The US Financial Crisis Inquiry Commission’s (FCIC’s) report on the financial sector meltdown of 2008 was submitted at the end of January 2011. The FCIC, which was established on the lines of the 9/11 Commission, comprised six members with Democratic and four with Republican sympathies. The Democratic majority’s views in this voluminous 662-page report and the two separate dissenting notes of the Republicans were on expected lines.
According to the majority view of the six Democratic FCIC members, the crisis of 2008 was avoidable and the principal causal reasons were: (a) Thirty years of steady deregulation; (b) excessive leverage; and (c) failure of credit rating agencies. The first dissenting note of three Republican members claimed that the crisis was caused by: (a) cheap credit which came from China and oil-exporting capital surplus countries; (b) non-traditional mortgages, securitisation and credit rating agencies; and (c) leverage. The second dissenting note from the fourth Republican member begins with a broadside that since the Congress had already passed the Dodd-Frank Act, it was too late to investigate what caused the financial crisis. According to this lone dissenter, from the right-wing American Enterprise Institute, the crisis was caused by: (a) low interest rates and inflow of funds from abroad; and (b) US government policies which encouraged risky housing loans. The point to note is that these disagreements on causality will be used by the finance industry to discredit the report and resist change.
In the UK, the Independent Commission on Banking (ICB), which is headed by John Vickers, is scheduled to submit its findings in September 2011. The ICB’s recommendations will be aimed at “reducing the probability and impact of systemic financial crises in the future to maintain the efficient flow of credit to the real economy”. Vickers spoke at London Business School on January 22 and his speech has attracted more attention than the FCIC report.
According to Vickers: (a) the rise in bank leverage leading to the crisis was “explosive”; (b) tax systems in developed Western countries favour corporate and personal debt compared to equity; (c) concern about consequences of making senior debt holders absorb losses led governments to “jump the queue” and fund bailouts; and (d) banks need more risk capital than what has been prescribed under Basel III.
Vickers was non-committal about contingent capital bonds (CoCos). Under the CoCo proposal, banks would issue bonds to raise debt capital which would convert automatically to equity if pre-agreed conditions of stress are triggered. This is a poor idea since it would be impossible to price such bonds correctly. Lead managers of CoCo bonds are likely to under-price the embedded option in these bonds. For instance, it was reported in the Financial Times of February 15 that Credit Suisse is planning a $6.2 billion CoCo issue. The debt- to-equity conversion would be triggered if Credit Suisse’s Tier I common equity ratio under Basel III falls below 7 per cent. If the trigger event were to happen, even at the envisaged coupon of 9 per cent for this CoCo bond, investors would probably find that they were not compensated adequately for the options they had implicitly sold to Credit Suisse.
Vickers does not seem convinced about segregating narrow/utility banking from casino/investment banking. Irrespective of individual opinions, lending volumes and efficiency in credit intermediation need to be promoted without engendering systemic risk. In this regard, many proposals have been aired such as the Volcker Rule and the reimposition of the Glass-Steagall Act. Another idea that is doing the rounds is to separate limited purpose banking, which would be funded 100 per cent by equity, from all other types of banking. This type of no-leverage banking has been advocated by Professor Lawrence Kotlikoff who seems to be exasperated with the steps taken till now to make a clean break with practices that lead to the breakdown in 2008. To quote Kotlikoff, “We’ve seen the Dodd-Frank Act, which left the current system’s terrible dangers largely in place. Wall Street has done it again.”
Risk taking could be severely restricted by allowing only limited purpose banks to be granted the limited liability company (LLC) status. As Kotlikoff has remarked, “Brilliant titans of Wall Street who produced the financial debacle would not have done so had their homes, villas, yachts, Austin Martins been on the line.” On balance, my sense is that the finance industry’s voracious tendency to gorge itself on leverage would be tempered if banks were to be eligible for the LLC status only if their debt-equity ratios were below prescribed ceilings.
There are continuing sharp differences of opinion between the finance industry and policy makers on compensation packages and bonuses. For example, on February 9, Lord Oakeshott, the Liberal Democrat UK Treasury spokesman, resigned because he disagreed with the government’s decision to allow the heads of Royal Bank of Scotland (RBS) and Lloyds to receive generous bonuses. After government bailouts, RBS and Lloyds are currently 84 per cent and 41 per cent owned by taxpayers. Oakeshott is reported to have remarked: “I have pinched myself in recent weeks and asked who is really running the country — the banks or the elected government?” I guess no prizes were offered for answering that question.
The FCIC report, ICB’s work and controversies about compensation are of limited relevance in India. At the same time, the extent to which any financial firm is leveraged is a dominant factor in determining its exposure to risk. Therefore, as India’s linkages with international markets increase, we should not allow financial firms to raise their leverage to self-serving levels. Indian policy makers could examine what should be the debt-equity levels above which LLC status should be diluted or even withdrawn. Further, let us not mimic practices in external financial markets just because those jurisdictions have higher per capita incomes. For instance, there have been press reports about State Bank of India (SBI’s) teaser housing loans. In fairness to SBI, these loans were probably not quite the kind of teaser interest rate loans offered in the US at the height of the housing boom mania. There is little available in the public domain about whether the exposures from SBI’s teaser loans could prove to be material.
Press coverage was more about SBI thumbing its nose at the Reserve bank of India. Maybe we could improve the quality of the discussion on risk exposures and be more mindful of what is relevant and what is not.
The author is India’s Ambassador to the European Union, Belgium and Luxembourg
The views expressed are personal
