By Henry C K Liu – May 14, 2002
Banking is an important institution in the economy, but it is not the economy. Banks’ traditional role is primarily that of an intermediary for money. Under finance capitalism, banks on the one hand take on new importance in the financial system (apart from their traditional lending role in industrial capitalism) while on the other hand they lose their traditional monopoly, as sole conduits of credit, to the unregulated global capital and credit markets dominated by non-bank financial entities and over-the-counter (OTC) derivative trades between market participants without intermediaries and outside of exchanges.
In these markets, banks are reduced to merely special market participants that both enjoy the protection of and are restrained by national regulatory regimes. The securities exchange commission views the difference between equity and debt as only technical, a distinction only meaningful in the legal accounting of risk. Convertible bonds, for example, blur the distinction by assigning the choice between debt and equity to the terms of credit.
Even under market capitalism, banking systems in different economies serve different economic policy goals, which invariably evolve and change over the course of history, reflecting the financial needs of various developmental stages in different economies. In developmental terms, economies in the take-off stages require different economic policies than those is consolidation stages. Economies that aim toward a hard landing from exuberant growth also require different economic policies than one aiming toward a soft landing. These differing economic policies are most effectively supported by differing banking regulations.
The United States did not have a central bank until 1913. President Franklin D Roosevelt’s New Deal responded to the Great Depression of 1929 with massive banking reform, adding to the Reconstruction Finance Corp (RFC) already set up by president Herbert Hoover, which lent to distressed corporations and banks. The RFC, designed as an emergency institution to be liquidated within two years, had a capital of US$500 million, and authority to issue government-backed, tax-free debentures of $1.5 billion. A Farm Credit Administration took over problem farm mortgages. A Home Owners’ Loan Corp did the same for problem urban mortgages. An abrupt bank “holiday” was declared to make the government the lender of last resort. Export of gold as well as the redemption of currency for gold were forbidden by executive order.
The Emergency Banking Act of 1933 endorsed emergency actions already taken by the president and created the Federal Deposit Insurance Corp to protect depositors. The Security Act of 1933 and the Securities and Exchange Act of 1934 created the Securities and Exchange Commission (SEC) to regulate equity markets. The Glass-Steagall Act of 1933 split investment banking from commercial banking to prevent the conflict of interest in pushing new issues of shares of the banks’ clients on the banks’ own depositors.
The New Deal made recent emergency banking measures in Argentina look like a tea party. The difference was that the New Deal did not have an International Monetary Fund (IMF) to insist on conditionalities of austerity on the government.
The emergence of junk bonds, providing risky ventures with open access to institutional money, was instrumental in restructuring the US economy, bringing into existence new productive apparatus, such as MCI, Turner Broadcasting, Dell, AOL and Microsoft, which constituted the New Economy. Drexel’s Michael Milken created a new use for junk bonds in the 1980s, persuading executives to issue them to restructure and grow their companies and speculators and investors to buy and trade them. Much of the phenomenal increase in indebtedness of US corporations during past decades has been due to junk-bond holdings, not bank loans, at least until creative accounting allowed corporation new off-balance-sheet access to virtual money. With Drexel’s aggressive campaign, the amount of junk bonds in the market swelled to $200 billion, and bonds became an important component in pension plans and mutual-fund investment.
Despite Drexel’s demise, corporate bonds outstanding in the United States has grown from $366 billion in 1980 to more than $2.5 trillion now. It is $1 trillion larger than municipal debt. It is 70 percent as large as the outstanding Treasury debt. Corporate bond issuance has increased more than fourfold since 1990 and, for high-yield junk bonds, more than 10-fold. A total of $16.4 billion of junk bonds, or 3.1 percent of the $510 billion outstanding, went into default in January and February 2002 alone – led by bankrupt telecommunications company Global Crossing Ltd ($3.4 billion) – on the heels of $43.6 billion of defaults last year. Charles Keating of Lincoln Savings and Loan purchased the since defunct institution in 1983 with $50 million raised by Milken through the sale of junk bonds, which started a daisy chain set of transactions that became a centerpiece of the savings and loan crisis.
From their different historical backgrounds, different banking systems and regulatory regimes have evolved for different national economies. The globalization of finance, accelerated by “big bangs” in major financial markets, has brought about the urgent push for global regulatory standards applicable to banks worldwide, while leaving credit and capital markets largely unregulated, and a foreign exchange regime driven by predatory processes disguised as free markets for currencies.
The situation is further complicated by the use of new instruments in structured finance: securitization and derivatives which permit the unbundling of risks that are marketed to bidders willing to take different levels of risks for compensatory returns. Looking to keep such risks from infesting the banking system while not preventing the banks from participating in the highly profitable new markets, national banking systems are suddenly thrown into the rigid arms of the Basel Capital Accord sponsored by the Bank of International Settlement (BIS), or to face the penalty of usurious risk premium in securing international interbank loans. Thus national banking systems are all forced to march to the same tune, designed to serve the needs of highly sophisticated global financial markets, regardless of the developmental needs of their national economies.
Banking reform becomes the mantra of neo-liberal globalization while the real systemic risk in the global economy has been socialized globally through structured finance, and the benefits of socializing such risk remains concentrated in the hands of private investors in the rich economies.
Many national banking systems came into existence to support mercantilist or national industrial policy goals, such as rapid industrialization, gaining global market share, building an armament sector, rural electrification, regional development, flood management, etc, free from the dictate of private institutional profitability.
Both the prewar and postwar German and Japan economic miracles were clear examples. With financial globalization, these banking structures of national policy have been forced to transform themselves into components of a globalized private banking system that puts institutional creditworthiness and profitability as prerequisites, serving the needs of the global financial system to preserve the security and value of global private capital. National policies suddenly are subjected to profit incentives of private financial institutions, all members of a hierarchical system controlled and directed from the money center banks in New York. The result is to force national banking systems to privatize and, in order to compete for interbank funds, to redefine and recognize domestic non-performing loans (NPLs) under BIS guidelines.
BIS regulations serve only the single purpose of strengthening the international private banking system, even at the peril of national economies. The BIS does to national banking systems what the IMF has done to national monetary regimes. National economies under financial globalization no longer serve national interests. They operate to strengthen what US Federal Reserve chairman Alan Greenspan calls US financial hegemony in the name of private profit. The IMF and the international banks regulated by the BIS are a team: the international banks lend recklessly to borrowers in emerging economies to create a foreign currency debt crisis, the IMF arrives as a carrier of monetary virus in the name of sound monetary policy, then the international banks come as vulture investors in the name of financial rescue to acquire national banks deemed capital inadequate and insolvent by the BIS.
Profit of financial institutions now depends on increased price volatility more than on interest-rate spreads. Price adjustments in capital markets have been most clearly visible in a re-pricing of risks in a wide range of equity and high-yield bond markets. The high correlation of asset price movements across countries reflects the globalization of finance and the heightened tendency of global investors to invest on the basis of industrial sectors or credit ratings, rather than geographic location. Yet large segments of many national economies have no intrinsic need for foreign direct investment (FDI), or even market capitalization in foreign currencies. Applying the State Theory of Money, any government can fund with its own currency all its domestic developmental needs to maintain full employment without inflation. FDI denominated in foreign currencies, mostly dollars, has condemned many national economies into unbalanced development toward export, merely to make dollar-denominated interest payments to FDI, with little net benefit to the domestic economies.
Further, assessment of risks is complicated by recent structural financial developments in the advanced national financial systems, including increasing global market power concentration in large, complex banking organizations (LCBOs), the growing reliance on over-the-counter (OTC) derivatives and structural changes in government securities markets. Despite all the talk of the need for increased transparency, these structural changes have reduced transparency about the distribution of financial risks in the global financial system, rendering market discipline and official oversight impotent.
Even blue-chip global giants such as GE, JP Morgan/Chase and CitiGroup have overhanging dark clouds of undisclosed off-balance-sheet risk exposure. Ironically, banks in emerging markets are penalized with disproportionate risk premiums when they fail to meet arbitrary BIS Basel Accord capital requirements, while LCBOs with astronomical risk exposures in derivatives enjoy exemption from commensurate risk premiums.
National capital markets around the globe are vulnerable to spillovers and contagion from volatility in US capital markets. Continuous and steady access by emerging markets to global capital has been strongly affected by events in the mature markets. While the emergence of exchange-rate and banking crises in emerging markets and the ensuing contagion led to an abrupt loss of markets access in the past, many emerging markets now lose market access mainly because of developments in distant mature markets, such as the collapse of market capitalization on the Nasdaq, or the collapse of the telecom sector debt market built on the US formula of “air ball” financing – loans based on pro forma future cashflow rather than hard assets or current profits.
The BIS is an international organization that aims to foster cooperation among central banks and other agencies in pursuit of global monetary and financial stability in the interest of the rich nations. It was established in the context of the Young Plan (1930), which dealt with the issue of the reparation payments imposed on Germany by the Treaty of Versailles. Thus from its birth, its institutional bias has been genetically in favor of winners/creditors. The reparations issue quickly faded into the background, focusing BIS’s activities entirely on cooperation among central banks and, increasingly, other agencies, such as the IMF, in pursuit of monetary and financial stability for the benefit of global private creditors. Incidentally, the US Federal Reserve, the head of the central-bank snake, is privately owned by member private banks, though it presents itself to the world as a government institution, presumably along the same logic as Christ being both God and man.
The BIS aimed at defending the Bretton Woods system until 1971, when the US abandoned the gold standard. It aimed at managing capital flows after the two oil crises and the international debt crisis in the 1980s. More recently, its thrust has been to foster financial stability in the wake of economic integration and globalization. Its Basel Committee on Banking Supervision recommended a risk-weighted capital ratio for internationally active banks (1988 Basel Capital Accord, currently under revision) that has become international standard, forcing banks in poor nations to observe the same rules as banks in rich nations. The BIS performs traditional banking functions, such as reserve management and gold transactions, for the accounts of central-bank customers and international organizations.
The total of currency deposits placed with the BIS amounted to $128 billion as of March 31, 2000, representing about 7 percent of world foreign-exchange reserves. In addition, the BIS has performed trustee and agency functions, acting as agent for the European Payments Union (EPU, 1950-58), helping the Western European currencies restore convertibility after World War II; as the agent for various European exchange-rate arrangements, including the European Monetary System (EMS, 1979-94), which preceded the move to a single currency. The BIS has also provided or organized emergency financing to support the international monetary system when needed. During the 1931-33 financial crisis, the BIS organized support credits for both the Austrian and the German central banks, resulting in a systemic financial collapse that contributed in no small way to the political success of the Nazis. In the 1960s, the BIS arranged special support credits for the Italian lira (1964) and for the French franc (1968) and two so-called Group Arrangements (1968 and 1969) to support sterling. More recently, the BIS has provided finance in the context of IMF-led stabilization programs (eg for Mexico in 1982, for Brazil in 1998, and for Turkey and Argentina in 2000-present).
On January 8, 2001, the BIS decided to restrict, for the future, the right to hold shares in the BIS exclusively to central banks and approved the mandatory repurchase of all BIS shares held by private shareholders, against payment of compensation of 16,000 Swiss francs for each share (equivalent to some $9,950 at the USD/CHF exchange rate on January 8, 2001). Financial affirmative action for weak economies is not part of the BIS lexicon of international finance.
Since 1988, banks that trade internationally have been “invited” to observe the terms of the Basel Capital Accord signed by more than 110 countries. The accord has been made compulsory for all credit institutions in the G10 (Group of 10, comprising Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) countries. The 1988 accord, with a deadline implementation by the end of 1992, focused on a single risk measure, with a one-size-fits-all, broad-brush approach, setting a minimum capital requirement at 8 percent. While Third World banks that do not meet BIS capital requirements are frozen from the global interbank funds, BIS rules have been eroded by LCBOs in advanced economies through capital arbitrage, which refers to strategies that reduce a bank’s regulatory capital requirements without a commensurate reduction in the bank’s risk exposures. One example of such arbitrage is the sale, or other shift-off, from the balance sheet of assets with economic capital allocations below regulatory capital requirements, and the retention of those for which regulatory requirements are less than the economic capital burden.
Aggregate regulatory capital thus ends up being lower than the economic risks require; and although regulatory capital ratios rise, they are, in effect, merely meaningless statistical artifacts. Risks never disappear; they are always passed on. LCBOs in effect pass their unaccounted-for risks onto the global financial system. Thus the fierce opponents of socialism have become the deft operators in the socialization of risk while retaining profits from such risk socialization in private hands.
Set for 2004, implementation of the new Basel Capital Accord II is meant to respond to such regulatory erosion by LCBOs. “Synthetic securitization” refers to structured transactions in which banks use credit derivatives to transfer the credit risk of a specified pool of assets to third parties, such as insurance companies, other banks, and unregulated entities, known as Special Purpose Vehicles (SPV), used widely by the likes of Enron and GE. The transfer may be either funded, for example, by issuing credit-linked securities in tranches with various seniorities (collateralized loan obligations or CLOs) or unfunded, for example, using credit default swaps. Synthetic securitization can replicate the economic risk transfer characteristics of securitization without removing assets from the originating bank’s balance sheet or recorded banking book exposures. Synthetic securitization may also be used more flexibly than traditional securitization. For example, to transfer the junior (first and second loss) element of credit risk and retain a senior tranche; to embed extra features such as leverage or foreign currency payouts; and to package for sale the credit risk of a portfolio (or reference portfolio) not originated by the bank. Banks may also exchange the credit risk on parts of their portfolios bilaterally without any issuance of rated notes to the market.
Another variant is to use credit derivatives to transfer the risk of a small number of corporate “names” rather than that of a larger portfolio. In this type of synthetic securitization, a SPV acquires the credit risk on a reference portfolio by purchasing credit-linked notes (CLNs) issued by the sponsoring banking organization. The SPV funds the purchase of the CLNs by issuing a series of notes in several tranches to third party investors. The investor notes are in effect collateralized by the CLNs. Each CLN represents one obligor and the bank’s credit risk exposure to that obligor, which may take the form of, for example, bonds, commitments, loans, and counterparty exposures. Since the noteholders are exposed to the full amount of credit risk associated with the individual reference obligors, all of the credit risk of the reference portfolio is shifted from the sponsoring bank to the capital markets. The dollar amount of notes issued to investors equals the notional amount of the reference portfolio.
Basel II regulation requires banks to build capital that will reflect a certain proportion of their financial activity, which occurs because of market volatility of financial instruments such as bonds, equities and derivatives. This discrepancy between the outcomes of the regulation capital and risk analysis has indeed fueled the development of new categories for financial instruments, such as credit derivatives or asset-backed securities, where regulated financial institutions transfer their low, but regulatorily expensive risks to non-regulated investors in order to extract value. As of December 31, 2001, CitiGroup held derivative exposure of $6.25 trillion, while its combined total asset was only $500 billion, according to the FDIC.
The proposed new Basel Accord II is built around three pillars, each of which reinforces the other. The first pillar establishes the way to quantify the minimum capital requirements in the context of the brave new world of structured finance, the second organizes the regulator’s supervision and the third establishes the foundations for market discipline through public disclosure of the way that banks implement the accord. Accurate internal risk-based (IRB) inputs are crucial to obtaining reasonably accurate regulatory measures of capital adequacy.
And the market will not believe or use risk disclosures unless it believes that the underlying risk measures, such as ratings and the probabilities of default, have been validated. Thus, supervisors must validate the risk measures to support both capital regulation and market discipline. While international rating agencies have been slow in coming to terms with true risk exposures of giant transnational corporations such as Enron and GE, they are subject of complaint from the government of Japan with regard to their “qualitative” judgment that lacks “objective criteria” of Japanese sovereign creditworthiness despite Japan’s undisputed status as the world’s leading creditor nation.
Japan is singled out among its peers in the advanced industrial world for scrutiny over the basic rating question of threat of default. Yet Japan has the largest savings surplus in the world and the largest foreign exchange reserves. There is increasing evidence that the Japanese bank system crisis is not the cause but merely the symptom of its economic malaise which has resulted from the disadvantaged structural position Japan has allowed itself to fall into in terms of the global financial system. BIS regulations are a big part of that structural disadvantage. This is the reason why Japan has been resistant toward US demands for Japanese bank reform. No doubt Japan needs to reform its banking system, but it is highly debatable that the reform needs to go along the line proposed by US neo-liberals or that bank reform alone will lift the Japanese economy out of its decade-long doldrums.
The record of US supervisory effectiveness has been gravely tarnished by the shameful performance of the US accounting profession and the unethical behavior of corporate management. The SEC is only now frantically trying to play catch-up after the horses have fled the barn, with dead and wounded corporate bodies strewn around the market landscape.
Fed governor Laurence H Meyer has publicly declared that at this moment and with current systems, no bank in the US likely would qualify to use the advanced IRB approach. LCBOs will be under pressure to enhance their risk management practices so that they might be prepared to adopt the advanced IRB approach. Tension exists between setting high standards and the expectation of wide adoption of the advanced IRB approach by LCBOs. There is a possibility that the US banking industry will simply stick with the standardized approach and turn a cold shoulder to advanced IRB. It would be the financial version of US unilateralism and exceptionism.
The effective average risk weight for a bank as a whole should decline with the more sophisticated approaches depending on the extent of capital arbitrage already accomplished. Such banks would achieve lower total regulatory capital charges and, consequently, a higher reported risk-weighted capital ratio. Given the different risk profiles at individual banks, capital requirements almost certainly would vary more widely under the new risk-based capital ratios than under current BIS measure. A bank with a relatively low risk portfolio would find that its risk-weighted capital ratio increased because its risk-weighted exposures had declined. It would, as a result, presumably reduce its capital, or increase its leverage, or even increase its risk exposure, defeating the purpose of the new accord. Banks in the emerging economies will definitely be put at a disadvantage due to their lack of sophisticated risk management capabilities and limited access to global capital and credit markets.
A look at US credit-market debt as a percentage of gross domestic product (GDP) is revealing. Domestic financial debt jumped from 12.3 percent of GDP in 1971 to 91.8 percent of GDP in 2001. According to Fed data on the flow of funds, banks’ share of net credit markets dropped from a peak of over 62 percent in 1975 to 26 percent in 1995 and is still falling rapidly, while security markets’ share rose from negligible in 1975 to over 20 percent in 1995 and still rising rapidly, with insurers and pension funds taking the rest. In 1999, US credit market debt amounted to $25.6 trillion, two and a half times GDP, of which commercial banking debt was only $5.0 trillion. Treasuries was $5.2 trillion, agencies were $8.5 trillion and mortgage or asset backed securities was $3 trillion. Commercial papers was $1.4 trillion. Money market instrument was $2.3 trillion. Securitization now stand at over $3 trillion, up from $375 billion in 1985. Insurance companies and banks in the US fell from 75 percent of financial industry assets in the 1950s to less than 35 percent today, while mutual-fund and pension-fund firms increased their share from 6 percent to 43 percent over the same time period. The fund-management industry has profited as individuals replaced the majority of their directly held equities with managed funds. Banks have lost assets to the financial markets, as those markets have become more attractive to debtors and investors.
More than 75 percent of the global volumes in securitization originate from the US. Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 financial crisis, primarily because of underdeveloped debt and securitization markets in Asia. And the Basel Accord capital requirements have a more restrictive impact on Asian economies for that reason.
Financial market creativity has brought forth an explosion in the number of securitized products which in turn has contributed significantly to the growth of capital and debt markets, which in turn has paralleled the decline of the banks’ share of financial industry assets. The importance of banks in the management of credit risk has also declined with the growth in the commercial paper and high-yield bond markets. Banks’ loss of market share in the credit card market has been extremely rapid, as their share of credit card receivables fell from 95 percent in 1986 to 25 percent in 1998. During this period, non-bank credit card companies and the securitization of receivables have exploded.
Over the same time period, securitized mortgages grew from 10 percent to 41 percent of the US mortgage market. Finally, there was the rise of money market accounts and brokerage firm sponsored cash management accounts. Banks’ share of checkable deposits fell from 85 percent to 55 percent from 1980 to 1998, while money markets and alternative checking accounts grew to 45 percent of checkable deposits. These new products have allowed consumers unparalleled declines in funding costs and transactions convenience.
Despite these tremendous losses in market share, banks have been able to maintain a position of importance in the modern economy. Banks have experienced an erosion in their core business of borrowing and lending, and net interest income has fallen precipitously. But banks have successfully replaced this income by growing fee-based and value-added services such as brokerage, trusts, annuities, mutual funds, trading, mortgage banking and insurance. In other words, by becoming non-bank financial entities, instead of providing safety to its customers, banks have become brokers of risk rather than cushions against risk.
A case study from Brady bond prices (July 2001) applying a reduced-form model to uncover from secondary market’s Brady bond prices, together with Libor interest rates, shows how the risk of sovereign default is perceived to depend on time. Thus Walter Wriston of Citibank was essentially correct that countries do not go bankrupt in the long run. What Wriston failed to take into account was that governments can default on their foreign currency loans. Subsuming liquidity risk in default risk may result in a mis-specified model that, while generating the desired negative correlation between credit spreads and default-free interest rates, also generates negative probabilities of default at long horizons. Floating exchange rates, of course, further complicates the situation on foreign currency loans, which every sane government should avoid at all cost.
Globalization of markets has put a premium on cooperation between national authorities and institutions as a means of achieving a more harmonized financial environment, while in the foreign exchange arena, violent volatility, erratic spreads, high trading volumes and liquidity crises are commonly expected as natural. In this context, national banks are pushed to fall in line with guidelines developed by the BIS, which demanded simplistic risk management formulae, not to mitigate real risk, but to appease rating agencies, which act as a police force for the BIS and global investors. Rating agencies now exercise powerful arbitration on the cost of sovereign and private sector credit.
Reversing the logic that a sound banking system should lead to full employment and developmental growth, BIS regulations demand high unemployment and developmental degradation in national economies as the fair price for a sound global private banking system. Stephen Roach, Morgan Stanley’s chief economist, wrote, “In theory, globalization is all about a shared prosperity – bringing the less-advantaged developing world into the tent of the far wealthier industrial world. But, in reality, when there’s less prosperity to share, these benefits start to ring hollow. As the world economy now tips into recession, the assault on globalization can only intensify. The intrinsic tensions of globalization: market-driven forces of cross-border economic integration are increasingly at odds with the politics of fragmentation and nationalism. In the end, it probably boils down to jobs, voters and the social contracts that bind politicians to these key constituencies. Disparities in social contracts around the world underscore the inherent contractions of globalization.”
While banks in the US have successfully shifted bad loans off their books through securitization, banks in Asia, including Japan, are saddled with a NPL crisis created largely by the Basel Accord capital requirements. Post-Keynesian economist Paul Davidson’s distinguishing NPLs into episodic or systemic types is very perceptive, as is his conclusion that “we should never let the score keeping per se retard the game as long as there are real resources available to engage in productive activities”.
Obviously, the most effective resolution of NPLs is to turn them into performing loans. Yet the approach of the BIS (escalating capital requirement, loan writeoffs and liquidation, and restructuring through selloffs, layoffs, downsizing, cost-cutting and freeze on capital spending), a banking version of the IMF austerity conditionality, creates macroeconomic conditions that would turn more performing loans into NPLs and NPLs into total loss.
Henry C K Liu is chairman of the New York-based Liu Investment Group.