Tuesday, May 29, 2012

Regulations adopted since financial crisis inhibit recovery

In his Telegraph column, Jeremy Warner provides a terrific description of the financial regulations adopted since the beginning of the financial crisis.

In this description, he confirms your humble blogger's observation that the regulations are a response to the financial crisis that treat symptoms without looking at the root cause.  Since the regulations only treat symptoms, they often contradict each other and/or inhibit recovery of the real economy.

As if the [corporate debt] refinancing problem wasn't already challenging enough, into it all stumbles the European commissioner for internal markets, Michel Barnier, to prove the old saw that there is no mess quite so bad that official intervention won't make even worse.... 
After a crisis of the magnitude we've just seen, it's perfectly right and proper, and certainly very human, to want to take immediate steps to fix the system, so as to ensure that this kind of nonsense can never happen again. 
However, you cannot count on luck if you want to fix the system and make sure this doesn't happen again.  You actually have to look not at the symptoms, but the root causes.

If policymakers had looked at the root causes of the financial crisis, they would have seen that the bankers  reintroduced opacity into the financial system.

They did this in many ways.

For example, rather than offer ultra transparency that was the sign of a bank that could stand on its own two feet, banks complied with minimalists disclosure requirements and turn themselves into 'black boxes'.

For example, they created structured finance securities that gave Wall Street an informational advantage over the investors as Wall Street had access to reports on the underlying collateral performance well before investors.
There is also something to be said for striking while the iron is hot. Leave things too long, and the political will to act melts away.
Actually, by investigating the cause(s) of the financial crisis, the political will to regulate remains.  This was shown in the aftermath of the Great Depression when the Pecora Commission paved the way for the regulations implemented by the FDR Administration 3+ years after the start of the financial crisis.
Even so, it's not clear that right now, with the crisis self evidently approaching some kind of fresh denouement, is the time to be buttressing the system against the once in a hundred year event of the present maelstrom. Nor in any case can the sort of extreme regulatory overkill we are seeing at the moment ever be seen as appropriate.
As I have been saying since the start of the financial crisis, the right regulation can both resolve the current problems with the financial system and buttress the financial system against the once in a hundred year event.

The right regulation was to adopt ultra transparency and shine a light into every opaque corner of the financial system.

Adopting ultra transparency leads directly to adoption of the Swedish model.  This leads to banks recognizing the losses on all the excess debt in the financial system.  In turn, this removes the burden of servicing this debt from the real economy and the restoration of growth.

Adopting ultra transparency also leads directly to market discipline being applied to the financial system.  With this disclosure, investors can actually assess the risk of banks and structured finance securities.  This leads directly to an ability to value these securities and make investment decisions (buy, hold, sell) based on the prices being shown by Wall Street.
As far as I know, Mr Barnier is well intentioned enough. He wants to protect us all from the calamities of the past. But in attempting to regulate away all future risk, he also threatens to undermine growth and further reduce already wanting European competitiveness. 
To be fair, it's not all Mr Barnier's fault. He's only part of a posse of international regulators riding furiously off in the wrong direction long after the horse has bolted.
A direct result of not investigating the causes of the financial crisis.
If even a fraction of the time spent on trying to protect us against a crisis that's already happened was devoted to finding a way out of it, then we might actually be getting somewhere. As it is, almost every part of the reform agenda is making matters worse, not better.
Please re-read the highlight text as it summarizes both why ultra transparency needs to be adopted and why most of Dodd-Frank (the Consumer Financial Protection Bureau and Volcker Rule being exceptions) should be repealed.
In its analysis of the refinancing challenge, S&P concedes that it might just about be possible for the banking system to cope with the wave of corporate debt maturities, assuming no further deepening of the eurozone crisis. But providing the $13 trillon to $16 trillion of new money to spur growth is going to be a much bigger ask, especially in Europe. 
"Much will depend on the continued ability of banking system regulators to pilot a path through the minefield that lies ahead", S&P observes. 
Well that appears to be that, then. Abandon all hope, for at the moment these very same regulators seem to be blundering their way forward as if entirely unaware of what lies beneath their feet. Ever more onerous capital and liquidity requirements have steepened the refinancing challenge, even with highly supportive central bank funding on hand. 
European banks, still grappling with high leverage and a worsening sovereign debt crisis, are particularly badly affected. Because of the escalating European banking crisis, they face intense pressure to meet new capital and liquidity requirements more quickly. With new equity virtually impossible to raise, this has only further exaggerated the de-leveraging problem. Enforced recapitalisation from governments which are themselves insolvent scarcely helps matters.
The financial regulator driven credit crunch I previously discussed.
In the US, there is at least a highly developed corporate bond market to act as an alternative to bank funding.
The reason is that non-financial corporations have to provide disclosure that provides all market participants with acces to all the useful, relevant information in an appropriate, timely manner.
That's not the case in Europe, where to the contrary, the regulatory agenda seems determined to put as many obstacles in the way of a viable bond market as possible. 
Standard & Poor's calculates that if corporate issuers in Europe were to tap the bond market for 50pc of their new funding requirements (up from 15pc historically), it would imply net new yearly issuance of $210bn to $260bn. In only two years in the last decade has net new European issuance exceeded $100bn. 
You might think this a significant growth opportunity, but Mr Barnier's new solvency directive threatens to snuff that one out too, by requiring that only the most credit worthy and liquid bonds count for capital purposes. 
The new solvency requirements virtually outlaw bundling together corporate loans and issuing them as asset backed securities, or rather, they prevent financial institutions from providing a viable source of demand for such bonds. Instead, finance is pushed by regulation ever more aggressively into sovereign bonds, even though many of them are now less than credit worthy.
As I previously said, most of the regulations that have occurred since the beginning of the financial crisis should be dropped.

Today, bank capital is completely meaningless (by extension, so are bank capital requirements).  Regulators are practicing forbearance and as Spain has shown banks have a virtually unlimited number of ways to practice 'extend and pretend' on zombie borrowers.

 Mr. Warner identifies one of several problems with the new solvency requirements.

A much better approach would be to adopt ultra transparency.  This will end the financial regulators' information monopoly and bring market discipline to the banking system for the first time in almost 80 years.

My bet is that market participants will reward firms that have a strong, liquid balance sheet.
Europe desperately needs growth, but it seems determined to stifle the credit needed to provide it. How stupid can you get?

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