Where is the quid pro quo for the trillion-dollar bailout?
More than a trillion dollars into the financial bailout, the end to the crisis is nowhere in sight. While lawmakers, including President Barack Obama, have denounced this culture of entitlement on Wall Street, such angst against compensation diverts attention from the real issue at hand—that not much regulation has changed to encourage banks to follow the narrow path of prudence. There is likely to be more success at moderating compensation by subtly influencing the ability of banks to pay such compensation by limiting the unacceptable risks, which indeed generated supernormal profits. Such risk management at a macroeconomic level has been done very effectively by the Reserve Bank of India (RBI) by impressing its value judgements of risk into the banking system.
This approach reached its acme under governor Y.V. Reddy, who presciently refused to be party to an overheating of the economy. Several approaches used by RBI could also now be used by the US Federal Reserve to achieve the right balance between free markets and mindless risk taking.
The marginalization of good risk management practices is at the heart of the current crisis. The mispricing of risk, thanks mainly due to the ability of banks to use their own, often motivated, models to determine the riskiness of their balance sheet. If the US Congress wants payback for its trillion, it is here that it ought to ask for changes. In particular, the argument that risk lies in the eye of the bank cannot be made any longer when the consequences of poor risks affects the entire system. At least for some types of assets, one needs a more deterministic approach to risk, where all banks treat the risk similarly. Listed below are some of the specific changes we might like to see:
The acquisition of apparently high-yielding securitized assets was one of the significant areas of mispricing of risk. The Basel II recommendation provided detailed advice on risk weightage (a higher risk weightage suggests you need to bring in more of your own money to mitigate against the risk going bad) to be used for securitization, off balance-sheet exposures, exposures to securities firms, real estate, etc. In most cases, the weightages assigned to the risk of holding these assets was between 20% and 50%. We now know that these were too small to dampen the incentives associated with risk taking. In contrast, most of the asset classes mentioned above would have a 100% or more risk weightage in India. Can these risk weightages in the US not be raised to set the right incentives in place?
While the previous suggestion to increase risk weights in some areas can help reduce the risks associated with foolhardy acquisition of securities, there is also a case to control the quality of the origination of these securities in the first place. The originate-to-distribute model of lending, where the original lender was able to pass off almost all the loans it gave as securitized pools, has proved to be a magnet for moral hazard. While not denying the value of this model of financing, could banks not be asked to hold say 50% of loans that they originate on their balance sheets?
On a general note, no one can really deny that sectors such as real estate and capital market tend to be more amenable to speculative bubbles. It is somewhat more difficult to create a bubble through, say, lending to potential restaurant owners than it is by lending to buy shares. RBI has candidly made this distinction and kept an eye on these sectors. Banks and non-banking finance companies are subject to special constraints, which in retrospect seem prescient.
So far, there has been little restriction in place by the Fed to mitigate the tendency to be overweight on such assets. If anything, the Fed and the US government will only succeed in reinflating the housing bubble through low interest rates.
It is also intuitively clear that greater risks tend to be in transactions where the assets are traded over the counter as opposed to those traded on an exchange. Since over-the-counter markets, valued at about $600 trillion (Rs31,020 trillion), are at least seven times the size of those traded on exchanges, keeping away from the benefits and regulations of an exchange is inexplicable.
One would recommend that all transactions above a certain size be traded over an exchange or at least be penalized by a significantly higher risk weightage, since these are most amenable to opacity and consequently to incorrect valuations.
During the present crisis, banks have admitted that a vast majority of transactions were speculative with only third-or-fourth order linkages to any transaction in the real world. For too long there has been no value judgement distinguishing credit going to a small job-creating business in rural Uttar Pradesh and financing an exotic trade in Italian bonds from a one-man desk in Mumbai. That one predominantly benefits the economy and the other predominantly benefits the individual or company concerned has been glossed over.
Congress needs to demand that banks reconstruct the bridge that existed between banking and real world for much of the 20th century and which broke down after the fiscal profligacy of the Reagan years. We would have liked to see Congress asking for incentives to support direct lending that can drive credit in the real economy, the real raison d’etré of high finance and capitalism itself. Can regulators find a way to attach different risk weights to distinguish between finance that creates value and that which is essentially speculative? I am told that this is not possible without destroying the innovativeness that lubricates the financial system. Given the significant value that can accrue from a better allocation of resources, it is worth trying to solve this problem instead.
Finally, on a different note, as suggested by award-winning journalist Allan Sloan, the government could have made bank directors share some of the pain that they have caused through poor oversight. While pay and perks were limited for executives of banks, directors, who are the main line of governance for shareholders, seem to have had it easy.
We have seen none of the above asked for explicitly as conditions of the bailout.
The US citizens have paid for the bank relief programme through taxes. Citizens of other nations have indirectly funded the US by investments in that country. Both these groups (which actually represent almost every citizen in the world) should have some stake in the way this relief programme plays out. There ought to have been fundamental and sweeping changes in the risk reward systems that pervade banking as well as direct changes in the way banking was conducted, particularly in the US. Instead we have seen what is truly a free lunch.
The right way out was nationalization of the large zombie banks, but banks have got the funds under the Troubled Asset Relief Programme (TARP) while giving away virtually nothing by way of tighter regulation. One hopes that while lawmakers keep doling out bailouts, we will at least see greater regulation on the lines described above as the quid pro quo of TARP.
If all this sounds too difficult to effect, the Fed could give former RBI governor Reddy a chance to sort things out.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance. The views expressed here are personal. Write to him at firstname.lastname@example.org