Regulation And Ratings

There’s a fascinating new working paper at the NBER that examines how the confluence of ratings and regulation conspired to help create the 2008-2009 global financial crisis (abstract):

Rating Agencies
Harold Cole, Thomas F. Cooley

For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings was compromised by the evolution of the industry to a form where issuers pay for ratings. In this paper we show how credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. There will always be an information distortion because of the fact that purchasers of ratings need not reveal them. We argue that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them. In this respect, much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.

Skipping over the math, what Cole & Cooley observe is that credit ratings and rating agencies continue to function pretty well, even under the potential conflict of interest arising from the “issuers pay” model, at least for “vanilla” credit securities.

BNM Annual Report 2013

I think I’ve finally settled down enough to start writing for the blog again, but posts will be a little sporadic still until I feel like I’ve got all the pieces of my new job in place. That might still take some time, so I’ll be focusing less on day-to-day data releases, and more on big picture stuff for now. I’ll probably go back to more regular posting in a few months or so.

In the meantime, Bank Negara released their annual report yesterday. There’s no big surprises in terms of their view on the economic outlook – better recovery in advanced economies (leading to higher export demand), and moderating growth in emerging markets. They’re less pessimistic on growth prospects for the latter than many others are. The Governor for instance was quite emphatic that China will be able to overcome their structural and financial imbalance issues, and avoid a hard landing.

Emerging Markets: No, It Isn’t 1997 Again

It seems to be my day to get beaten to the gun. I was going to write a post on this issue, but Lars got there first (excerpt):

Please don’t fight it – the risk of EM policy mistakes

Emerging Markets are once again back in the headlines in the global financial media – from Turkey to Argentina market volatility has spiked from the beginning of the year….

…Lets take the case of Turkey and lets assume Turkey is operating a pegged exchange rate regime – for example against the US dollar. And lets at the same time note that Turkey presently has a current account deficit of around 7% of GDP. This current account deficit is nearly fully funded by portfolio inflows from abroad – for example foreign investors buying Turkish bonds and equities.

Tapering And What To Do About It

As always in such matters, the answer is: it depends (excerpt; emphasis added):

Should Policy Makers in Emerging Markets be Concerned about “Tapering”?

The US and European economies are showing some signs of recovery from the global financial crisis that began in 2008. As a result, the US Federal Reserve Bank is considering phasing out, or “tapering”, the extraordinary monetary policy measures through which it responded to the crisis…The World Bank's East Asia and Pacific regional update estimated that in East Asia alone $24 billion was withdrawn from equities and $35.2 billion from bonds...Financial markets largely recovered once the Fed decided to postpone tapering in September, but there is still nervousness….

The Role Of Credit Ratings: No Replacement On The Horizon

Credit rating agencies aren’t perfect – in fact, far from it. Ratings can sometimes (often?) be inaccurate guides to the potential for debt defaults, and the consistency and integrity of ratings can and have been questioned. The business model used by most credit rating agencies globally, where debt issuers pay for ratings on their own debt, is subject to potentially considerable conflicts of interest.

Unfortunately, attempts to find a replacement have come up with alternatives that are even worse (abstract):

Replacing Ratings
Bo Becker, Marcus Opp

Since the financial crisis, replacing ratings has been a key item on the regulatory agenda. We examine a unique change in how capital requirements are assigned to insurance holdings of mortgage-backed securities. The change replaced credit ratings with regulator-paid risk assessments by Pimco and BlackRock. We find no evidence for exploitation of the new system for trading purposes by the providers of the credit risk measure. However, replacing ratings has led to significant reductions in aggregate capital requirements: By 2012, equity capital requirements for structured securities were at $3.73bn compared to of $19.36bn if the old system had been maintained. These savings reflect the new measures of risk, and new rules allowing companies to economize on capital charges if assets are held below par. These book-value adjustments dilute the predictive power of the underlying risk measures, Our results are consistent with a regulatory change being largely driven by industry interests rather than maintaining financial stability.

Somehow, getting fund managers and private equity firms to do portfolio risk assessments strikes me as a little bit like putting the fox in charge of the hen house.

Driven by “industry interests”, indeed.

Technical Notes

Bo Becker, Marcus Opp, "Replacing Ratings", NBER Working Paper No. 19257, July 2013

The Hammer Falls

BNM isn’t wasting much time (excerpt, emphasis added):

Measures to Further Promote a Sound and Sustainable Household Sector

Bank Negara Malaysia announces today, the implementation of a set of measures aimed at avoiding excessive household indebtedness and to reinforce responsible lending practices by key credit providers. These measures, which take effect immediately, complements the earlier measures introduced since 2010 to promote a sound and sustainable household sector. The measures are:

1. Maximum tenure of 10 years for financing extended for personal use;
2. Maximum tenure of 35 years for financing granted for the purchase of residential and non-residential properties;
3. Prohibition on the offering of pre-approved personal financing products.

The limits on financing tenure will not affect applications made before today...

...These measures are issued pursuant to section 31(1)(a) of the Central Bank of Malaysia Act 2009 and apply to all financial institutions regulated by Bank Negara Malaysia, credit cooperatives regulated by the Suruhanjaya Koperasi Malaysia, Malaysia Building Society Berhad and AEON Credit Service (M) Berhad. This is to ensure consistency in the financing practices across all the key credit providers.

Not before time. This action was long overdue, and only needed the legislative authority to allow BNM to enforce it effectively outside of the banking system.

About the only other thing I can think of to add to this would be if the government tightened its own limits on salary deductions allowed to civil servants. But that’s obviously not within BNM’s purview.

The Financial Services Act

BAFIA is no more; long live the FSA (excerpt):

Financial Services Act 2013 and Islamic Financial Services Act 2013 Come Into Force

The regulatory and supervisory framework of Malaysia enters a new stage of its development as the Financial Services Act 2013 (FSA) and Islamic Financial Services Act 2013 (IFSA) come into force on 30 June 2013.

The FSA and IFSA is the culmination of efforts to modernise the laws that govern the conduct and supervision of financial institutions in Malaysia to ensure that these laws continue to be relevant and effective to maintain financial stability, support inclusive growth in the financial system and the economy, as well as to provide adequate protection for consumers. The laws also provide Bank Negara Malaysia with the necessary regulatory and supervisory oversight powers to fulfil its broad mandate within a more complex and interconnected environment, given the regional and international nature of financial developments. This includes an increased focus on preemptive measures to address issues of concern within financial institutions that may affect the interests of depositors and policyholders, and the effective and efficient functioning of financial intermediation.

It is important that Malaysia's regulatory and supervisory system is adequately equipped to respond effectively to new and emerging risks so that confidence in the financial system is preserved and that the critical financial intermediation activities which are vital to the economy are not disrupted. The FSA and IFSA amalgamate several separate laws to govern the financial sector under a single legislative framework for the conventional and Islamic financial sectors respectively, namely, the Banking and Financial Institutions Act 1989 (BAFIA), Islamic Banking Act 1983, Insurance Act 1996 (IA), Takaful Act 1984, Payment Systems Act 2003 and Exchange Control Act 1953 which are repealed on the same date…

Shadow banking has become an increasing concern among regulators the world over in the aftermath of the Great Recession. The FSA and IFSA is BNM’s response, allowing it broader powers and a wider scope for those powers, encompassing “financial holding companies and non-regulated entities to take account of systemic risks that can emerge from the interaction between regulated and unregulated institutions, activities and markets.”

This suggests that entities previously outside banking regulation such as co-ops, development institutions, and companies with significant shareholdings in banks may come under BNM’s withering and critical eye.

I can’t wait to see what happens.

Putting A Price Tag On Moral Hazard

I’m conscious of the fact that there are many more readers of this blog than there used to be, and not many have a background in economics.

So to introduce this subject, here’s Wikipedia’s definition of moral hazard:

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.

BNM Watch: Liberalisation Measures

Announced yesterday, among the first moves under the new Financial Sector Blueprint:

Liberalisation measures to develop the domestic financial markets

As part of continuous efforts by Bank Negara Malaysia to enhance competitiveness in the economy and to develop the domestic financial markets, Bank Negara Malaysia wishes to announce the following liberalisation measures, with effect from 31 January 2012:

• To further spur the domestic foreign exchange market through greater product innovation, licensed onshore banks are permitted to trade foreign currency against another foreign currency with a resident.
• To further deepen the domestic interest rate derivatives market, a licensed onshore bank is allowed to offer ringgit-denominated interest rate derivatives to a non-bank non-resident.
• Towards enhancing the asset liability management of residents, flexibility is permitted for a resident to convert their existing ringgit or foreign currency debt obligation into a debt obligation of another foreign currency.

The above measures which are in line with the broad thrust of the Financial Sector Blueprint will contribute towards increasing the liquidity, depth and participation of wider range of players in the domestic financial markets.

The Future of Banking

VoxEU has a new compilation of the latest European thinking on  reforming finance. While a lot of it is in EconoEnglish, I think many will find some sympathy with the ideas and issues being addressed. For example, since in a crisis the importance of finance to the economy means that banks will be bailed out or at least debt will be worked out, there is a socialisation of losses but gains will be private in more normal times. In other words, there is a negative externality involved in banking, which is not fully reflected in its pricing, the pursuit of gain or risk taking, or in its distribution of profits.

These and more issues are discussed, so if you’re willing to wade through some of the jargon, the e-book is still a worthwhile read.

Technical Notes:

Beck, Thorsten ed., “The Future of Banking”, Centre for Economic Policy Research, October 2011

Maybank Chief Says: Personal Loans A Concern

Responsible corporate citizen or conniving oligopolist? I’ll plop for the former for now, despite the inherent conflict of interest in the CEO of the country’s largest bank pleading “over-competition” in the domestic banking sector. Why? Because I think he’s right as far as non-bank lending is concerned, and because if the remark came from outside the banking community it would have been accepted without reservation (excerpt):

‘Rein in super-easy personal loans’

KUALA LUMPUR: Maybank wants the authorities to tighten control on the ease with which personal loans are being given out to consumers.

CEO Datuk Seri Abdul Wahid Omar cited personal loans given out either by non-bank entities or “over-competitive” banks, as worrying.

“We need stronger enforcement from the authorities on the personal loans issue as it is becoming a cause for concern,” he said after the group's annual general meeting.

Wahid suggested that non-bank lenders were quite lax when giving out personal loans, saying that these institutions should look at adopting some of the same standards as banks, especially when underwriting the loans.

A Different Perspective

Peruvian economist Hernando de Soto has an unconventional perspective on the causes of the Great Recession (excerpts):

The Destruction of Economic Facts

During the second half of the 19th century, the world's biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. If you wanted to know who owned land or owed a debt, it was a fact recorded locally—and most likely shielded from outsiders...

Income Inequality, Household Debt and Financial Fragility

I really like this article, not least because it backs some of my instincts regarding some of the underlying issues underlying Malaysia's low-wage problem:

Inequality, leverage and crises
Michael Kumhof & Romain Rancière

Of the many origins of the global crisis, one that has received comparatively little attention is income inequality. This column provides a theoretical framework for understanding the connection between inequality, leverage and financial crises. It shows how rising inequality in a climate of rising consumption can lead poorer households to increase their leverage, thereby making a crisis more likely.

The US has experienced two major economic crises during the last century – 1929 and 2008. There is an ongoing debate as to whether both crises share similar origins and features (Eichengreen and O'Rourke 2010). Reinhart and Rogoff (2009) provide and even broader comparison.

One issue that has not attracted much attention is the impact of inequality on the likelihood of crises. In recent work (Kumhof and Ranciere 2010) we focus on two remarkable similarities between the two pre-crisis eras. Both were characterised by a sharp increase in income inequality, and by a similarly sharp increase in household debt leverage. We also propose a theoretical explanation for the linkage between income inequality, high and growing debt leverage, financial fragility, and ultimately financial crises.

A Worthy Experiment: The EU Contemplates A Tobin Tax

So says the Forex Blog (excerpt):

EU Ponders Tobin Tax

Only two years after the worst financial crisis in decades, the DJIA is now back above 12,000. Yield-hungry investors are pouring record amounts of cash into emerging markets. Commodities and food prices are rising into bubble territory. In fact, not a single meaningful reform has yet to be passed that would prevent such an event from erupting again. The EU, however, is trying to change that, with the proposed introduction of the first-ever Tobin tax on foreign exchange trades...

...The so-called Tobin tax was first proposed in 1971 by Nobel Laureate James Tobin. While it has always enjoyed support from a handful of leftist economists, it has never been seriously considered by any western country. In the wake of the financial crisis, however, anger towards speculation seems to be peaking, and some governments might finally have enough political capital to push forward the idea. In fact, France has already obtained the tepid support of other EU members, notably Austria. In addition, the Economic and Monetary Affairs Committee of the European Parliament has backed the idea. The EU is fighting to keep the Euro alive and its member states solvent, and it clearly resents the (perceived) role of speculators in betting on default and breakup.

Proponents of the Tobin tax generally cite the amount of revenue it could raise as its chief benefit. For example, it has been estimated that a .005% on forex transactions could raise $26 Billion worldwide, while a .05% tax on all financial transactions could generate as much as $700 Billion in revenue. Even though studies suggest that it wouldn’t do much to reduce volatility (and perhaps speculation), the fact that it shouldn’t destabilize markets is enough to satisfy some of its naysayers.

Not surprisingly, the US remains opposed to such a policy, on the grounds that it could “send misleading signals that could hamper investment to end extraction and cause production bottlenecks.” This kind of incantation rings hollow, however, and it’s clear that the biggest obstacle to its being implemented is almost certainly the bank lobby, which has insisted that a Tobin tax would “cause serious damage to this highly efficient [forex] market.”

Are We Creating A Malaysian Sub-Prime Market?

Also from Monday’s news (excerpt):

No-deposit housing package for low, middle income group

KUALA LUMPUR: Syarikat Perumahan Negara Berhad (SPNB) will launch a mega nationwide promotion, offering 10-30percent discount to attract prospective buyers for houses priced between RM35,000 to RM250,000.

The houses will be offered to low and medium wage earners who will not have to pay a deposit to own such houses.

SPNB managing director Datuk Dr Sr Kamarul Rashdan Salleh said he was confident of achieving the targetted sales of 6,300 houses for the year, through the promotion.

"In 2010, SPNB sold about 3,000 units worth about RM400mil, and made a pre-tax profit of about RM15mil.

"Based on last year's success, SPNB is confident that sales this year will double since we are going to sell in cooperation with Cagamas Berhad (Cagamas), while offering an attractive package, including, a discount of between 10-30percent - depending on the location - along with free legal services.

"Apart from Cagamas Berhad, Malaysia Building Society Bhd and Bank Simpanan Nasional (BSN) are also involved," he told Bernama in an interview here Monday.

Risk, Return And The Perfidious Banker

Just a quick post to a question posed by Wenger J Khairy in my post on SRR:

Why is the bank sitting pretty on a pile of cash?

I think the answer has to be the huge almost titanic differential between cost of funds (deposit rate) vs. the BLR. I think the spread is like 400 bps, something which makes it very easy to be a banker and very crappy to be a consumer. So banks don't have to stretch to be profitable, just lend to the consumers and earn the differential

This is a fair concern, especially in light of the charges levelled at the Federal Reserve during this past crisis – by keeping interest rates at near 0% and inviting banks to borrow against all sorts of collateral, coupled with record issuance of US Treasury Bills, meant that US banks had an almost risk free way to gain profits. 30 year Treasuries were yielding over 3% in 2009, and over 4.7% currently. Nice business if you can get it.

The Impact Of Financial Liberalisation

I usually publish only the abstracts when highlighting research papers, but this one’s so fascinating and not a little controversial from a Malaysian perspective, that I’m taking excerpts from the introduction instead (excerpts, emphasis added):

Rethinking The Effects Of Financial Liberalization
Fernando A. Broner & Jaume Ventura

...The conventional view, part of the so-called Washington Consensus, was quite optimistic regarding the effects of financial liberalization...

New World Bank Publication Discusses The Future Of Economic Policy

From the World Bank blog (excerpts):

The Day After Tomorrow: Macro-Financial Policy Catches Up With Reality

The 2008–09 crisis opened the door to a different kind of thinking in international macroeconomics—and closed it on some of the previous orthodoxy. Let’s take a look at some of the most obvious cases.

First, some now see a bit of inflation (perhaps as high as 5 percent per year) as desirable for countries that pursue inflation targets, because it would allow more space to reduce nominal interest rates when an economy falls in recession. In fact, what to target (e.g., consumer, producer, asset, housing, or other prices) is the question.

Second, regulatory parameters and practices in the financial sector have proved to be more critical for real growth than we previously thought, whether through systemic risk, over-lending, costly bailouts, or other channels. Floating exchange rate regimes are falling out of favor, since “managed” ones proved to be better at controlling inflation and reducing sudden, unnecessary fluctuations. Controls on the movement of capital across boundaries have become an acceptable tool (they used to be heretical), almost the price to pay for policy success.

Third, multilateral surveillance is in the cards, initially through the G-20, since the actions of hard-hit, over indebted rich countries cause volatility in many emerging markets. But fiscal policy advice is bifurcated—between a short-term need for sustained stimulus and a medium-term need for consolidation, and between massive deficits in the developed world and the accumulation of surpluses in sovereign funds in the developing one.

From all this, a new paradigm is likely to rise…

…The bottom line is that the search for financial stability, through regulatory or macroeconomic policy, is just beginning. This is putting developing countries in a bind. Should they wait for new global standards to emerge, or should they tailor their own regulatory strategies? Stay tuned.

There He Goes Again…

Tun Dr Mahathir on free markets, regulation and gold:

Dr M: Banking, finance need to be regulated

…Former prime minister Tun Dr Mahathir Mohamad said governments must continue to oversee the regulation of banks and financial institutions.

“Unless the Government oversees and limits the ability for the market to abuse (the banking systems) then, of course, we are going to have this kind of (global economic) crisis…

…“This idea of a free market has become almost like a religion. You cannot question it, even when it fails,” he said…

…“And the abuses became rampant because of the idea that governments must not interfere with the financial market. (That) the market it seems would regulate itself,” he explained.

He urged for the gold dinar to be institutionalised as the standard against which all currencies were measured for the sake of stability.

“It’s something tangible and something that has value anywhere in the world,” he said.

However, he said the gold dinar system, if implemented, should only be used for settlements of international trade…

…“The US dollar has got no value whatsoever. It’s got no backing, no reserve. But we accept it as if it has some value and because we accept it, it has value,” he said.

Book Plug: Fixing Global Finance

I’ve an awful lot of research papers that I want to highlight, in addition to going through the ETP proposals in detail. As such there won’t be any posts for the next couple of days, so in the interim, I’d just like to showcase a book and a working paper that supports it.

Back in July, I highlighted an article on VoxEU regarding the imposition of capital controls in East Asia. The author got in touch with me, and has now published a book on the subject:

Fixing Global Finance
A Developing Country Perspective on Global Financial Reforms
Kavaljit Singh

The financial crisis which erupted in mid-2007 has been widely viewed as the most serious financial crisis since the Great Depression of the 1930s. The crisis which originated in developed countries quickly spread to developing countries and the rest of the world. The turbulence in financial systems was followed by a significant reduction in real economic activity throughout the world. The crisis has highlighted that financial markets are inherently unstable and market failures have huge economic and social costs. The crisis has renewed debate on the role of global finance and how it should be regulated.

The aim of this book is to encourage and stimulate a more informed debate on reforming the global finance. It examines recent developments and problems afflicting the global financial system. From a developing country perspective, it enunciates guiding principles and offers concrete policy measures to create a more stable, equitable and sustainable global financial system. Several innovative measures have been proposed to reform the global finance and to ensure that it serves the real economy.