Next steps on the road to financial stability

Crises always accelerate the process of change. Two years after the collapse of Lehman Brothers, it is not surprising that the signs of a deep transformation in the financial landscape are very visible. Two main driving forces are at work.

The first is a different perception of risk. For many years an optimistic view that underestimated the level of risk and overestimated its dispersion across participants had become the conventional wisdom; that view has been wiped out by the crisis. A re-pricing of risk of all sorts, higher volatility, reduced valuation of certain assets, more careful examination of credit quality and greater attention to the longer-term sustainability of debt positions – as highlighted by the recent sovereign debt crisis in Europe – are all manifestations of this changed perception. Business models are being reassessed according to their ability to manage risk. Complexity and opacity of financial instruments are no longer rewarded; the demand for transparent, complete and accurate information has increased.

The second source of change is policy driven. After Lehman, any remaining doubts on the need profoundly to reform the financial sector were dispelled. It became clear that a common, internationally co-ordinated approach, involving both advanced and emerging economies, was needed.

At the prompting of the Group of 20 leading economies, and under the co-ordination of the Financial Stability Board, the weaknesses highlighted by the crisis are being tackled. A fundamental step was taken last weekend with the agreement reached by the Basel committee’s governing body on new bank capital and liquidity standards. These standards will markedly increase the resilience of the banking system, including by constraining the build-up of excessive leverage and maturity mismatches that proved the tinder for this crisis.
At the same time, the Lehman case reminds us that other, more deep-seated problems need to be addressed. Lehman was the first global systemically important institution that was allowed to fail during the crisis. It was also the last. The public will not, and should not, accept more such bail-outs. Addressing the problem of “too big to fail” is therefore the next central step in the reform programme.

The work under way in this area has several dimensions. First, systemically important institutions must have loss-absorbing capacity beyond the minimum standards agreed for the banking system in general last weekend. This loss-absorbing capacity could include a combination of equity capital surcharges, contingent convertible capital and mechanisms to “bail in” creditors. The former would increase the resilience of such institutions on an ongoing basis, while the latter instruments would strengthen market discipline.

Second, systemically important institutions will operate with correct incentives only if an effective resolution framework is in place. Many countries lack the powers, the tools and the operational capacity needed in this area. Effective regimes must enable the authorities to resolve financial crises without systemic disruptions and without taxpayer losses. They should include powers that facilitate “going concern” capital and liability restructuring as well as “gone concern” restructuring and wind-down measures, including the establishment of a temporary bridge bank to take over and continue operating certain essential functions. Statutory powers enabling the resolution authority to bail-in senior debt holders would expand the options for going concern resolution.

Third, we need to improve cross-border resolution capacity. Global banks have substantial operations across multiple jurisdictions and thousands of legal entities. In the absence of a global resolution regime, we need not only effective regimes at the national level, but also strong capacity for such regimes to co-ordinate across borders. Assessments of resolvability are part of the recovery and resolution plans being developed by and for the largest international financial institutions. If home and host authorities deem that a bank’s structure is too complex to be resolved in an orderly way, they should demand changes to its legal and operational structure.
Fourth, the effectiveness and intensity of supervision needs to be strengthened both for banks in general, and for systemically important institutions in particular, given the wider damage their failure would cause. Countries need to strengthen supervisory mandates, independence, resources and methods.

Fifth, core financial market infrastructures must be strengthened to reduce contagion risks and to ensure that critical infrastructure is not itself a source of systemic risk. A key source of the risk transmission is the network of major institutions’ exposures to each other; not least in the over-the-counter derivatives and in funding and repo markets. Central clearing arrangements can simplify and greatly reduce the risks associated with this web of counterparty exposures.
The FSB and its members are developing measures in all the above areas and will present their recommendations to the November G20 summit in Seoul.

Last, a central lesson of this crisis was the lack of effective system-wide oversight. One of the blind spots, and an important contributor to the crisis, was the regulatory arbitrage that developed in the shadow banking sector. This sector continues to play an important role in credit intermediation and liquidity transformation, but outside the capital and liquidity regulatory framework that applies to banks. As we strengthen the requirements for banks, we must make sure that we also capture within the regulatory perimeter the sources of systemic risk currently outside it. This will be a priority for the FSB’s work in 2011.

(FT)

U.S. Banks Tightened Loan Terms

A majority of U.S. banks made it tougher for consumers and businesses to get credit in the past three months even as lenders received infusions of taxpayer funds. About 65 percent of domestic banks reported having tightened lending standards on commercial and industrial loans to large and middle-market firms. Large fractions of domestic banks continued to report a tightening of policies on both credit-card and other consumer loans.

It may underscore concern among Obama administration officials and some U.S. lawmakers that banks that have received more than $200 billion of taxpayer funds are failing to lend that on to customers.

The U.S. economy continues to be hampered by a financial system that lost more than $1 trillion on housing credits since the mortgage crisis began in 2007.

Treasury Secretary Timothy Geithner is supposed to soon announce a new strategy for reviving our financial system that gets credit flowing to businesses and families. Obama’s goals are to lower mortgage costs and extend loans to small businesses so they can create jobs.

A less favorable or more uncertain economic outlook was cited by all domestic banks as the cause for tighter standards on commercial loans, as well as lower risk tolerance and problems in specific industries.

By contrast, concern about strains on their capital levels were less of a reason for the tightening in lending standards in the period. Only about 25 percent of domestic respondents said a deterioration in their bank’s current or expected capital position had contributed to the change, in comparison with approximately 40 percent in the October survey.

This result maybe is due to distribution of more than $194 billion through Fed program of purchasing stakes in U.S. banks. It has also mounted rescues of Citigroup Inc. and Bank of America Corp., insuring a total of more than $400 billion of illiquid assets on their balance sheets.

Now, Obama’s team is discussing ways to overhaul the bailout fund, called the Troubled Asset Relief Program, in an effort to ensure banks step up lending. Possible strategies include insuring other banks’ hard-to-value investments, and setting up a so-called bad bank that would remove toxic assets from their balance sheets.

But the question is, who borrows? The decline in demand partly reflects the fact that nearly all banks continued to tighten their lending standards and boost the cost of the loans they did extend, making loans unavailable or less economical for many borrowers.

However, it also shows that the recessionary rot has moved deeper into the economy. Even if efforts to spur consumption are successful, businesses may not need to boost capacity or finance large inventories for some time. Other types of borrowers are in similar straits.

“Liquidity trap” is here, and it will keep Obama finger-crossed for a long time.

Bernanke calls for banking clean-up

Ben Bernanke called for fresh efforts to clean up the US banking system, warning that fiscal stimulus measures alone would not be enough to overcome the economic crisis.

The Federal Reserve chairman said he would like the Obama administration to combine capital injections with a plan to cut troubled assets from bank balance sheets – the idea behind the original version of Treasury secretary Hank Paulson’s troubled asset relief program (TARP). More capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets.

Banks and investors are sitting on many thousand billion dollars’ worth of illiquid assets for which there is little demand and fire-sale prices. There were some $2,794bn worth of US asset-backed bonds alone at the end of last September, including subprime, credit card and commercial mortgage-backed deals, plus more than €1,500bn ($2,010bn) of similar assets in Europe.

Mr Bernanke’s comments came as Obama officials battled to avoid a protest vote in Congress against releasing the second $350bn tranche of the Tarp fund.

The Fed chairman was careful not to tell the Obama team what to do. But raising the possibility that the Obama Treasury might decide to supplement injections of capital by removing troubled assets from institutions’ balance sheets, he gave three options.

One would be public purchases of troubled assets – as proposed by Mr Paulson. A second would be for the government to provide asset guarantees in return for warrants. The third would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank.It seems that we are still on the half way of financial unrest.

Banks link loan to CDS

It’s a new move in the credit market. Some banks including Citi and Credit Suisse are tying corporate loan rates to credit- default swaps. It’s reported that Nestle, the biggest food producer, and Nokia, the largest mobile-phone maker and at least other four companies agreed on banks’ demand to link the interest rate on their credit line to the CDS.

The inclusion of the CDS shows that banks are shifting away from setting loan pricing by relying on debt ratings and Libor. This move may leave companies exposed to fluctuations in derivative instruments that not tightly regulated by government.

This transformation is partly due to the concerns that Libor may not truly reflect borrowing costs helped bring about the change. Earlier this year, widespread suspicion arose that a number of banks had been understating the interest rates they were paying, particularly for 3-month money, and that official Libor rates had therefore been falling short of actual rates in the market place. At times the gap was believed to be as high as 30 bps. While millions of borrowers have clearly been better off as a result of the understatement, this small difference translates into billions of dollars collectively for those on the wrong side of the contracts.

Though collusion between the banks was suggested, a less blameworthy reason is more likely. Individual banks were apparently scared of being seen to be paying too much for their loans, fearing that this might spark off questions about their creditworthiness and lead to bigger problems, such as those suffered by Northern Rock and Bear Stearns.

Banks are also seeking to shift from a reliance on credit ratings amid concern Moody's Investors Service and S&P have been too slow to act when credit quality deteriorates.

It also could be regarded as a self-saving measure by banks. It wasn't long ago that banks were basically giving away credit. That could be major reason we're in the problem today. And those days are gone.