Enlightened Economics

Economics for an Enlightened Age

Posts Tagged ‘Bank for International Settlements’

• Banks’ Cheap Money is Economic ‘Poison’

Posted by Ron Robins on March 13, 2011

By Ron Robins. First published March 10, 2011, in his weekly economics and finance column at alrroya.com

Developed world bankers continue to proclaim that enforced low interest rates—cheap money—will lead their countries back to economic prosperity. But didn’t the same policies a few years ago help bring us to the precipice of financial and economic collapse? Do they still not understand that cheap easy money led to many large US and European banks becoming gambling institutions, eventually failing and bailed out at taxpayers’ expense?

And above all, that cheap easy money enticed people, companies and governments, to become horribly indebted, with many individuals and companies failing. Soon, even developed country governments may go bankrupt. As proof that cheap easy money is again causing extraordinary economic problems, just look at where some of it is now going—to the commodities’ markets. There, it helps inflate food prices, thus causing starvation and food riots around the world.

Do the bankers not read history and know that artificially induced cheap easy money can be economic poison?

Of course one simple reason that many bankers advocate cheap easy money is that it makes them a lot of money. When they can—as they did for many years and still seem able to do—‘leverage-up’ their assets in relation to their equity, they can make multiples of profits compared to before. And since, often courtesy of their benevolent central bank, they can frequently borrow at nearly free rates and ‘invest’ those proceeds in bonds/securities/commodities that often offer high potential returns, it is possible for them to make ever bigger profits.

For most large US and European banks, their assets frequently exceeded their equity by 20 to 60 times before the financial crises. That is, keeping it simple, they were somehow able to leverage every $1 of equity, usually by borrowing funds, to create $20 to $60 of assets! The risk in such high leverage is that a small loss in asset values of say, just five per cent, could wipe out their equity and cause insolvency and bankruptcy.

Unfortunately, very high leverage ratios continue in many developed countries’ banking and financial institutions. (Perhaps this is the real unspoken reason for cheap money: to inflate asset markets to keep the banks semi-solvent! Though, that topic is for another post.)

Therefore, the real story is the culture of leverage and risk that numerous developed world banks now embody as a result of easily available cheap money. This is in contrast to that during much of banking history when money was regularly relatively expensive (with higher rates of interest) than today and often difficult to obtain.

The easily available cheap money encourages enormous ‘moral hazard’ among bankers and all players in the financial system. Moral hazard denotes a lack of morality and a carefree greed mentality that produces excessive speculation. It is this attitude that promotes the creation of maximum leverage and the taking of big risks—and not caring too much about any potential losses as they are covered by others. Bankers under the influence of moral hazard are like addicted gamblers who cannot stop gambling. But the gambling is not at the card table. It takes place in their boardrooms and trading desks.

And fortunately for the bankers they can enjoy their moral hazard largely at the expense of taxpayers. As we know, much of the potential and accumulated massive losses in the US and European financial and banking systems have been transferred to governments and central banks. The US and European governments and central banks make light of these burdens saying that as their economies recover these losses will be greatly reduced. However, the ‘central bank of central banks,’ the Bank for International Settlements (BIS), has issued new global bank regulations (Basel III) that—if implemented—might reign in some of the excesses associated with moral hazard.

Of course not all banks speculate or gamble to the same extent. In Islamic banking, spiritual and ethical considerations greatly restrain speculation. Also, for instance, Canadian banks adhere to more conservative principles and are better regulated and so have not suffered the same fate as that of many of their US and European rivals.

For now though, cheap easy money is seen by bankers as our economic salvation. And it inflates global markets, including those related to food and energy. As their prices rise, the unforeseen repercussions of the bankers cheap easy money ‘poison’ assists in creating starvation, food riots, and political upheaval around the globe.

Furthermore, the continuing high leverage, moral hazard, and gambling tendencies within the banking and financial system assures that some of today’s ‘good’ investments will sour and suffer large losses. Will the taxpayers again assume those losses? If not, then what? Until the cheap easy money poison is banished it continues creating conditions for even bigger economic and social catastrophes in the years ahead.

Copyright alrroya.com

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Posted in Banking, Economics, Monetary Policy | Tagged: , , , , , , , , , , , , , , , , , , | Leave a Comment »

• New Bank Regulations Likely to Fail

Posted by Ron Robins on December 22, 2010

By Ron Robins. First published December 15, 2010, in his weekly economics and finance column at alrroya.com

New banking and financial industry regulations in the US and the Basle III rules for banks globally—might fail on key issues. The newly enacted US Dodd-Frank Wall Street Reform and Consumer Protection Act, despite its noble purpose to prevent further financial chaos, is unlikely to do that. And the Basle III requirements for higher and better quality bank reserves are good on paper, but full implementation is improbable amidst likely future hefty bank losses.

At the heart of the financial crises were derivatives, and as Warren Buffett the famed investor has warned, “derivatives are financial weapons of mass destruction.” Yet, after about two years of Congressional wrangling, the Dodd-Frank bill incorporates a rough future structure for derivatives but authorizes yet another committee to report back in the spring of 2011 with detailed regulations governing them. And the old expression, ‘the devil is in the details,’ is never more apt than in this instance.

Already, US Banks are calling for derivatives called ‘foreign exchange swaps’—a $42 trillion market—to be exempt from the rules.

Derivatives are major profit centres for the too-big-to-fail US banks. These banks have repeatedly told US lawmakers—who receive considerable campaign funding from them—not to restrict those profits. Because of the influence of Wall Street on the Obama Administration and the US Congress, it is difficult to be hopeful that when it comes to the detailed regulations, and especially their enforcement, that much will really change concerning US banks’ derivatives’ activities.

Two particular varieties of derivatives are at the centre of our financial debacle. They are mortgage backed securities (MBS) and credit default swaps (CDS). The latter, though originally considered ‘insurance policies’ against debt default, are now frequently gambling vehicles that incentivize the taking-down of struggling companies (AIG)—and now, governments (Ireland?).

The size of the derivative problem for US banks cannot be overstated. As Alasdair Macleod, a British banker and economist remarked on October 28, “according to the FDIC [the US Federal Deposit Insurance Corporation], outstanding derivatives held by US banks increased from $155 trn to $225 trn between mid-2007 and mid-2010. In other words, since the credit-crunch the derivative bubble in the US has grown a further 45 per cent and is now fifteen times total US GDP, literally dwarfing the banks’ total equity, which is only $1.35 trn. Consider this fact: derivative exposure is 189 times total bank equity.”

Aside from the derivatives issue, and also not addressed in the Dodd-Frank bill, are the two massive US mortgage progenitors now on US government life-support, Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac were formerly somewhat private institutions and own or guarantee about half of all US residential mortgages. But as the real estate crises exploded and due to their potential for vast losses that could paralyse the housing markets, the US government commandeered them in September 2008.

The principle offering in the Dodd-Frank bill concerning Fannie Mae and Freddie Mac is that by January 2011 President Obama offers a proposal to Congress to bring them out of government receivership.

Thus, on the two vital issues of derivatives and real estate, the Dodd-Frank bill seems queasy and deficient. These inadequacies allow for a re-ignition of the financial meltdown at almost any time.

Acknowledging the severe problems in the banking industry, banking regulators have introduced new global banking rules. In September, the Bank for International Settlements (BIS) in Geneva, Switzerland—which sets the regulations that banks everywhere generally adhere to—issued its Basel III regulations, which are due to come into effect for all banks between 2013 and 2019.

Basel III’s most important requirement will be that banks hold higher and better quality reserves.

But the BIS may be too optimistic about the ability of many banks, particularly the too-big-to-fail banks, to reach the new reserve requirements. For instance, a Reuters report on November 21 said, “the new Basel III banking rules will leave the biggest US banks short of between $100 billion and $150bn in equity capital, with 90 per cent of the shortfall concentrated in the top six banks, the Financial Times said, citing research from Barclays Capital.”

However, these equity shortfalls may well err on the low side. In the next few years, US and European banks especially, are likely to be hit with big waves of new losses related to real-estate, derivatives, and sovereign debt.

Real estate losses because US and European banks have still not written-off their full potential losses concerning toxic MBS that they may have to buy back due to newfound paperwork improprieties related to the emerging foreclosure fraud, as well as mortgage losses generally, on foreclosed and other properties.

Additionally, banks may suffer further huge derivative losses as they are eventually forced to price certain derivative and other asset classes at more realistic appraisal values instead of the ‘mark to fantasy’ that often now exists.

And recently, an even greater potential hit to banks’ capital has arisen: the possibility of gargantuan losses on bad sovereign debt in the EU and elsewhere.

On September 13, The Economist magazine had this to say on the MBS and derivatives issue relating to Basle III. “The most serious failure in Basel III is that it doesn’t address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights [for instance, risks associated with MBS]… What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.”

The US Dodd-Frank bill either passes the buck or overlooks the very problems that led to the financial meltdown, and the Basel III regulations may be rendered impotent due to massive future bank losses. Thus, these new bank regulations are likely to fail.

As Henry Ford, the founder of the Ford car company once said about banking, “it is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

Copyright alrroya.com

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