PrefBlog

Willem Buiter of the London School of Economics has authored Lessons from the 2007 Financial Crisis, published by the Centre for Economic Policy Research.

The paper includes one thoroughly delicious quote that shows the author understands the nature of regulation:

Because Sarbanes-Oxley compliance is mainly a matter of box-ticking (like most realworld compliance, especially compliance originating in the USA), it has not materially improved the informational value of accounting or the protection offered to investors.

All in all, the essay is extremely good … I may not agree with all of it, but the man makes some good points and has some well-founded opinions. I’ll present some quotes from the essay with my own thoughts … but the full document is well worth reading.

There is a long section on the credit rating agencies. Mr. Buiter states as problems:

• Any model of credit risk will have flaws and these flaws may be exploited by issuers. Even honest models won’t work particularly well during black swan events.
• Only default risk is rated – not market risk and not liquidity risk
• agencies are conflicted, in that:
  • they are paid by the issuers
  • they sell advisory services to their rating service clients
  • the complexity of some instruments results in designer and issuer working with the same model … possibly one designed by the issuer

To Mr. Buiter’s credit, he does not attempt to solve the first two problems with rhetoric:

There is no obvious solution other than ‘try harder and don’t pretend to know more than you know’ for the first problem. The second problem requires better education of the investing public.

His third problem, which has three facets, has a five part solution:

• Reputational concerns
• Remove the CRA’s quasi-regulatory role
• Make the CRAs one-product firms
• End payment by issuer
• Increase competition

I don’t have a major problem with the idea of removing the CRAs’ quasi-regulatory role (their ratings are a factor in determining the credit conversion factor that converts the total value of the loan to risk-weighted assets), but Mr. Buiter is not clear on what is to replace the current system.

It seems clear that a loan to IBM is safer than a loan to Joe’s Barbershop; it also seems clear that this difference should have an effect on the measured risk profile of the bank. I suggest that the CRAs have a very good track record in assessing these risks – and yes, I am including the subprime & Enron debacles when reviewing their record.

The thing about risk, you see, is that it’s risky.

With respect to his third proposition, making the CRAs one-product firms … how is he going to enforce this and why would he want to? Yesterday we saw extremely poor performance by the CIBC preferred issues. I will suggest that some portion of this, at least, was due to stockbrokers telling their clients that CIBC was a relatively poor credit (relative to other banks, and relative to their financial position last year at this time) and exposure to it should be minimized. In such a case, the stockbroker is acting as a Credit Rating Agency.

In the absence of a regulatory role for CRAs, how is one to differentiate between a one-product-by-regulation firm and … anybody else?

His proposal for ending issuer payment is so convoluted I will reproduce it in full, to avoid charges of mockery by misquotation:

Payment by the buyer (the investors) is desirable but subject to a ‘collective action’ or ‘free rider’ problem. One solution would be to have the ratings paid for by a representative body for the (corporate) investor side of the market. This could be financed through a levy on the firms in the industry. Paying the levy could be made mandatory for all firms in a regulated industry. Conceivably, the security issuers could also be asked to contribute. Conflict of interest is avoided as long as no individual issuer pays for his own ratings. This would leave some free rider problems, but should permit a less perverse incentivised rating process to get off the ground. I don’t think it would be necessary (or even make sense) to socialise the rating process, say by creating a state-financed (or even industryfinanced) body with official and exclusive powers to provide the ratings.

Frankly, I don’t understand why his proposed solution, involving mandatory payments by firms in the industry, is different from the socialization he decries. There may also be some conflict with his proposal to emphasize reputational concerns and competition … how do I go about getting some of the lolly? Can I just declare to the central body that I am a credit rater, that will be $500,000 please?

Reputational concerns and competition currently work along the lines of … some firms are better regarded by investors than others. I, for instance, have greater respect for Fitch and Moody’s than for S&P and DBRS … give me my choice of any two ratings on a bond, and you know which ones I’ll pay attention to! How would this be reflected in such a centralized system?

In the end, I have to reiterate my familiar refrain: Credit Ratings are Advice. Take it, leave it, your choice. So far, the Bank of Canada has said it best:

investors should not lose sight of the fact that one can delegate tasks but not accountability.

After reviewing the macroeconomic situation he makes further proposals, including:

if a financial institution borrows short and lends long, if it borrows liquid (during normal times, but with the risk of occasional illiquidity in its usual funding channels) and lends illiquid, and if banks are substantially exposed to it, then it should be regulated like a bank, even if it says ‘Hedge Fund’ on the letterhead. The rules should aggressively chase the unceasing attempts, through institutional and instrument innovation, to avoid regulation.

I disagree with this, particularly with the implicit belief that rules exist in order that they be followed. The weak point of the argument here is “if banks are substantially exposed to it“. It does seem likely that there has been far too much contagion in the past crisis, but regulating the universe is not the proper answer. What should be done is to improve the capital requirement rules and force the banks to make a more substantial capital provision for their riskier assets – such as Mr. Buiter implies is a good description for their hedge fund exposure.

If the risk weights applied to, for instance, the provision of a global liquidity line to a SIV have been shown to be inadequate (and this has not been documented, although I suspect that it is the case) … increase the risk weight of the line! Currently it’s at a flat 10% … I suggest that a tiering be considered, so that a bank with $10-billion of tier 1 capital can extend such a line for $10-billion at the 10% rate, but the next ten billion is charged at a 20% rate, etc.

Ensuring that everything is regulated is poor policy. Let us ensure that the core of the financial system – the banks, who have access to lines provided by the central banks – is secure, and then let people play around on the edges to their, and their investors’, hearts’ content.

The main problem with the arrangement [separating bank supervision functions from liquidity provision functions] is that it puts the information about individual banks in a different agency (the FSA) from the agency with the liquid financial resources to provide short-term assistance to a troubled bank (the Bank of England). This happened when the Bank lost banking sector supervision and regulatory responsibility on being made operationally independent for monetary policy by Gordon Brown in 1997. It’s clear this separation of information and resources does not work.

This issue was discussed on December 5.

Liquidity can vanish today, because market participants with surplus liquidity fear that both they themselves and their potential counterparties will be illiquid in the future (say, three months from now), when the loans would have to be repaid. A credible commitment by the Central Bank to provide liquidity in the future (three months from now) would solve the problem, but it is apparent that the required credibility simply does not exist. Therefore, the only time-consistent solution, in the absence of a credible commitment mechanism, is to intervene today at a three-month maturity.

One lesson – that Canadian non-bank ABCP investors will be happy to explain thoroughly – from the current crisis is that liquidity risk is different from credit risk. Traditionally, LIBOR spreads are explained in terms of credit risk – I suggest that liquidity risk is the operational concern and that liquidity hoarding is its sympton. I remember on anecdote from the Panic of 1907 … a banker complained to J.P. Morgan that his liquid assets had been eroded to 18% … Morgan gave him the what-for, telling him that liquid assets were held precisely for such circumstances.

If a bank’s afraid to make three-month interbank loans because it might have its credit lines drawn on in the intervening time, then part of the problem is that it has too many lines – a problem that would be addressed by higher capital charges.

To address the point, however, I have no problem with, for instance, a regular three month term facility, to be financed with treasury bills as a neutralizer.

Capitalism, based on greed, private property rights and decentralised decision making, is both cyclical and subject to bouts of financial manic-depressive illness. There is no economy-wide auctioneer, no enforcer of systemic ‘transversality conditions’ to rule out periodic explosive bubble behaviour of asset prices in speculative
markets. It’s unfortunate, but we have to live with it. The last time humanity tried to do away with these excesses of capitalism, we got central planning, and we all know now how well that worked. Hayek and Keynes were both right.

Hear, hear!

All in all, a fine article.