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It was clear, back in 1997, that there was something rotten in the kingdom of Denmark or, more precisely, its one time Atlantic archipelago, Iceland. Have you ever met a bond fund manager worthy of the word ‘fiduciary’ who took the work of credit rating agencies seriously? I have not. At best they offer a sense check, a reinforcement of an existing view or a way to keep clients reassured. But at worst they are a comic parody of reality.
This column pointed this out when Iceland’s banks were bizarrely upgraded, even as rumours of malfeasance began to whirl at the onset of the financial crisis.
Euromoney was in the vanguard of getting that news out.
The strange quasi-official status of credit rating agencies is a by-product of regulation.
The Securities and Exchange Commission gave the agencies oligopolistic control of defining default risk in the 1970s.
Apart from providing them with a state-backed licence to print money, the result has been a disaster.
That is why you do not have to be on the libertarian fringe to think more regulation is scary.
Scary
These days flicking through the Financial Times on the morning commute is often subliminally accompanied by the minimalist theme tune to John Carpenter’s Halloween.
It is no wonder everyone else on my carriage chooses to sleep.
This is not a criticism of the editorial quality of the FT; this stuff is properly scary.
Where to begin on the unintended consequences of re-regulation? Has anyone tried trading a bond in the secondary market recently? Unless you can sell it to your friendly central bank that is buying everything with a coupon, dream on. Regulators have forced banks out of intermediation. Financial institutions are allowed to hold government bonds, because they count as capital, but anything else is viewed as risk and comes with capital charges that the banks say are punitive.
Two modest suggestions
Will super-bright financiers with huge incentives attempt to stay one step ahead of their regulators?
Yes.
Are they sometimes guilty of special pleading?
Undoubtedly.
It would be disingenuous to say that a higher cost of capital is not presenting banks with challenges. But that sympathy is tempered by the dishonesty of how the banks make their case.
Whingeing about new capital requirements constraining their ability to do business is unlikely to get much sympathy. A bank can still leverage 33 times according to Basel’s provisional ratio.
At 33 times leverage with 3% equity plus 97% borrowing, a bank’s balance sheet needs to lose only 3% to wipe out 100% of its equity.
If it loses 1% it will be 50 times leveraged, a 2% loss would leave it 100 times leveraged.
Deleveraging has been more honoured in the breach than the observance.
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It would be disingenuous to say that a higher cost of capital is not presenting banks with challenges. But that sympathy is tempered by the dishonesty of how the banks make their case. Whingeing about new capital requirements constraining their ability to do business is unlikely to get much sympathy. A bank can still leverage 33 times.
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Total loss-absorbing capacity includes bank debt and assets but they are not as real as they seem, they are risk-adjusted.
This does not add up to an excuse to walk away from market-making.
What is required is an old-fashioned approach that puts clients first, the ability to work a phone and a network of customers that trust the dealer, and a weaning off the prop of the prop desk.
If the banks cannot fulfil that role in markets anymore, the likelihood is that they will be overtaken by technology.
The buy side will find its own solutions.
Control
The big banks have been bailed out, propped up by QE, and in spite of all of the fines, opprobrium, name-calling and appalling headlines still control the agenda.
It is called regulatory capture.
Let’s all move on.
If banks held proper capital, they would not need invasive regulatory scrutiny.
If they then started behaving properly regulators might even reach the same conclusion.
Let us all accept that bankers have got things wrong in the past and will in the future.
Let us also acknowledge that regulators have also made mistakes – the credit rating agencies still enjoy their special privileges (sigh).
I propose a mutual pact for bankers and regulators based on the Hippocratic oath: Do no harm.