolutely nothing that requires it to be innovative per se and much less so when the innovations, in this case regulatory innovations, can generate crisis like the current.

15. In this respect there is a need for a banking system that does not substitute bankers staring at monitors for bankers knowing their clients’ business, looking into their clients’ eyes or feeling the firmness of their clients’ handshake. It is indeed of extreme concern to see parents in developed countries giving almost more importance to some opaque credit scores than to the school grades of their children.

16. Therefore paragraph 57 should be rephrased placing as the primary objective of financial policies and regulations the development of the real economy in a sustainable and in a just way. The paragraph 28 of the Recommendations, though incomplete, reflects much of what needs to be stated.

The systemic risks of global arrangements

17. There are continuous references made to the need of “global institutional arrangements for governing the global economy” and this is all well, as longs as it comes with the absolute recognition of the systemic risks such global governance can produce. We should be aware that an objective analysis of the current financial regulations would have to conclude that the world would have been much better off without any of that global public common good we were told that the Basel Committee was, and which has now sadly revealed itself as a real global public common bad.

18. The worst regulator ever, in a small village, will produce harm of little aggregate significance. An extremely good regulator, globally connected, is a monumental menace. In this respect we need to value some of the diversity that different regulatory environments can bring and never underestimate the dangers of the rigidities that global regulations can introduce

Risk as the oxygen of development

19. According to the minimum capital requirements for banks established by the Basel Committee if a credit of $100 is given to a borrower who does not possess a credit rating, the banks need $8 in capital, but if the banks lends to a borrower that has an AAA to an AA- rating, the loans are risk-weighted at 20% and therefore the banks needs only $1.6 in equity. This is equivalent to an authorized 62.5 to 1 leverage.

20. That difference of $6.4 in required equity, especially in times when bank-equity is expensive, costs real money and acts like a de-facto tax on risk. This tax is laid as a surcharge tax on all the different risk spreads that the market already demands. Since the lack of development, just by itself normally generates in the market a perception of additional risk which has to be paid for, and since risk-taking is in so many ways the oxygen of development, it is clear that the developing countries are being especially discriminated by the current regulatory framework.

21. Now if you want to know the real extent of how the minimum capital requirements favored those able to dress up as risk free read paragraph 615 of the Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version of June 2006 which refers to investment in securities that are risk weighted at only 7% and therefore signify an authorized leverage of 179 to 1.

22. The importance that risk-taking has for development and the need to avoid imposing de-facto taxes on risk as has been done with the minimum capital requirement for banks risk-weighted structure and much less introducing artificial incentives to direct funds to real or fictitious low risk investments is completely absent in the document.

23. Paragraph 14 of the Draft argues correctly that “Financial subsidies can be just as detrimental to the efficiency of a free and fair trading system as tariffs. Indeed, they may be more inequitable, because rich countries have more resources to support subsidies” and yet, neither the Draft nor the Recommendations mention even once the current minimum capital requirements for banks and which are as previously explained a real tax or a real tariff on risks, of which the developing countries have the most… at least as perceived by the markets.

24. For a more detailed comment on this I reference a document that I was honored to see posted in October 2007 in the Finance for Development site.
http://www.un.org/esa/ffd/hld/HLD2007/UN_FFD_Statement_Basel_Accord.pdf

Restructuring of International Institutions

25. There are many proposals related to the need of better more transparent and more democratic global institutions. They are all correct but missing from that is the following:

26. First it is not sufficient in structures like for instance the Financial Stability Forum (a name that in itself you might understand that I find much lacking) to have a representation of developing countries as this might not by itself guarantee diversity of thought. What is foremost needed is to avoid that the discussions of vital global issues are hijacked by clubs of mutual admirations and which, due to often strange ying-yang relations sometimes even include representatives from civil society.

27. Second in order to be able to introduce a more global perspective there is also need for more representatives who are not wedded to very local interests. As a former Executive Director of the World Bank I have often held that the least represented entity in the bank is planet earth itself.

Financing for Restructuring and Survival

28. Though I agree with some of the proposals made in paragraphs 21 trough 35 I just cannot comprehend how in paragraph 27 one finds room to mention minor initiatives such as PetroCaribe without even mentioning in the Recommendations or in the Draft the importance of remittances. Given that the enormous sacrifices of many migrants is what is holding many economies afloat it is truly an embarrassing omission.

29. Also and given the current role of the dollar as a kind of borrower of last resort, as a sort of last perceived safe-haven I certainly miss efforts to discuss the possibilities the US recycling some of those dollars to developing countries with perhaps some partial guarantees from other developed economies that also have a vested interest in it.

30. Paragraph 28 speaks of “efficient mechanisms for mobilizing the funds available in countries that have accumulated large reserves” and this could create the false illusion the existence of funds that have not already been deployed. In fact these reserves have one way or another already been invested and their divestment signifies by itself a major challenge.

31. Finally if there is a possibility for a Global Stimulus Fund, then now, in the midst of a crisis, this is not the best of times time to delay its workings by trying to also ascertain the voice of recipient countries.

Sincerely,

Per Kurowski
A concerned citizen and that while being an Executive Director at the World Bank 2002-2004 had little luck in having his voice heard on this issue.

My voice and noise on the financial sector during the spring meetings of the World Bank and the IMF, April 2008

As a former Executive Director at the World Bank (2002 - 2004) and now as Civil Society, the following are the three financial sector issues that I raised at the spring meetings of the World Bank and the IMF in Washington, April 10-13, 2008.

Risk is the oxygen of development!

It is absurd to believe that the US and other countries would have reached development without bank failures. When the Basel Committee imposes on the banks minimum capital requirements based solely on default risks, this signifies putting a tax on risk-taking, something which in itself carries serious risks. The real risk is not banks defaulting; the real risk is banks not helping the society in its growth and development. Not having a hangover (bank-crisis) might just be the result of not going to the party!

We need to stop focusing solely on the hangovers and begin measuring the results of the whole cycle, party and hangover, boom and bust! The South Korean boom that went bust in 1997-1998 seems to have been much more productive for South Korea than what the current boom-bust cycle seems to have been for the United States.

All over the world there is more than sufficient evidence that taxing risks has only stimulated the financing of anything that can be construed as risk free, like public sector and securitized consumer financing; and penalized the finance of more risky ventures like decent job creation. Is it time for capital requirements based on units of default risk per decent job created?

When is the World Bank as a development bank to speak up on this issue on which they have been silent in the name of "harmonization" with the IMF?

When are we to stop digging in the hole we're in?

The detonator of our current financial turmoil were the badly awarded mortgages to the subprime sector and that morphed into prime rated securities with the help of the credit rating agencies appointed as risk surveyors for the world by the bank regulators.

If we survive this one and since it is "human to err" we know that if we keep empowering the credit rating agencies to direct the financial flows in the world, it is certain that at some time in the future we will follow them over even more dangerous precipices.

Note: I have just read the Financial Stability Forum brotherhood's report on Enhancing Market and Institutional Resilience and while including some very common sense recommendations with respect to better liquidity management and "reliable operational infrastructure"; and some spirited words about more supervision and oversight (the blind leading the blind); with respect to the concerns expressed above, bottom line is that they recommend we should deepen the taxes on risks and make certain that the credit rating agencies behave better and get to be more knowledgeable… all so that we are more willing to follow them where we, sooner or later, do not and should not want to go.

Do micro-credit institutions make too much use of "predatory ratings"?

Any group of debtors that is charged a higher interest rate because it is considered a higher credit risk is composed by those spending their money servicing a debt that they will finally default on, and those who should have in fact deserved a lower interest rate. Are there any real winners among them?

Who is out there informing the poorly rated about how very dearly they are paying for their loans? Who is out there analyzing the murdering impact that credit ratings have in chipping away at the minimum levels of solidarity that any society needs to keeps itself a society?

If there is a minimum of things that needs to be done in the world of micro credits that is to focus more on transparent system of incentives that: 1. Stimulates and rewards good group behaviour and returns to the compliant borrowers some of the "extraordinary" margins earned. 2. Spreads out the costs of those who cannot make it over a much wider group of debtors.

And, by the way, this applies just the same to the financing of mortgages to the subprime sector.

ARE THE BASEL BANK REGULATIONS GOOD FOR DEVELOPMENT?

Document that I presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007, as a member of New Rules for Global Finance.

ARE THE BASEL BANK REGULATIONS GOOD FOR DEVELOPMENT?

1. It is very sad when a developed nation decides making risk-adverseness the primary goal of their banking system and places itself voluntarily on a downward slope, since risk taking is an integral part of its economic vitality, but it is a real tragedy when developing countries copycats that and falls into the trap of calling it quits.

2. In his book “Money: Whence it came, where it went” (1975), John Kenneth Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment. Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.

3. Few things can be so relevant to the financing of development as the regulations that are being applied to commercial banks. Unfortunately, as the world has been quite infatuated with the banking regulations emanating from Basel ; as they seemingly kept the bank crisis at bay so efficiently –although some of us believe they seemed more destined to stop the small tremors than to help to avoid the big quakes, or what in recent Alan Greenspan terminology would amount to a lack of "benevolent turbulence"– there has been no room to question the basic principles of the regulations, much less so from the perspective of developing countries that "needed" to be "saved" from their recurring bank crises.

4. As a former Executive Director at the World Bank (2002-2004) who tried to voice this issue frequently, among others at an ECOSOC-Bretton Woods-WTO meeting at the UN in April 2004, I can testify to the difficulties.

5. Some specific problems, such as the possible reinforcement of the pro-cyclicality of bank lending, and some specifics of the Basel II reforms such as its high costs, which could give the larger banks a comparative advantage, have been recorded as discussed, though resulting in nothing special of practical consequence. We should also comment that it is a bit surrealistic to debate the Basel II reforms without ever having entered into and much less exhausted the discussions on the fundamental principles imbedded in Basel I, which clearly contain the genesis of a series of factors that could affect the financing of development.

6. The recent financial turmoil that has cast some serious shadows on some of the Basel operational methods, for instance the high reliance on credit rating agencies, can perhaps now provide us with the opportunity to ask and debate "Are the bank regulations coming out from Basel truly compatible with the best interests of developing countries?" It is in this vein that we would like to start by raising the following issues:

Current regulatory arbitrage favors risk adverseness

7. The bank regulations that come out from Basel are almost exclusively against-risks-at-any-cost driven and so they completely ignore the other two major functions of banking systems, namely to help generate growth and to distribute opportunities.[1] The fact that in a developing society there are some risks more worthy to take than others is completely ignored in the minimum capital requirements ordained by Basel. The argument that "a stable banking system is critical to the long-term growth of an economy" is repeated like a mantra with no consideration of the stage of development and circle of growth in which a country finds itself.

8. Credits deemed to have a low default or collection risk will intrinsically always have the advantage of being better perceived and therefore being charged lower interest rates, precisely because they are lower risk. But, the minimum capital requirements of the Basel regulations, by additionally rewarding "low risk" with the cost saving benefits resulting from lower capital requirements, are unduly leveraging the attractiveness of "low risk" when compared to "higher risk" financing.

9. Allow us to illustrate this central argument in a very simplified way. Under the current Basel I Standardized Approach, a low risk corporate loan (rated AAA to AA-) requires a bank to hold only 20% of the basic 8% capital requirement, meaning 1.6 in units of capital, while a much riskier loan (rated below BB-) requires it to hold 150% of the basic 8%, meaning 12 units of capital. If the current cost of capital for the bank is 15%, then the bank's carrying cost for the low risk credit is 0.24% (8%*20%*15%) while the bank's carrying cost for the high risk credit is 1.80% (8%.150%*15%), thereby producing an additional cost of 1.56% that must be added on to the normal spread that the market already requires from a high risk compared to a low risk loan in a free market.

10. The extra Basel spread on risk makes it more difficult for higher risk borrowing needs to have access to credit from the commercial banks. In a developed country this might not be so serious because there are other alternative sources, but in a developing economy this is fatal, as the commercial banks frequently represent the only formal and supervised source of finance.

11. And of course the Basel effect does not limit itself to the extra carrying cost. From the perspective of the balance sheet we see that each unit of bank capital can sustain 62.5 units of low risk lending but only 8.3 units of high risk lending, and since bank capital itself is more scarce in a developing country, this also induces channeling of local savings increasingly towards the low risk side of the economy.

12. In Basel II, while the "Internal Ratings-Based Approach" provides a much more refined instrument for assessing risks it creates even more bias against risk, much the same as a health insurance scheme is able to offer more differentiated rates the more they know or think they know about the expected health prospects of their clients. We should not ignore that the finance of development requires the current generation to be willing to share in the risks of the future so as to help the society and coming generations to progress. In this respect the Basel risk adverseness could be described as a baby-boomer generation's invention to assure that their savings are there when they need them, with little consideration to what might come after.

13. By adding on a new layer of sophistication and digging deeper in the hole created by Basel I, Basel II will ironically increase the possibilities of new systemic risks and make the fight against the risks targeted by the Basel Committee even more difficult. This particular problem lies outside the context of this paper but for those interested we refer to the Statement number 160 of the Shadow Financial Regulatory Committee, March 2000,[2] where they propose instead the more logical route of harnessing more market discipline by using subordinated debt to make capital requirements more risk sensitive.

14. We are by no means implying that the risks in lending should be taken lightly, but since development normally does not make a living in the land of low risks, much the contrary, this regulatory arbitrage of overly benefiting risk adverseness, and adding on costs, is very costly for development. In short, Basel provides economic signals for maintaining the status quo rather than fostering development.

15. In this respect, and since the current Basel II proposals do contain much that could stimulate the banks to better quantify and manage risk, an alternative that could perhaps provide some of the benefits with less regulatory-ordered bias would be to require a flat percentage of assets as the capital requirement for the banks but forcing them to report to the market a Basel-calculated minimum capital, thereby allowing the market participants, investors or depositors, to price in their views on the differences between these two figures. Going this route would also diminish the quite dangerous possibility that the markets begin to believe that the Basel minimum capital requirements constitute a perfect risk equalization machine among banks with totally different risk structures.

16. As much of the risk management used by Basel is based on the analysis of old data, so as to establish loss probabilities, we also need to acknowledge the fact that a desired future does not stand on past statistical data, much less in the case of developing countries where that past statistical data refers precisely to what should be avoided in the future, and bears little relevance to what needs to be done.

17. But again we wish to make absolutely clear that this is NOT a proposal to abolish the Basel minimum capital requirements outright, but rather to study its other social costs in order to contain these or develop alternative methods that better balance the different societal objectives for the banks.

Current regulatory arbitrage leads to risk hiding

18. An excessive anti-risk bias will naturally stimulate risk hiding. Let us not forget that the need for assets to be qualified as more or less risky is exactly the reason why the credit rating agencies were so much empowered that now we also have the credit rating agencies bias risk, which already helped to create the sub-prime mortgages debacle.

19. One of the dangers for a developing country, where regulatory weaknesses might be more easily exploitable, is that the banks deviate all assets that in their opinion carry a lower capital requirement than what the regulator-credit rating agencies order into other formal or informal places of the market, while loading up their balance sheet with assets for which the risk/capital allocation seems a bargain; giving new meaning to the Thomas Gresham's principle that states that "bad money drives out good money.”

20. The mentioned risks are clearly not limited to developing countries and we can find a discussion of it in the context of developed countries in a speech of Alan Greenspan on "The Role of Capital in Optimal Banking Supervision and Regulation"[3] in 1998.

Excessive empowerment of new participants

21. Credit rating agencies. The Basel I Standardized Approach regulations led to the credit-rating agencies substituting for some of the traditional in-house credit analyst departments in local banks which, for better or for worse, had allowed credit analysis to be more colored by local factors. This has affected the whole credit environment, and the recent drive towards "development banks" and the establishing of the micro credit institutions can be seen in great part as efforts to satisfy needs created by the Basel inspired bank regulations.

22. It is indeed very difficult for developing countries to understand how authorities that have frequently preached to them the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies, especially as this must surely be setting us up for very serious new systemic errors.

23. Powers to the Supervisors. The Basel II "Internal Ratings-Based Approach" returns much of the credit analysis to the banks themselves, where it belongs, but in doing so it generates a series of new hands-on activities for bank supervisors who will need to consent, concur, approve and what have you, and which can only create new sources of distortions. In this respect suffice it to read the book by James R. Barth, Gerard Caprio, Jr. and Ross Levine, "Rethinking Bank Regulations: Till Angels Govern" [4] to reflect on the possible consequences.

We need much more research

24. When looking at how consumer credit is growing fast in so many developing countries, mainly because it can be more easily packaged (or camouflaged) as a low risk operation while traditional entrepreneurial credits barely skimp along, it would be natural to ask whether this could not be the direct result of the Basel regulations.

25. Could Basel be hindering development finance? What are the consequences of regulatory arbitrated risk adverseness? Is Basel introducing a bias in favor of public sector finance? Could the paradox of the increasing net outward financial flows from developing to developed countries be in any way related to these regulations?

26. These are all vital questions but there seems to be no ongoing research to try to understand how global financial flows have been affected by the Basel regulations and by the use of the credit rating agencies. The topic seems almost taboo, but given the importance of banking regulations for the financing of development, we would urge giving more priority to the research of these issues.

Who is the lender of last resort?

27. One concern, much aggravated by the new Basel II regulations, is that the world might have been irrevocably placed on a route that leads it to end up with just a couple of big international banks. In such a case, if one of these banks that have captured a very large share of local deposits in a developing country runs into problems, who is the real lender of last resort? Is the European Central Bank, for instance, willing to furnish Latin American countries with at least a letter of intent to provide support if a European-owned bank runs into problems while working in Latin America? Clearly there is an urgent need for close international collaboration on this matter.

28. The issue of a possible tendency to have fewer banks, which would seem to imply that damages caused by an individual bank default could grow as a result of upping the ante, also raises the question of why this is not considered by Basel. If the Basel risk assessment methodology favors a diversification in the portfolio of a particular bank, then shouldn’t society, and the lender of last resort, also apply this criteria to their own portfolio of banks? Is there not a need for an additional capital requirement based on the individual bank's market share?

What can be done?

29. There are no easy answers, but to discuss these problems openly and candidly is as good a start as any, and so therefore these questions and issues need to be brought to the forefront of the discussions, like for example:

30. Can and should the minimum capital requirements be supplemented or complemented in such a way as to neutralize the risk adverseness of current regulation by, for instance, providing an adjustment for credits destined to create jobs? If the bank regulators of the world insist on imposing the criteria of the credit rating agencies, should we development agents request the presence of our development rating agencies and distribution of opportunities rating agencies?

31. Instead of using the differences in the perceived risks of the credits to determine the formal capital requirements an alternative is to apply an equal percentage to all the assets of the bank but then having the banks to report something similar to a Basle risk valuation as an additional transparent information reference. Although this approach looks to incorporate a more holistic market view than the strictly risk related “subordinated debt route suggested by the Shadow Financial Regulatory Committee, there is nothing that stops it from being complementary to the former.

32. Some could argue that to rely on the markets is impossible in developing countries where markets are deemed to be non-existent or weak but the other side of that coin is that that constitutes precisely the reason for having to rely on whatever little market there is.

Who is debating?

33. Put together the chefs from many different countries and you might get a quite varied menu, but gather the brain-surgeons and there is not going to be a great deal of diversity in their opinions. One of the main problems in discussing the Basel issue, and more so of being able to introduce any changes, is the current lock-hold that central bankers and bank supervisors have on the debate. Sometimes it is argued that if developing countries are better represented in Basel, they will be better able to voice their development concerns, but if this representation of diversity is only to happen by convening experts from all around the world that profess the same principles and have the same mindset, then no matter where they come from, this will be a dead-end street.

34. The numerous comments made by Basel officials about the importance of not rushing the implementation of Basel II, would seem to indicate that experts from developing countries feel the pressure to be recognized as being just as up-to-date and risk-adverse as their peers in developed countries. This syndrome, that costs many developing countries dearly in many of their WTO negotiations, needs to be controlled by assuring the presence of professionals that have other interests beside bank regulations.

35. The World Bank, as a development institution, should have played a much more counterbalancing role in this debate, but unfortunately it has been often silenced in the name of the need to "harmonize" with the IMF. Likewise, the Financial Stability Forum is also, by its sheer composition and mission, too closely related to the Basel bank regulations to provide for an independent perspective, much less represent the special needs of developing countries. Therefore the introduction of independent development voices in the debate is absolutely crucial, and perhaps this could be arranged through a G77 or a G24 effort.

36. As evidence for the lack of inclusion of other points of view different from risk avoidance, let us just refer to the Policy Conclusion in the Report of the Secretary General on the International Financial System and Development dated July 6, 2007, where "surveillance" appears seven times and except for one reference to the development of the financial sector there is not a single word about development itself.

37. For the record, let us state that although we have made the above comments from the perspective of "finance for development," most of the criticism put forward is just as applicable to developed countries. In this respect it is interesting to note that in the United States there has been some serious questioning of whether those regulations are not too uniform as to be applicable to all of their banks.

38. To conclude, we wish to insist that no society can survive by simply maximizing risk avoidance; future generations will pay dearly for this current run to safety. So therefore, more than placing our trust in the banks’ financial standing, we need to trust in what the banks do. Let us make certain our bank regulations help us to do just that.

[1] http://www.bis.org/publ/bcbs107.htm

[2] http://www.aei.org/publications/pubID.16542/pub_detail.asp

[3] Federal Reserve Bank of New York Economic Policy Review of October 1998.

[4] Cambridge University Press, 2006

Let them bike

Intro: The debate about using Country Systems. Why did I spend so much time on this issue?

Whether to let the countries learn and develop on their own in their own way and assisting them by freely giving some of the very scarce resources or whether to impose some conditions on how they are to manage these resources is one of the most difficult balancing acts of any development policy.

There must be thousands of examples of how development funds have been squandered to no avail by bad governments and crooked politicians, and certainly there are thousand of examples of how good-intentioned agencies have, in a quite similar and yet opposite way, squandered these scarce funds by imposing absolutely misplaced rules and conditions.

As I never believed that you could create good artists by having students practice painting by numbers, this little spot number 17 blue, and as those wanting to impose more and ever stricter conditions on the borrower were in the clear majority, my devil’s advocate instincts and my normal tendency of siding with the weaker inspired me to take a very strong position in favor of allowing for a more frequent use of the countries’ own systems. 

Let them bike

Friends, listening to your exhaustive list of concerns, I was reminded of the moments when I had to teach my daughters how to ride their bikes: I heard their mother’s anxious calls in the background; I felt my own nervousness; nonetheless, I just knew I had to let them go.

One could find and read thousands of manuals about how to put a bike together safely; about all the safety implements a kid should wear, such as helmet and wrist-guards; about all the precautions he or she needs to take, not going downhill or out on the main road; but nowhere can you find even a single manual that clearly and exactly instructs you how to learn to ride a bike. Left leg up, right leg down! Or was it right leg up first? 

We need to understand that development is a bit like learning how to ride a bike and, at the end of the day it is something that must be done on one’s own. In fact, no matter how much we could help in the preparations, we will not stand a chance to achieve lasting results if we are not willing or do not know how to let them go. 

It is not easy to let go, I probably even closed my eyes for fractions of seconds after letting my girls roll away on their bikes, but I let them go and they know how to ride a bike now. 

So, my colleagues, in these discussions, not as caring parents but as caring development partners, let us try to act accordingly, letting them go, always remembering that, at the end of the day, countries need to do it on their own. What else could ownership mean?

Of course, anyone might fall trying, but that is exactly the risk we need to be able to take if they are going to achieve real sustainable development results and, if they fall, there is probably nothing more to do than to help them rebuild their confidence so that they can just have another go at it.

Moreover, if you try to hold the bike while they ride it, the bike might not really behave like a bike, and so they might never get the hang of it. What we really should be concerned about is that they have what is most needed at the time of trying: sufficient confidence in themselves. In fact, what unwillingly might be the first victim of all our other secondary concerns is precisely that, their confidence. 

So, my colleagues, let them go, again and again and again, learning to ride their bike, and as they believe a bike should be ridden.

P.S. I know it is not as easy as it sounds and in fact I would only give someone the freedom to try it on their own whenever he or she convinces me she or he is ready for it and is sufficiently confident.

Extracted from: Noise and Voice

Unsustainable debt

"There cannot be a road more conducive to debt turning unsustainable, than to award credits just because they are sustainable."

The mutual admiration club of firefighters in Basel

(A letter Financial Times did publish)

Sir, if a citizen from a developed country wishes to obtain finance from his local bank to buy a pricey retirement home in his local overheated market, then Basel poses no problem.

But should he want to buy a much more affordable home in a developing country and have his bank there finance him, then Basel slaps such capital-reserve requirements on the bank as to make it an impossibly onerous proposition.

This is just one way by which our bank supervisors in Basel are unwittingly controlling the capital flows in the world.

We also wonder how many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.

Please, help us get some diversity of thinking to Basel urgently; at the moment it is just a mutual admiration club of firefighters trying to avoid bank crisis at any cost—even at the cost of growth.

Towards a counter cyclical Basel?

(A letter to the Financial Times extracted from Voice and Noise, 2006)

Sir, the financial system is there to safeguard savings, to generate economic growth by channeling investments, and to promote equality by providing full and free access to capital and opportunities.

Currently, our bank regulators headquartered in Basel are primarily concerned with the first goal, that of avoiding bank collapses, and how could it be otherwise, if you have only firemen on the board that regulates building permits.

Now, one of these days, the financial system, neatly combed and dressed in a tuxedo, but lying more than seven feet under in the coffin of financial de-intermediation, is going to wake up to the fact that it needs the presence of others in Basel. At that moment, perhaps we might start hearing about flexible capital requirements, moving up to 8.2 % or down to 7.8% by region, in response to countercyclical needs.

Meanwhile it’s a shame that even their first goal might turn out to be elusive, since although the individual risks have fallen with Basel regulations, the stakes have increased, as those same regulations accelerate the tendency towards fewer and fewer banks.

A NEW BREED OF SYSTEMIC ERRORS

(A letter Financial Times did publish)

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.

Warning about Basel bank regulations

Denying a loan, only seeking to reduce the vulnerability of the financial system, could mean the loss of a unique opportunity to achieve economic growth.

All development involves risks, so its path, by definition, is littered with bankruptcies and tears, framed in the human oscillation of one little step forward and 0.99 little steps back. Perhaps then the best way to regulate is to allow some banks to fail, too, before their problems have calcified or become too great.

Developed countries may never have developed under the yoke of puritanical financial regulation, hence my insistence since 1997 on the need for the development perspective to be considered when regulating. Paraphrasing someone; regulation of the financial system is too important to be left in the hands of regulators and bankers. (See note)

Furthermore, in a world that so much preaches the benefits of the invisible hand of the market, with its millions of mini-regulators, we are surprised that Basel delegates, without question, so much responsibility in the hands of a very few and very fallible credit rating agencies.

Basel has recently come under significant criticism:

The World Bank in its 'Global Financial Development of 2003', referring to the new ways of calculating capital requirements, known as Basel 2, warns both about the risk of making access more expensive and more difficult for developing countries to financial sources, such as favoring international banks to the detriment of domestic banks.

Dr. Alexander Kern, from the University of Cambridge, recently stated at a seminar organized by the G24 (developing countries), that because standards have been developed almost exclusively by European countries (G10), they lack the transparency and legitimacy necessary to accept that they are subject to a quasi-mandatory international legalization process.

The comptroller of the United States Currency, in charge of supervising 55% of the banking system in his country, declared his disagreement with the Basel 2 regulations, and even said that they may simply ignore them.

Friends, it may be worth including in all encyclopedias issued by Basel: 'Warning, excessive banking regulations in Basel can be very detrimental to the development of your country'

Note: “War is too serious a matter to entrust to military men” Georges Clemenceau

PS. Sometime later I found out about the bank capital (equity) requirements with risk weights of 0% government and 100% citizens, as if bureaucrats know better what to do with credit than e.g., small businesses and entrepreneurs. If I was to help finance development in developing (and in developed) countries, the first condition for doing so would be to eliminate such loony regulations.

El Universal

PS. This I wrote while being an Executive Director of the World Bank 2002-2004

PS. Mi first Op-Ed ever June 12, 1997 Puritanism in banking

Some comments made at a Risk Management Workshop for Regulators

Dear Friends,

As I know that some of my comments could expose me to clear and present dangers in the presence of so many regulators, let me start by sincerely congratulating everyone for the quality of this seminar. It has been a very formative and stimulating exercise, and we can already begin to see how Basel II is forcing bank regulators to make a real professional quantum leap. As I see it, you will have a lot of homework in the next years, brushing up on your calculus—almost a career change.

But, my friends, there is so much more to banking than reducing its vulnerability—and that’s where I will start my devil’s advocate intrusion of today.

Regulations and development.

The other side of the coin of a credit that was never granted, in order to reduce the vulnerability of the financial system, could very well be the loss of a unique opportunity for growth. In this sense, I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel.

A wider participation.

In my country, Venezuela, we refer to a complicated issue as a dry hide: when you try to put down one corner, up goes the other. And so, when looking for ways of avoiding a bank crisis, you could be inadvertently slowing development.

As developing sounds to me much more important than avoiding bank failures, I would favor a more balanced approach to regulation. Talleyrand is quoted as saying, “War is much too serious to leave to the generals.” Well, let me stick my head out, proposing that banking regulations are much too important to be left in the hands of regulators and bankers.

Friends, I have been sitting here for most of these five days without being able to detect a single formula or word indicating that growth and credits are also a function of bank regulations. But then again, it could not be any other way. Sorry! There just are no incentives for regulators to think in terms of development, and then the presence of the bankers in the process has, naturally, more to do with their own development. I believe that if something better is going to come out of Basel, a much wider representation of interests is needed.

A wider Scope.

I am convinced that the direct cost of a bank crisis can be exceeded by the costs of an inadequate workout process and the costs coming from the regulatory Puritanism that frequently hits the financial system—as an aftershock.

In this respect, I have the impression that the scope of the regulatory framework is not sufficiently wide, since the final objective of limiting the social costs cannot focus only on the accident itself, but has also to cover the hospitalization and the rehabilitation of the economy. From this perspective, an aggressive bank, always living on the edge of a crisis, would once again perhaps not be that bad, as long as the aggressive bank is adequately foreclosed and any criminal misbehavior adequately punished.

On risks.

In Against the Gods Peter L. Bernstein (John Wiley & Sons, 1996) writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Today, when seeing so much risk managing, I cannot but speculate on whether we are not leaving out God’s hand, just a little bit too much.

If the path to development is littered with bankruptcies, losses, tears, and tragedies, all framed within the human seesaw of one little step forward, and 0.99 steps back, why do we insist so much on excluding banking systems from capitalizing on the Darwinian benefits to be expected?

There is a thesis that holds that the old agricultural traditions of burning a little each year, thereby getting rid of some of the combustible materials, was much wiser than today’s no burning at all, that only allows for the buildup of more incendiary materials, thereby guaranteeing disaster and scorched earth, when fire finally breaks out, as it does, sooner or later.

Therefore a regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

Knowing that “the larger they are, the harder they fall,” if I were regulator, I would be thinking about a progressive tax on size. But, then again, I am not a regulator, I am just a developer.

Conspiracy?

When we observe that large banks will benefit the most with Basel II, through many risk-mitigation methods not available to the smaller banks which will need to live on with Basel I, and that even the World Bank’s “Global Development Finance 2003” speaks about an “unleveling” of the playing field for domestic banks in favor of international banks active in developing countries, I believe we have the right to ask ourselves about who were the real negotiators in Basel?

Naturally, I assume that the way the small domestic banks in the developing countries will have to deal with these new artificial comparative disadvantages is the way one deals with these issues in the World Trade Organization, namely by requesting safeguards.

Credit Ratings

Finally, just some words about the role of the Credit Rating Agencies. I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.

The Board As for Executive Directors (such as myself), it would seem that we need to start worrying about the risk of Risk Managers doing a de facto takeover of Boards—here, there, and everywhere. Of course we also have a lot of homework to do, most especially since the devil is in the details, and risk management, as you well know, has a lot of details.

Thank you.

The financial handicap

In horse racing, to try to equalize the chances of victory among the competitors, the handicap system is frequently used, which implies putting a greater weight on the horses, which have shown a greater ability to win. The world of finance is not so benevolent, there more weight is imposed on those who, according to the market, have fewer prospects... present greater risk.

Every morning when a Venezuelan goes out to build his future and that of his Homeland, whether he is a public or private servant, he carries on his shoulders the weight of the country risk (CR) that the financial markets have set that day. That CR, which in principle is calculated based on how much more interest the market requires for Venezuela's external public debt, compared to a similar one in the United States, is currently located at 11% - 14%.

CR affects not only the public sector, but permeates the entire economy. Effectively, we see, for example, a private person who wishes to contract external debt and if he does not have external guarantees to offer, he must pay his normal interest rate, plus the CR. In terms of public service rates, the models indicate the need to reward the investor with a normal profit margin, plus the CR.

A high CR is economic contamination, which covers everything and prevents breathing normally. If Venezuela wants to recover from this economic emphysema, there is no better way than to reduce the CR fast and considerably.

Obviously, CR has many causes and many origins, but the main one is generally related to the ability to service the country's public debt.

In this sense, I guarantee you that if we only manage to spread the amortization of our public debt over a much longer term and guarantee to the market that this is not done to increase it later, due to its relatively modest size, we could quickly achieve that our debt was classified as investment grade, which would reduce the CR considerably.

All it takes is a little will and drive. If the discordant parties insist on preferring to fight suffocated and short of breath, then so be it. However, I am convinced that the oxygen that reducing the CR would produce would benefit both the Government and the opposition, not to mention the rest of our country, which needs and deserves it so much.

Translated from El Universal

.

About the Global Bank Insolvency Initiative

(An informal email sent in 2003 to my then colleagues Executive Directors of the World Bank and which is extracted from my Voice and Noise, 2006)

Dear Friends,

We recently had a technical briefing about the Global Bank Insolvency Initiative. Having had a special interest in this subject for some years, I wish to make some comments.

As I have always seen it, the costs related to a bank crisis are the following three:

The actual direct losses of the banks at the outbreak of the crisis. These are represented by all those existing loans that are irrevocably bad loans and therefore losses without a doubt.

The losses derived from mismanaging the interventions (workout costs). These include, for example, losses derived from not allowing some of the existing bad loans the time to work themselves out of their problems. They also include all the extraordinary legal expenses generated by any bank intervention in which regulators in charge want to make sure that they themselves are not exposed to any risk at all.

The long-term losses to the economy resulting from the “Financial Regulatory Puritanism,” that tends to follow in the wake of a bank crisis as thousands of growth opportunities are not financed because of the attitude “we need to avoid a new bank crisis at any cost.”

For the sake of the argument, I have hypothesized that each of these individual costs represents approximately a third of the total cost. Actually, having experienced a bank crisis at very close range, I am convinced that the first of the three above costs is the smallest ... but I guess that might be just too politically incorrect to pursue further at this moment.

In this respect, it is clear that any initiative that aims to reduce the workout costs of bank insolvency is always welcome and in fact the current draft contains many well-argued and interesting comments, which bodes well for its final findings and suggestions.

That said, the scope of the initiative might be somewhat limited and outdated, making it difficult to realize its full potential benefits. There is also the danger that an excessive regulatory bias will taint its findings.


Traditional financial systems, represented by many small local banks dedicated to very basic and standard commercial credits, and subject to normally quite lax local regulation and supervision, are mostly extinct.

They are being replaced by a system with fewer and bigger global bank conglomerates governed by a global Basel-inspired regulatory framework and they operate frequently by transforming the economic realities of their portfolios through mechanisms and instruments (derivatives) that are hard to understand even for savvy financial experts.

In this respect I believe that instead of dedicating scarce resources to what in some ways could be deemed to be financial archaeology, we should confront the new market realities head on, making them an explicit objective of this global initiative. For instance, what on earth is a small country to do if an international bank that has 30% of the local bank deposits goes belly up?

We all know that the financial sector, besides having to provide security for its depositors, needs also to contribute toward economic growth and social justice, by providing efficient financial intermediation and equal opportunities of access to capital. Unfortunately, both these last two objectives seem to have been relegated to a very distant plane, as the whole debate has been captured by regulators that seem only to worry about avoiding a bank crisis. Unfortunately, it seems that the initiative, by relying exclusively on professionals related to banking supervision, does little to break out from this incestuous trap. By the way if you want to see about conflict of interest, then read the section “Legal protection of banking authorities and their staff.” It relates exactly to those wide blanket indemnities that we so much criticize elsewhere.

And so, friends, I see this Global Bank Insolvency Initiative as a splendid opportunity to broaden the debate about the world’s financial systems and create the much needed checks and balances to Basel. However, nothing will come out of it if we just delegate everything to the hands of the usual suspects. By the way, and I will say it over and over again, in terms of this debate, we, the World Bank, should constitute the de facto check and balance on the International Monetary Fund. That is a role we should not be allowed to ignore—especially in the name of harmonization.

Only under strict invitation

Recently, Camdessus, former managing director of the International Monetary Fund, declared without blushing that “We have never forced any country to liberalize its capital accounts. Never!"The statement seemed to me similar to that of a drug dealer, who initially gives away the drug to create the addiction and then, in his defense, maintains that he never forced anyone to buy it. 

The IMF's policies at the time, which I quite protested, focused on increasing taxes, ignoring the fact that the country was in a recession and imposing a monetary policy with exorbitant interest rates. As a consequence, the recession worsened and the bolivar was artificially strengthened, thus killing long-term investment opportunities and attracting, due to the immense real returns, short-term speculative capital. Swallow capitals were not only a direct consequence of the IMF's policies, but also their mere presence was the main indicator to measure their success. 

If today there is awareness of the damage caused by such capital, why then is nothing being done? As in so many other aspects, I maintain that the cause of our timidity to act is due to a complex of globalizing insufficiency, caused by repeating the false mantra of “We globalize or we die.” 

In 1983, after the devaluation, when someone rebuked the authorities about why they had not put exchange controls in place before, they were responded with “why close the stable doors if the horses are already gone.” In this regard, I consider that to control speculative flows, it is better to do so before they enter the country and not after. Those who believe that something can be gained by letting capital in, and then retaining it against their will, do not know the matter. To begin with, the damage that these capitals cause when entering can even exceed the damage they cause when leaving. 

In a way, Venezuela has been lucky not to have had, during the last decade, the excessive confidence of the short-term investor. In the present juncture, when some nationalist economic rationality can once again turn Venezuela into a Boccato di Cardinale, we must ensure that unwanted guests do not sneak into the party.

In this sense, I suggest immediately establishing rules, taxes or special reserves that discipline the inflow of short-term capital. The moment may also be opportune for us, with tax exemptions and debt conversion programs, to demonstrate our interest in new long-term investments. 

When controlling the flow of capital, what matters most is its term and not its origin. For this reason, the controls must also affect Venezuelan capital, which although it has and always should have the right to leave, should not have the right to enter whenever it wants, just to take advantage of a short-term situation. 

Friends, I have not gone crazy when, in the midst of a recession, I intend to close the door to capital. I only seek to ensure that our country manages to attract the capital that interests it, also taking advantage of promoting Venezuela in the way that something truly good is promoted, that is, as something exclusive whose access is restricted. 

Published in El Universal on February 15, 2001

Translated by Google

Financial misregulation

July 2000. Extracted and translated from an Op-Ed in Venezuela titled "Our full of complexes economic policy."

"Financial regulations. Banking, in addition to promoting savings, offering reasonable returns and certainty of recovery, must fulfill the functions of supporting economic growth and democratizing access to capital. In terms of banking regulation, it would seem that the country has forgotten these last two functions, accepting, without blinking, the Basel regulations, much more appropriate for the banking of an already developed country than for ours. There is nothing wrong with being a developing country, what is wrong is believing that by simply adopting different positions, you can reach another level of maturity – like a little girl who borrows her mother's lipstick to feel grown up."

Puritanism in Banking

In his book Money: Whence it came, where it went” (1975), John Kenneth Galbraith discusses banks and banking issues which I believe may be applicable to the Venezuela of today.

In one section, he addresses the function of banks in the creation of wealth. Galbraith speculates on the fact that one of the basic fundamentals of the accelerated growth experienced in the western and south-western parts of the United States during the past century was the existence of an aggressive banking sector working in a relatively unregulated environment.

Banks opened and closed doors and bankruptcies were frequent, but as a consequence of agile and flexible credit policies, even the banks that failed left a wake of development in their passing.

In a second section, Galbraith refers to the banks’ function of democratization of capital as they allow entities with initiative, ideas, and will to work although they initially lack the resources to participate in the region’s economic activity. In this second case, Galbraith states that as the regulations affecting the activities of the banking sector are increased, the possibilities of this democratization of capital would decrease. There is obviously a risk in lending to the poor.

In Venezuela, the last few years [the 1990s] have seen a debate, almost puritan in its fervor, relative to banking activity and how, through the implementation of increased controls, we could avoid a repeat of a banking crisis like the one suffered in 1994 at a cost of almost 20% of GDP. Up to a certain point, this seems natural in light of the trauma created by this crisis.

However, in a country in which unemployment increases daily and critical poverty spreads like powder, I believe we have definitely lost the perspective of the true function of a bank when I read about the preoccupation of our Bank Regulating Agency that “the increase in credit activity could be accompanied by the risk that loans awarded to new clients are not backed up with necessary support (guarantees)” and that as a result we must consider new restrictions on the sector.

It is obvious that we must ensure that banks do not overstep their bounds while exercising their primary functions—a mistake which in turn would result in costly rescue operations. We cannot, however, in lieu of perfecting this control, lose sight of the fact that the banks’ principal purpose should be to assist in the country’s economic development and that it is precisely with this purpose in mind that they are allowed to operate.

I cannot believe that any of the Venezuelan banks were awarded their charters based purely and simply on a blanket promise to return deposits. Additionally, when we talk about not returning deposits, nobody can deny that—should we add up the costs caused by the poor administration, sins, and crimes perpetrated by the local private banking sector throughout its history—this would turn out to be only a fraction of the monetary value of the comparable costs caused by the public/government sector.

Regulatory Puritanism can affect the banking sector in many ways. Among others, we can mention the fact that it could obligate the banks to accelerate unduly the foreclosure and liquidation of a business client simply because the liquid value for the bank in the process of foreclosure is much higher than the value at which the bank is forced to carry the asset on its books. In the Venezuela of today, we do not have the social flexibility to be able to afford unnecessary foreclosures and liquidations.

In order to comprehend the process involved in the accounting of losses in a bank, one must understand that this does not necessarily have anything to do with actual and real losses, but rather with norms and regulations that require the creation of reserves. Obviously banks will be affected more or less depending on the severity of these norms. Currently, a comparative analysis would show that Venezuela has one of the most rigid and conservative sets of regulations in the world.

On top of this, we have arrived at this extreme situation from a base, extreme on the other end of the spectrum, in which not only was the regulatory framework unduly flexible, but in which, due to the absence of adequate supervision, the regulations were practically irrelevant.

Obviously, the process of going from one extreme to the other in the establishment of banking regulations is one of the explanations for the severe contraction of our banking sector. Until only a few years ago, Venezuela’s top banks were among the largest banks of Latin America. Today, they simply do not appear on the list.

It is evident that the financial health of the Venezuelan banking community requires an economic recovery and any Bank Superintendent complying with his mission should actively be supporting said recovery instead of, as sometimes seems evident, trying to receive distinctions for merit from Basel (home of the international bank regulatory agencies).

If we insist in maintaining a firm defeatist attitude which definitely does not represent a vision of growth for the future, we will most likely end up with the most reserved and solid banking sector in the world, adequately dressed in very conservative business suits, presiding over the funeral of the economy. I would much prefer their putting on some blue jeans and trying to get the economy moving.

Published in The Daily Journal, Caracas, June 1997 and republished in Voice and Noise (2006)