Banking regulation: Volcker vs. Basel

There’s additional chatter about financial regulatory reform today due to a luncheon speech that Paul Volcker’s giving on the subject. The debate continues to center around whether more stringent restrictions under the so-called Volcker Rule make sense, or whether capital requirements are a better way to go. The latter approach has some eloquent defenders, and seems to be favored by Asian and European regulators, but they should take heed of this new IMF study:

Using data for over 3,000 banks in 86 countries, we find that neither the overall index of BCP [Basel Core Principles on capital requirements] compliance nor its individual components are robustly associated with bank risk measured by Z-scores. We also fail to find a relationship between BCP compliance and systemic risk measured by a system-wide Z score.

And the band plays on…with each passing day it becomes more doubtful that something constructive will be done before the next financial crisis unfolds.

URLs:

http://www.imf.org/external/pubs/ft/wp/2010/wp1081.pdf

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy.

Masters of the Universe: They’re baaaack…

A new BIS paper has some very telling data points. First, they demonstrate the extent to which leveraged financial speculation drove foreign currency movements in the financial crisis (it’s quite reasonable to assume that this factor was at work in other asset class dislocations too). Second, it provides evidence that highly leveraged masters of the universe were back to their old tricks in fairly short order.

Let’s start with a  quick primer on “carry trades.”  A carry trade occurs when a financial market participant borrows in some currency with a low nominal interest rate (the “funding currency”) and invests the loan proceeds in some asset(s) (a “target asset”) that’s expected to appreciate at a rate that exceeds the interest rate due on the borrowed currency. The target asset can be a higher yielding currency, a credit instrument, equities or a stock market proxy, commodities or a commodity index proxy, and so on.

The Yen carry trade — borrowing low yielding Japanese Yen and using them to acquire riskier assets – has been increasingly employed by speculators since the 1990s, and appears to have played a key role in the speculative period of 2004-2008.

Speculators engaging in this activity are taking risks (sometimes massive risks) with (for the most part) Other People’s Money (OPM). When it works, they return the borrowed funding currency plus interest, and pocket the difference. When it goes terribly wrong, you wind down operations and hide from your creditors behind a corporate liability shield, forcing them to write down the value of their loans to you (their funding currency assets).

Nice work if you can get it, and amazingly, investment banks and their subsidiaries have been falling all over themselves to make these loans to privileged clients — including their own proprietary desks and funds — since the late 1990s (in competitive strategy, herd pursuit of bad ideas is usually a sign of an over crowded industry).

Better yet for the carry traders, increasingly lax financial regulation has allowed speculators to lever their carry up to levels not seen before in modern history, meaning they can borrow more money for a given level of collateral, and/or purchase more assets with a given amount of funding currency.

As some of those trades started to go bad in 2008, the result was a breathtakingly sharp and sudden reversal in the key funding currency, the Yen. This can be seen in the circled graph below, along with the following observations:

• The rate of appreciation in the Yen was far greater in 2008 than in the 1997 and 1998 global financial crises. The left most graph shows foreign exchange movements between the Yen and thirty three other currencies during the Asian crisis of 1997. Clearly, forex movements in that crisis were country specific.
• The middle graph shows currency movements against the Yen during the 1998 crisis associated with the Russian sovereign debt default. The appearance of a positive slope is apparent, implying that forex dislocations were due more to speculative behaviors including the rising use of leverage than to country-specific risks (for that we can probably thank the pioneering geniuses at LTCM and their investment bank benefactors).
• The third graph shows the appreciation of the Yen during the recent global financial crisis. The slope, which gives an idea of how sharply the Yen appreciated against those 33 other currencies, is breathtaking. The median interest rate on the target currencies (on the horizontal axis) also appears to have been roughly half of what it was in 1998.

Translating into English, this means that in 2008-09, the Yen appreciated even more sharply than it did in 1998, and against target assets that offered half the expected return of those in 1998. This calls to mind a question we raised recently, which is whether some powerful financial market participants are confusing ”efficient dislocation” with “market efficiency.” That would be understandable after all. History shows that the fatter the economic rents being justified, the more deluded the economic rationales tend to be.

In the BIS paper, the author also notes that carry trade activities are inherently pro-cyclical: borrowing activity tends to push down the market value of the funding currency, while investing activity tends to push up the market value of the target assets, and this will tend to invite increasing levels of speculation until something causes a breakdown.

Higher degrees of leverage make the pro-cyclicality and the eventual fallout that much worse. Unfortunately, while a great deal has been made of John Maynard Keynes’ alleged return in the past year, it appears that the brief 2008-09 resurgence of Hyman Minsky — who warned presciently of such dangers – has already been forgotten.

That “Minsky fade” appears to be supported by the bottom right graph (though admittedly, this case isn’t as strong as the leveraged carry trade evidence discussed above). The negative slope in that graph shows that less than a year later, the Yen depreciated markedly against many currencies, especially against higher yielding target currencies, which runs counter to the aftermath of 1997 and 1998.

The implication is that the Yen carry trade came back on line fairly quickly after financial markets regained their footing. Apparently financial cockroaches are, like their arachnid namesakes, largely immune to the effects of fallout. As described by the BIS author:

…with extreme risk aversion abating, carry trade activity – a relatively risky strategy – may have returned in the second half of 2009. Indeed, carry trades in a number of high-yielding currencies, especially those of commodity exporters, provided extraordinarily high ex post returns over this period. Moreover, near zero interest rates prevailed in many major currencies, increasing ex ante profitability not only for traditional funding currencies such as the yen. Carry-to-risk ratios support this conclusion…

A a critically important aspect of this issue is financial regulatory reform. Very little has been done from a regulatory standpoint to bring down the astronomical leverage that was available for carry trade speculation prior to 2008. Yesterday, Larry Summers gave an interview to CNBC in which he emphasized that the scope of the proposed “Volcker Rule” was limited to particular types of banks.

If true, over leveraged areas of global financial markets are likely to continue escaping prudent regulation, which means that the pronounced cycles of euphoria and distress in risky asset classes will continue. While those swings create opportunities for contrarian investors, the dynamic behind them is a zero-sum or even net-negative economic game. In the long run, it causes more economic harm than it’s worth.

And while interest rates have converged substantially since the 1990s, current spreads are likely to persist in the decade ahead for multiple reasons, not least being variation in demographic cycles, which will mean lower nominal rates in most developed countries, and higher rates in most emerging markets.

In other words, the roach bait isn’t going anywhere soon. That means that sound regulation absolutely must fill the void in order for the gains from financial market speculation to approach something resembling a social optimum.

UPDATE 3/2/2010 – AP report on further progress in Senate Finance on financial regulation

URLs:

http://www.bis.org/publ/qtrpdf/r_qt1003f.pdf?noframes=1

http://symmetrycapital.net/index.php/blog/2010/02/wsj-hedge-fund-career-trades/

http://news.yahoo.com/s/ap/20100302/ap_on_bi_ge/us_financial_overhaul

Dollar Strength & Foreign Credit

We came across an interesting piece on the relationship between the USD and commercial credit activity outside the U.S., as shown in the chart below. The implication, based on a quick and dirty visual analysis, is that if USD strengthening continues (the red line, which is plotted inversely), then foreign commercial paper (the blue line) is likely to contract. In other words, a dearer dollar could spell trouble for foreign economies, and that would have negative implications for economic activity, commodities, and risky assets abroad, all else equal.

This piece of evidence, combined with our strong dollar call yesterday, raises some fascinating possibilities. A rush to the USD was not on many strategists’ radar in 2009, or even to this point in 2010. Judging by markets’ performance today and yesterday, we could be seeing a significant break from those views. Then again, we might just be seeing the first notable stock market correction since last year; a USD squeeze might also be a short lived phenomenon.

We see too many moving parts to make a firm call either way. The markets continue to face the spectre of tightening federal purse strings and a ‘less easy’ Federal Reserve in 2010, and as of this week, they are now sitting in the middle of the open conflict that has broken out between the administration and the financial industry.  

We also see complexities in that battle that make it hard to come down on either side. We offered criticism of Obama’s initial remarks on the financial assets tax, though we later qualified it, and some of his remarks today were spot on. And while government policies and institutions certainly set up incentives to greed and stupidity, the actions embodying greed and stupidity (and the massive trading of rents that did little or nothing — arguably less – for economic welfare) were taken by individuals and organizations in the financial industry. And yet the overall tone of hawkishness from policymakers has negative implications for everyone, regardless of what street they make a living on.

There’s also a little noted irony in the apparent desire of some Democrats to constrain the size and activities of the financial sector. If Ajay Kapur’s research is on the mark, the sector is going to be shrinking in the years ahead regardless of regulatory changes, due to the shrinking ratio of middle aged adults.  A more interesting thing to speculate on, given the continuing centrality of the USD in the global economy, is how well those faster growing regions of the world will cope with tigher global liquidity. 

[UPDATE 1/21/2010 - In a CNBC interview moments ago, House Financial Services Commitee chairman Barney Frank put a far kinder and gentler spin on the recent presidential bluster, saying that a regulatory regime shift would have to be drawn out over several years and do a minimal amount of harm. This appears to have calmed frayed nerves in the market, and is a nifty scoop for Burnett and Cramer. Cramer's inferring that Paul Volcker (a man with a history of bull-in-a-china-shop approaches to policy) has the President's ear, while Frank comes down with the more nuanced regulatory views of Fed and Treasury, which could make for some political drama in the year ahead. It could even be a high stakes game of good cop, bad cop -- time will tell.]

http://shadowcapitalism.com/2010/01/20/the-implications-of-a-dollar-squeeze-on-foreign-banks-credit-access/

http://www.miraeasset.com/data/download.jsp?file_path=upload&file_name=MiraeAsset_TheGlobalInvestigator_20090812.pdf

http://www.cnbc.com/id/15840232?video=1340630859

http://www.cnbc.com/id/34979114/site/14081545

Idle Speculator: Is the Federal Government Too Tight?

In our latest Idle Speculator piece, we ask whether — despite large recent and expected budget deficits — the federal government risks being too tight. We argue that:

(1) At certain times and under certain economic conditions, deficit financed improvements in the tax code and public expenditures and investments make sense.

(2) The U.S. may be in one of those periods now, while Japan may be exiting one. In both cases (as well as the Great Depression), demographic trends might be playing a larger role than conventional theories assume.

(3) Pro-growth fiscal policies would give the Federal Reserve a lot more room to raise rates and defend the USD.

(4) Given: the enormous nominal dollar figures attached to discussions of U.S. budget deficits and national debt; widespread misconceptions about public finance and its economic effects; and ideological rancor among voters and politicians; there will be increasing pressure to tighten up the federal budget in coming years. Such actions could be premature and threaten a nascent economic recovery.

http://symmetrycapital.net/idlespeculation/20091109.pdf

An “Outraged” John Mauldin

Industry scribe John Mauldin let loose on current proposals for financial regulatory reform in a recent email bulletin:

…I am outraged at the paltry proposed financial “reforms.” Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don’t care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen.

Git ‘em, John.

s+b: Better Way to Regulate Bankers’ Pay

Another take on the political fight over regulating compensation in the financial industry, this time from Shumeet Banerji at Booz+Hamilton:

…plans to limit compensation will not work, because they do not address the core problem: the disconnect among bank capital, risks (borne by both banks and society), and compensation structures (particularly the way traders are paid).

…the system is ripe for change. The solution lies not in aggregate, rules-based regulation, but in a microeconomic reassessment, within each bank, of how…to interweave the ways risk is taken, capital is allocated, and people are paid. There are probably several self-regulating and self-correcting mechanisms that banks and regulators could put in place right now. Two simplified examples…illustrate the point.

The first is “paying on the trade.” Instead of paying commissions based on a “mark-to-market” estimate of the value of a position, as most banks do now, base them on the actual profit made when a deal is consummated and the position is liquidated. There would be no need to further reserve against the downside because the risk of the deal would be fully internalized. The second is to require each institution to reserve enough capital to account for the downside risk of the asset that has been purchased, including the value of the share of the putative profit that has been paid out in bonuses.

Either of these solutions would tie compensation and capital directly to the risk and leverage in each contract, rather than setting up crude aggregate standards that don’t take into account the characteristics of a particular trade. Instead of shifting the burden of judgment to regulators, this approach would better harmonize individual and institutional incentives. And when bankers have reason to pay attention to the true economics of their deals, rather than to the impact on their bonuses alone, they might find themselves making better deals — and thus reclaiming the reputation they have lost.

Sounds nice — adjust the institutional frameworks by setting up a “granular”, trade-level approach to regulation that will make banks better stewards of shareholder, depositor, and taxpayer capital. But if the last two decades are any indication, it’s a pipe dream. Here’s the scariest part of Banerjee’s proposition (emphasis added):

…one proposal would set in place a maximum leverage ratio: borrowed funds should not exceed some value, such as 25 times equity. In principle, limiting leverage seems like a good idea, but no aggregate rule can possibly apply to the wide variety of banks, trades, and risk profiles. Such a rule would trump good judgment by skilled risk takers. And a billion dollars worth of investment capital, operating within a regulatory leverage cap, could still be deployed and lost in a million lousy trades.

We’ll make very clear where we stand on this issue:

• Leverage caps are the best and only way to manage systemic financial risk. It was the “competitive” lifting of caps by regulators in Europe and the U.S. that helped get the world into this mess.
• Any given trade has a winning and losing side. A precious few might have enough skill to win persistently, but trading involves a great deal of luck and provides limited social benefits (talk about crowding out…). Luck should not be leveraged!
• There is absolutely no reason, however skilled an individual trader might think themselves, to allow them to leverage their capital many times over.
• The performance of 99% of professional risk takers in 2007-2008 sucked, primarily because traders and risk management departments look myopically at their own books; they are not equipped to monitor systemic leverage and fragility, and the risks that their burgeoning trade books pose to the underlying payments system itself. Sucking and institutional blind spots should not be leveraged!
• A 25x cap on leverage still looks generous, and it’s absolutely fair game for the public to have a debate over what the caps on financial leverage should be. 

The fact that we’re talking about proposals as timid as 25x — a level which has still managed to get the global financial system into plenty of trouble in recent decades — is damning evidence of regulatory capture. As William Buiter put it:

The Fed, unlike the ECB and the Bank of England, is also a banking sector regulator and supervisor. This gives it an informational advantage. The downside to the Fed’s position is the risk of regulatory capture. I believe that what I call ‘cognitive regulatory capture’ of the Fed by Wall Street has occurred during the past two decades. The net result is that both as regards macroeconomic stability and as regards future financial stability, the Fed has performed worse during this crisis than the ECB and the Bank of England.

Future regulation will have to be base on size and leverage of institutions. It will have to be universal (applying to all leveraged institutions above a certain size), uniform, countercyclical and global.

Financial crises will always be with us.

Given the timidity of a 25x cap on leverage, we’ll revisit the mathematics of leverage once more. At 25x, a financial entity can acquire (create) $25 of assets for every $1 of equity (which according to balance sheet mechanics, means it takes on liabilities of $24). Because liabilities are senior to equity (liabilities have to be serviced from either operating cash flows or equity), a $1 loss on those assets — i.e., a decline of only 4% — wipes out all equity (or “capital”, in banking lingo). At a leverage ratio of 10:1, the loss on assets would have to be at least 10% to wipe out an entity’s capital. We know from history that financial assets in the aggregate can lose 4%, or even 10%, often in short order. The risks posed to the financial system’s solvency by high leverage should be painfully obvious (and as John Geanakoplos and others have pointed out, leverage tends to be increased and decreased by the banking sector in a very procyclical fashion).

We applaud Banerjee for trying to integrate compensation issues with systemic ones, but it’s extremely speculative to think that the deep seated human behaviors associated with outsized risk taking are going to change due to a shift in compensation practices. Leverage, commitments, and systemic fragility must be the center piece of any new financial regulations, otherwise it will be back to the future - probably within five years, almost certainly within ten.

In fact, if you want to see over-leveraged “skilled risk takers” in action, take a look at gold, which seems ready to go parabolic as traders jump alongside central bank buyers — who historically happen to be the ultimate contrary indicators in gold markets. When the fever breaks — and admittedly, there could still be plenty of ‘parabola’ to ‘trace’ before that happens – it won’t be pretty. Momentum lemmings should not be leveraged!!! Unfortunately, they still are…

URLs:

http://www.strategy-business.com/article/00007?pg=all

http://www.nber.org/~wbuiter/NAcrisis.pdf

http://www.arts.cornell.edu/econ/CAE/conferences/John%20Geanakoplos.pap.pdf

DISCLAIMER and IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by corporations mentioned. Symmetry Capital Management, LLC is an Amazon.com associate, and may earn a percentage of any sales generated by clicking through to the Amazon.com website from links on our website.

Tasker: China following in Japan’s footsteps?

China analyst Peter Tasker in the Financial Times:

[In the late 1980s, while] the western world was stuck in the post-crash doldrums, the Japanese economy had got back on track with apparent ease. Japanese corporations were using their high market capitalisations to finance acquisitions of foreign trophy assets. Japanese banks boasted the world’s strongest credit ratings.But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster. And it was the weak western economies, not Japan, that produced healthy investment returns over the next decade.

[Japan's] current account surplus and strong fiscal position provided the macro policy leeway to make any slowdown strictly temporary. The Bank of Japan duly put the pedal to the metal and the recently deregulated banks went on a patriotic lending spree. High-end consumption boomed but the real action was in the asset markets and capital investment, which soared as a proportion of gross domestic product.

Sound familiar? It should, because the same dynamic is evident today in China and some other emerging economies.

Tasker then invokes turn-of-the-20th-century economist Wicksell, a favorite of ours:

If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China’s interest rates should have been close to 10 per cent for most of this decade. Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that “imported” it. The result could only be a massive misallocation of capital.

Tip of the hat to the truly prolific Ed Harrison at the Credit Writedowns blog. On a related note, one of his colleagues, Marshall Auerback, is the first analyst we’ve come across who’s aware of the continuing significance of China’s yuan devaluations in the early/mid 1990s:

…between 1992-94, China devalued the RMB by close to 60% (she was already running a current account surplus when she did it the second time), which created huge competitive pressures for the other [Asian] countries and pushed them rapidly into deficit.  This time, China is devaluing along with the US dollar and reflating a credit bubble — not to encourage domestic demand, but to create a renewed export juggernaut, at a time of weak external demand.  This could really be problematic for the rest of the world.

I wonder how long before the protectionist pressures emerge?

All fair points, though Chinese authorities seem to be aware of the multiple risks they’re facing (whether they can manage them effectively is another question). But there’s another factor that might be just as important, and that’s demographics. The age composition of China’s population is trending in a direction that is not conducive to sustained 10%+ GDP growth.  Other BRIC  members should see more favorable demographic trends, with Russia the true standout. Russian markets also happen to sport the highest risk premia compared to Brazil, India, and China.  

URLs:

http://www.ft.com/cms/s/0/39f61cb6-c818-11de-8ba8-00144feab49a.html

http://www.creditwritedowns.com/2009/11/china-is-now-on-the-same-bubble-path-as-japan-post-1987-crash.html

http://www.creditwritedowns.com/2009/11/china-reflation-play-spells-trouble-for-rest-of-the-world.html

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1&pageNo=1

DISCLAIMER and IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by corporations mentioned. Symmetry Capital Management, LLC is an Amazon.com associate, and may earn a percentage of any sales generated by clicking through to the Amazon.com website from links on our website.

Roubini re USD Carry Trade – Back to the Future

Via an Edward Harrison post on Seeking Alpha, we learned of Nouriel Roubini’s recent comments that the USD is fueling the “mother of all carry trades” and creating multiple global asset bubbles.

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.

“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”

There is plenty of truth in what Roubini said, but it’s nothing new — carry trades have been a recurring feature of the post-WWII global financial system, especially since the 1960s, when the breakdown of the Bretton Woods global gold exchange system began. And as we have noted for some time, the U.S. is in a long (perhaps multi-decade) cycle where monetary policies appropriate to domestic economic conditions will have inflationary consequences abroad, and thus some residual stagflationary effects at home. This is the inverse of the 1980s and 1990s, and parallels experiences of the 1960s and 1970s. And while we previously believed that fiscal, regulatory, and other economic policies were the only important drivers of such outcomes, we now believe that demographic trends play a major and possibly decisive role. If true, we expect with near certainty that current trends will remain intact through the next decade, based on global demographics. Economic policies certainly play a critical role, but their effects unfold at the margin, i.e., outcomes can be made marginally better or marginally worse by policymakers’ decisions (though history shows that there is always the possibility of policies going off the rails, and thus having more than just marginal effects).

Despite Roubini’s protestations, it’s not clear how far USD fueled asset speculation might go. Harrison rightly points out that Japan’s quantitative Yen easing in recent years coincided with bubbles in mortgage finance. But as we have pointed out in prior assessments of the crisis, that carry trade was amplified substantially by historic leverage ratios in the U.S. and parts of Europe among investment banks, some of their clients, and private households. This was due primarily to regulatory lifting of leverage limits and public support of mortgage markets, as well as bankruptcy reform legislation that made lending to consumers more attractive (or so it seemed at the time!).  That’s clearly not the trend at present: deleveraging continutes apace in the private sector, offset only partially by governments as they try to ameliorate declining resource utilization. Furthermore, some beneficiaries of the current carry trade are behaving rather soberly, at least for now. For example, Brazil recently instituted capital taxes to act as a brake on hot flows. That’s precisely the opposite of what homeowners, consumer credit borrowers, investment banks, private equity funds, hedge funds, and many others did during the height of the Yen trade.

Unfortunately, the global financial system is a rather efficient beast these days; not necessarily at finding the best targets and optimal levels of investment, but at finding and over-exploiting any pockets of demand for credit flows it can find, and at keeping sounder regulatory constraints at bay. And if a sounder regulatory framework and capital standards are not imposed globally – a risk that seems to have a rising probability at the moment – then Roubini will certainly be proven right, and our global financial system will impose substantial social costs on billions of people yet again. The more this song repeats itself, the worse the public’s demand for retribution will be on the other side of any future crisis. Bonus caps today, firing squads tomorrow?

URLs:

http://www.creditwritedowns.com/

http://seekingalpha.com/article/169364-is-u-s-dollar-carry-trade-replacing-the-one-in-japanese-yen?source=article_lb_articles

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=atlyygQuBLUI

http://symmetrycapital.net/idlespeculation/20090209.pdf

Treasury: Stronger Capital, Liquidity Standards

The U.S. Treasury has telegraphed its objectives for reformed international capital standards (emphasis added):

The global regulatory framework failed to prevent the build-up of risk in the financial system in the years leading up to the recent crisis. Major financial institutions around the world had reserves and capital buffers that were too low; used excessive amounts of leverage to finance their operations; and relied too much on unstable, short-term funding sources. The resulting distress, failures, and government bailouts of these firms imposed unacceptable costs on individuals and businesses around the world. Going forward, global banking firms must be made subject to stronger regulatory capital and liquidity standards that are as uniform as possible across countries. Today the Treasury Department set forth the core principles that should guide reform of the international regulatory capital and liquidity framework to better protect the safety and soundness of individual banking firms and the stability of the global financial system and economy.

This is good stuff. Hopefully Secretary Geithner’s people will be able to get something like this done, and health care won’t prove to much of a distraction for the Administration — hopefully.

The bulletin claims that the standards should be agreed formally by the end of 2010, and regulations implemented by the end of 2012 — which unfortunately leaves plenty of time for another crisis or two to unfold, especially with the Fed and LIBOR rates being as easy as they are.

URLs:

http://www.treas.gov/press/releases/tg274.htm

A Couple of Trinities

Trinity #1 – CFO.com carried an interesting article from The Economist on Thailand’s recent bungling with capital controls, a problem related to the ”impossible trinity” of domestic liquidity, exchange rates, and capital accounts. We’re not so much interested in the trinity or the theory behind it as in this tidbit — the authors correctly point out that, although this episode might have reminded the markets of the currency crises associated with the ‘Asian Flu’ in 1997, it’s actually quite different [diametrically opposed, in our view]. Where the 1997 crisis was marked by capital outflows, the current challenge facing emerging Asian economies is one of capital inflows, a symptom of the so-called ’savings glut’ theorized by some economists in recent years. I suspect that many non-theorists would be curious to know how the world could go from a shortage of savings to a glut of savings in such a short span of time, given that we tend to think of ’savings’ as a reserve of wealth accumulated over long periods of time. The answer actually has to do with the money creation process, which is controlled largely by the U.S. Federal Reserve, and how this process influences the use of existing assets. Rather than delve into the theory behind it, we’ll just offer this pithy rule of thumb: when Federal Reserve policy supports a high real rate of interest, the demand for savings rises, pushing up the marginal cost of investment capital; while a low real interest rate dampens the demand for savings, thus lowering the cost of capital available for investment. From roughly 1996 to 2002 (ignoring the runup to Y2K), the Fed enacted policy that tended to raise the real rate of interest, and ended up causing all kinds of trouble globally, as capital became scarce: Asia in 1997, Russia in 1998, Argentina in 2001, and finally the U.S., starting with commodity and cyclical industries in the first half of the period, and ending with the infamous corporate debacles and bear market slides of the period. Since 2003, the Fed has kept the real rate of interest historically low, thus encouraging a ‘glut’ of savings available for investment globally. The recent episode in Thailand merely shows that both extremes (too tight or too loose) have global consequences.

Trinity #2 — Another Economist story carried on CFO.com discusses the ‘misaligned triangle’ between public companies, private equity, and investment managers, as articulated by Morgan Stanley strategist Henry McVey. The basic thesis is that long term investment by publicly traded firms is falling short of the level required to ensure long term profitability, because: (A) the executives of public companies are tending to hoard cash as a reserve for hedging against regulatory risk and for buying back stock in order to boost earnings per share and thus maximize expected compensation; (B) private equity firms are often attracted to firms with cash on the balance sheet, but rather than putting that cash to work in long term investments, their interest is typically in maximizing short to intermediate term cash flows, which naturally precludes capex; and (C) rather than fighting for the cash reserves that public shareholders are entitled to, many fund managers instead accept the performance pop their portfolio receives whenever a private equity bid is at a significant premium to market (or more precisely, to carry value). This is a great example of agency theory in action, and leads us to take a rather interesting long view: in coming decades, more and more of the heavy lifting related to investment will be carried out by closely held private firms (or consortiums of such firms), while larger pools of capital will take over an increasing share of financing such investments. In fact, we can think of several current examples that might mark the beginning of such a trend, and thus lend support to the hypothesis. The long term impacts on markets, investors, businesses, and governments could get very interesting.