from Follow the Money

Read the annual report of the Bank of International Settlements

July 2, 2008

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International institutions usually put out reports filled with turgid and overly-qualified prose.

But not the BIS. At least not this year. The introduction and conclusion of its 78th annual report are a pleasure to read. The prose is clear and direct. An example:

“If asset prices are unrealistically high, the must eventually fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off. Trying to deny this through the use of gimmicks or palliatives will only make things worse in the end.” (p. 145)

Outgoing Chief Economist William White’s is unsparing in his criticism of both the big private banks and the major central banks. Central banks, in White’s view, held rates too low for too long after the equity bubble burst – creating asset bubbles that fueled excessive demand growth to offset what he views as the natural fall in prices associated with the integration of large new pools of labor into the world economy. Private banks ignored the risks building on their balance sheets

And central banks and private bankers alike failed to appreciate the risks created by the new world of securitized mortgage finance – particularly a world where a lot of exposure was held off-balance sheet in “vehicles” of various kinds.

“Recent innovations such as structured finance products were originally thought likely to produce a welcome spreading of risk-bearing. Instead the way in which they were introduced materially reduced the quality of credit assessments in many markets and also led to a marked increase in opacity. The result was the eventual generation of enormous uncertainty about the size of losses and their distribution. In effect, through innovative repackaging and redistribution, risks were transformed into higher-cost and, for a while at least, lower-probability events.”

It isn’t hard to get the impression that White thinks innovation increased the both the cost and probability of a crisis by contributing – along with low policy rates – to reduced credit standards and asset bubbles. He clearly thinks that the credit losses that followed the bursting of the bubble cannot be “cleaned up” easily.

“It is not clear where the losses [on “new financial instruments”] are, how they should currently be valued or how large they might grow given ongoing declines in the prices of underlying assets.”

The solution? In the first instances, the banks who originated and distributed (sometimes to their own treasury or internal hedge) the bad loans should take their losses.

“Both dividends and bonuses should be cut in order to increase capital cushions.”

I would guess White didn’t approve of the large bonuses many banks paid in 2007. Come to think of it, some of the investors who put money into the big banks in late 2007 also may have second thoughts about the wisdom of these bonuses.

It is striking that US banks had far higher returns on their assets in 2005 and 2006 than the banks in other countries (see the table on p.119). Those high profits were achieved even as the yield curve was inverted - -normally something that isn’t good for bank profits. That should have been a warning sign. Those profits proved to the illusions – as they gave rise to large losses later.

And if cutting dividends and bonuses doesn’t provide the capital needed to absorb the losses associated with valuing assets at their “true” value, public funds should be used.

“The valuation of many of many structured products is difficult, because there is effectively no market for them and valuing them using models has many drawbacks. The banks might agree on a common template for valuations … nevertheless has significant merit. Of course such an evaluation might also reveal that losses are uncomfortably large, a possibility for which the authorities should make preparations in advance. … Mergers, takeovers, the establishment of a “bad bank” to house bad assets, recapitalization using public funds and even nationalization are all procedures that should be contemplated.”

White puts a bit more weight on lax credit and a bit less on policies that pushed down emerging market exchange rates and pushed up savings rates than I would. The Fed can be faulted for not raising policy rates more during the housing boom, but the Fed’s actions alone cannot explain why long-term rates remained below short-term rates for a long time. Nor can a “US only” explanation fully explain why rising rates and a falling fiscal deficit produced an expansion of private housing credit rather than more of an adjustment. To White’s call that “If savings rates are unrealistically low, they must rise” I would add that “If savings rates are unrealistically high, they must fall – and if exchange rates are unrealistically low, they must rise.”

White doesn’t criticize excess savings in many emerging economies – or if he did, I didn’t see it. He certainly doesn’t criticize the policies that have pushed up Asian savings and led to record Asian current account surpluses even as oil rose to $70 last year (see Chapter III of the annual report) with the same vigor as he attacks the argument that central banks shouldn’t try to stop a credit fueled asset bubble. He didn’t spare the emerging economies from criticism though. He writes:

“Upon closer scrutiny, doubts about the longer-term health of emerging economies began to surface. In China, the extraordinary rapid pace of fixed capital investment, much of it in heavy industry, fueled worries about a misallocations as well as the broader effects on both global commodity prices and the environment. In the Middle East, fears intensified that different countries might be pursuing similar strategic development plans that might eventually result in problems of excess supply. And in central and eastern Europe, large and rising current account surpluses seemed increasingly unsustainable.”

I guess he doesn’t think Qatar, Abu Dhabi and Dubai all need huge new airports. And, I rather suspect, he isn’t a big fan of the credit fueled real estate booms in many emerging economies – booms fueled by negative real interest rates and rapid credit growth.

White clearly calls for emerging economies to tighten monetary policy, and recognizes that tightening monetary policy in response to rising inflation requires that many emerging economies allow their exchange rates to rise (p. 144). I suspect that call will have as much impact as White’s efforts to get the US to preemptively prick the housing bubble.

The BIS report concludes, as Martin Wolf notes, with a call both for for a more “macroprudential” focus for bank regulation. The current system is both procyclical, as rising asset prices tend to support credit expansion that pushes asset prices (and risk premia) down and overlying focused on the health of individual institutions rather than the resilience of the overall system to large shocks. Emerging market banks in “liability dollarized economies” have often been devastated by exchange rate moves that pushed many borrowers into default at the same time. The US financial system seems to have had a similar exposure to housing. Rather than looking at how individual institutions could weather a shock to their specific balance sheet, regulars need to worry more about how the overall system could weather a large common shock. Shocks that impact many institutions simultaneously have a much greater risk of triggering a broader decline.

A macrofinancial regulatory framework would include greater attention “on the dangers associated with many institutions having similar exposures to common stocks, for example a turn in the property cycle …. While such an approach would not imply paying less attention to the health of individual institutions, it would certainly imply significantly enhanced oversight of firms that were very large or had complex relations with other parts of the system.”

That presumably includes Goldman Sachs, not just UBS and Citi.

Regulation would also be tightened when the good times are rolling and all looks good (and institutions look both profitable and well capitalized), not just when the music stops. Indeed tighter regulation in good times creates more room for forebearance in bad times. Such a framework would include greater willingness on the part of central banks to try to restrain rapid asset price rises fueled by rapid credit growth.

A more "macro-prudential" approach to regulation makes sense to me.

(p.s. anyone who thinks I am exaggerating global reserve growth should look at the table on p.83 – a table that leaves out most of the $75 billion increase in Saudi foreign assets). Take the total, adjust it for Saudi Arabia and then add in another $150b or so to the 2007 total for the increase in the sovereign funds of Norway, Abu Dhabi, Kuwait and Qatar)

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