A government stake in banks is useless without enforceable regulations.
In taking a step back to review the turmoil in the international financial markets it is apparent that: (a) financial firms in G7 countries took highly leveraged positions on mortgage backed securities; (b) banks and insurance firms were rendered insolvent as asset values plunged, which was triggered by an erosion in housing prices; (c) CEOs of financial firms did not take responsibility for their actions and compensated themselves excessively; (d) High levels of Credit Default Swap (CDS) protection were sold; and (e) Regulators did not treat CDSs as insurance contracts or insist on accurate marking-to-market of exposure positions.
As bankruptcies spread from the US to Europe it was clear that these failed financial firms had leverage ratios of debt to equity of 30:1 or more. However, all banks did not have their equity base wiped out. Why then did they stop lending to each other? It is likely that trust evaporated as bankers saw investment banking suddenly ceasing to exist. More importantly, banks suspect each other of carrying toxic securities which have not been fully marked-to-market.
The lack of accountability in Lehman was evident from Richard Fuld’s (former CEO) testimony before the US House Committee on Oversight and Government Reform on October 6, 2008. Fuld said “our actions were prudent based on information available at that time”. This can be contrasted with indications that Lehman may have sold Credit Default Swaps (CDSs) on itself — that is, it sold insurance against its own default. This was intended to be a win-win proposition for Lehman. If it survives, it collects the CDS premiums; and if it does not and Lehman omits to set aside adequate capital against its own default, the resulting losses are borne by creditors. It is likely that several banks sold CDSs to each other and it seems such practices are not prohibited by the US regulators. Fuld also told the House Committee that short-sellers had contributed to Lehman’s bankruptcy. This was a remarkable explanation since Lehman and other market-makers probably engage in short-selling in their proprietary trading. As regards over-generous compensation, the Committee Chairman reminded Fuld that during 2000-2007, he had received about $480 million in cash in addition to payments received in stock.
The initial auctions on October 9, 2008 of the CDSs linked to Lehman’s default, which amount to about $400 billion, yielded 9.75 cents to a dollar. That is, banks and investors who had underwritten the CDSs against default will need to provide the balance 90.25 cents. Some proportion out of this may have already been accounted for since CDSs are marked-to-market. However, the residual exposures cannot be that low since Lehman’s outstanding bonds amounting to $130 billion are presently trading at 8.5 cents to a dollar.
Maurice Greenberg the former head of AIG was forced to leave in 2005 since his firm was found to have manipulated its financial statements. It follows that regulators should have paid particular attention to AIG’s books. Martin Sullivan, who took over from Greenberg, while testifying before the House Committee on 7 October, 2008 said that mark-to-market (MTM) accounting rules destroyed AIG. Whereupon a Committee member was constrained to comment that this was equivalent to blaming “the thermometer for a fever”. Sullivan had to leave in June 2008 as AIG’s losses mounted and he received $50 million as severance pay.
Along with all this disingenuous obfuscation by overpaid CEOs, others have made misleading comments about derivatives. For example, news items refer to the size of the credit derivatives market as $62 trillion without explaining that this is the notional principal for such contracts and net exposures are smaller (in the same way as for other over-the-counter derivatives such as interest rate and currency swaps). Credit derivatives have been called financial weapons of mass destruction. Can insurance be a weapon of mass destruction? CDSs can provide insurance to bond holders against issuers going bankrupt. Since there are regulators for other forms of insurance, why were CDSs allowed to be traded without regulatory supervision and a central clearing house to keep track of net exposures? If current and potential exposures are estimated on a daily basis, collateral posted with custodians, which is reconfirmed by auditors, exposure levels can be contained within risk limits.
To avoid fragmentation of financial sector regulation the UK, Germany and Japan have consolidated their multiple regulators into one regulator. There is also all this discussion about why regulation by principles is superior to regulation by rules. Let us stop fooling ourselves — regulators have to resist interference from political-economy quarters. This is difficult to achieve in practice and one has to reluctantly come to the conclusion that regulators should allow only such innovation in finance which they can supervise.
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At this stage, capital infusion and liquidity enhancement packages are being implemented in countries affected by the financial crisis. Concurrently, regulatory authorities need to employ batteries of finance professionals to get an “independent” idea of the net exposures involved. For example, it is difficult to value CDS exposures because it is not enough to estimate the default probabilities of insured companies and make a corresponding assessment of the risk exposure to the banks which underwrote the CDSs. A reliable estimate of a bank’s exposure would involve listing of all assets and liabilities of the bank’s counterparties and the correlation positions of their respective exposures. Accurate estimation of exposures should restore public confidence that the envisaged levels of provisioning will be adequate.
Of the various plans that have been announced by governments and central banks till October 16, 2008 the UK package appears to be the best conceived. This plan provides for recapitalisation of banks and measures to defreeze inter-bank and money-market lending. In return for recapitalisation, the UK proposal stipulates acquisition of preference shares (which do not give voting rights) and common stock. Tax-payers’ interests would be better served if the preference shares came with a free option that these can be converted into common stock within say the next three years. In the next few years as the full fall-out of this crisis unfolds, governments could decide whether part-public ownership needs to be retained to prevent banks from becoming a drain on public funds again. Effective regulatory oversight is a prerequisite since government ownership is not a solution in itself. As we know from the Indian experience, public sector banks had to be recapitalised on more than one occasion.
(The author is Ambassador of India to Belgium, Luxembourg and the European Union. Views expressed are personal)