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Can regulators effectively supervise banks?
A V Rajwade
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March 16, 2009

The huge losses suffered by major banks recently, particularly in the United States and the United Kingdom, have brought to the fore the weaknesses of the architecture of the Basel II capital ratios, and have also raised questions pertaining to the wisdom of fair value accounting norms.

As for the first, as far back as June 8, 2007, based on my analysis of half a dozen major banks' trading profits for the year 2006, I had concluded that:

"If my assumptions and analysis are reasonably correct, the data lead to several issues and questions: Given the fact that an efficient and competitive market would balance risk and reward, is the risk being underestimated? Alternately, is the Basel Committee on Banking Supervision (BCBS) capital charge for market risk too low?"

The conclusion was based on comparing the value-at-risk numbers reported by the banks with their trading profits.

One was pleasantly surprised to see Adair Turner, chairman, Financial Services Authority (FSA), making the same point in a speech on January 21, 2009, discussing "The financial crisis and the future of financial regulation."

To quote from the speech: "It is clear that in respect to the trading books of banks, we need to remove pro-cyclicality and to increase requirements not just marginally but by several times . . .  It fails to allow effectively for the low probability tail events which are crucial to extreme idiosyncratic and even more so to overall systemic risk. And, overall, the level of capital required against trading books has been simply too low relative to the risks being taken."

Exactly the point I made in the article quoted. In retrospect, one is amazed at how believers in market efficiency, Alan Greenspan for example, could not see the huge skew between (reported) risk and reward, something so evident even to a distant analyst like your columnist! Or did they deliberately shut their eyes to evidence as true believers? One hopes the Basel Committee listens to Turner's call.

There is perhaps one other loophole in the Basel II approach, which permits regulatory arbitrage. This struck me when I started wondering as to why the major commercial and investment banks securitised sub-mortgage debt in the form of Mortgage Backed Securities (MBS) or Collateralilsed Mortgaged Obligations (CMO), only to bring them back on their books as part of the investment portfolio. The answer seems to be that they indulged in regulatory arbitrage on a massive scale as follows:

  • As part of the loan book, below-investment grade mortgage loans would have a risk-weight of 75 per cent (risk-weight of 150 per cent for below-investment grade, and 50 per cent of that for mortgage loans).
  • Converted into AAA securities, the risk-weight came down to 10 per cent (20 per cent for AAA securities and 50 per cent of that because the underlying was mortgage loans).

    On a billion-dollar portfolio, banks found a way to reduce capital from say $60 million (75 per cent of 8 per cent) to $10 million -- and the lower the capital, the higher the return on equity for a given margin. Lower capital was traded for the risk of having to mark-to-market the securities in the trading book; MTM is not necessary for the loan book.

    And, a huge proportion of the losses reported are actually mark-to-market losses, which would not have been incurred had the assets remained in the loan book. In fact, this also illustrates the weakness and illogicity of fair value accounting, a point this column has argued earlier. Market values are not always "fair", over-dependent as they are on market liquidity for the asset in question.

    The giant insurance company, American International Group (AIG), now practically under government control, indulged into another kind of regulatory arbitrage. As one may recall, the firm ran into trouble because it wrote $400 billion of Credit-Default Swaps (CDS), quite a few of them on securitised mortgage loans.

    This was done by a small unit based in London, apparently under extremely loose regulatory regime. In the US, insurance companies are regulated at the state level and, quite possibly, the regulators did not understand, or took much interest in, what the London unit was doing. And, as a unit of an American company, it was also probably not supervised closely by the FSA.

    Turner has referred to the issue of pro-cyclicality of the regulatory norms, in relation to the trading book. This pro-cyclicality is even more pronounced in respect of the banking book, precluding banks from acting counter-cyclically at a time of economic slowdown.

    A recessionary economy means higher non-performing assets, which eat into the banks' capital, reducing their ability to lend. The banking system's inability or unwillingness to lend can only prolong the slowdown/recession, if not convert it into a full-scale depression, which is the worst-case scenario the world economy is facing right now.

    Coming back to regulation of financial services, there are a couple of other issues:

  • What should constitute the capital of a bank?
  • Do the regulators have enough specialist knowledge to effectively supervise modern finance?

    But more on this in a later article.

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