Monday, October 20, 2008

The Lesson of the Financial Crisis

Would tighter control have prevented East Germany from collapse? An analogous lesson to avoid future financial crises is currently offered all over the world by both professionals in financial stability and all-round intellectuals, in particular.

Of course, there were skeptics who did not believe in the Fed funds rate cut of 18 March 2008 as a healer of the credit crunch: why an additional dose of the same drug, low nominal and real rates of interest which was behind the excessive growth of credit and money. There are possibly fewer skeptics who see the on-going crisis as a consequence of the regulatory system of banks.

Any effective measure of regulation creates its own counterforce that tries to nullify the initial impact of regulation because inventive individuals are always clever in finding out ways to circumvent the constraints set on them. Solvency regulation of banks is based on the risk-weighted assets in the balance sheet of a bank that must be matched by the minimum of the so-called tier I capital, i.e., equity in practice.

Because equity is an expensive source of funding the simplest way to avoid issuing new equity is to reduce the size of the risk-weighted balance sheet in respect of a growing loan book. Therefore the US financial institutions transferred the risky loans off balance sheet by the originate-to-distribute practice. Though in Federal Reserve Chairman Ben Bernanke’s words the model "broke down at a number of key points, including at the stages of underwriting, credit rating, and investor due diligence," he believed in fixing the model April 10, 2008. My Green cheese factories post explained why the credit risks were not transferred off balance sheets in the end and why recapitalization of the financial institutions quickly would help the central banks to fight the inflation problem.

An additional means to reduce the size of the risk-weighted assets is to buy insurance for the loan book which contributed to the exceptionally low world interest rates. AIG, an established and profitable insurance company but a novice in evaluating credit risks, was the biggest underwriter of such deals, i.e., the final counterparty that was supposed to bear the risks of mortgage defaults.

Perhaps the final feature of the US system which so abruptly ended the music playing is that their mortgages are non-recourse loans. Such a legal contract gives the borrower the incentive for walking away from the mortgage whenever she expects the value of her house to remain below the value of the mortgage. After the repossession of the collateral, the mortgage will no longer be the borrower’s problem, but the bank gets an additional problem from the realization of the house.

Imagine yourself as investing the extra cash of your bank in short-maturity mortgage backed securities to awaken next morning to the fact that your over-night investment returns a capital loss. You would immediately lose confidence in the issuer of the securities and in all those middlemen who originally helped in its issue. That is why short-term money market rates of interest, libors and euribors, shot up well above the steering rates of the central banks.

Tight solvency regulation of banks combined with low steering rates of central banks is at the root of the current crisis.

One policy comment focuses on tighter regulation, another on better regulation and a third comment on border-crossing regulation in preventing the world from future crises. East Germany was controlled by border-crossing military forces. They did not prevent it from collapse, though choked down uprisings.

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