More than liquidity, the really powerful means in the regulatory toolbox is solvency and therefore capital, says Dimitris N. Chorafas in ‘Risk Pricing: New approaches to de-risking financial products’ (www.visionbooksindia.com). Underlining that solvency must be used to protect taxpayers, as well as to persuade banks to reform themselves, he adds that to do so in an able manner the capital amount should correlate to assumed risk, measured objectively.
The author reminds that capital comes from savings and investments, not from the printing press of the Federal Reserve, the Bank of England or any other monetary institution, and notes that capitalism is promoted through entrepreneurship, and not by the government’s generosity. He narrates how, since 2000, the global banking industry had a whole new trove of big risks through novel instruments, but lacked one basic ingredient, viz. real money. “As leveraging reached for the stars, first came the stock market crash of 2000, then the sub-primes, credit crunch, illiquidity, insolvency and deep recession of 2007-2009, which saw to it that capitalism was left without capital.”
Cause of collapse
Behind the collapse of the financial system, what Chorafas sees is the absence of metrics that could have enabled the measurement of exposures assumed by banks and other financial institutions. He mentions, for instance, how financial innovation and technology have seen to it that the approach of counting credit risk and market risk separately no longer allows the regulators, and the bank’s own management, to watch over exposure.
What accentuates the woes of central banks is ‘the recently developed practice of running the banking system not as a vital social service but as a bunch of off balance sheet vehicles,’ the author observes. “The after-effect has been a radical change to the mission of monetary institutions, as they found themselves obliged to proceed with a massive salvage operation of banks that were ‘too big to fail,’ the invention of quantitative easing and super-leveraging of their own balance sheets.” The result, dangerously, is the spread of off balance sheet gearing from the private to the public sector, undermining thus the economy’s financial stability for which the central bank is responsible.
The book cites worrisome numbers, in the context of the US economy, such as that the cost of the bailout may reach $23.7 trillion, an astronomical amount representing 177 per cent of the gross national product! Sceptical of the US Treasury letting ten financial companies repay loans they had received under TARP (the Troubled Assets Relief Programme), the author frets that the repayments may look encouraging but they were connected to the permission to pay big bonuses rather than to financial health.
He also counts in ‘the liabilities side’ the sharply diminished value of banks’ assets sheltered by central banks’ asset purchases, and sugar-coated by generous accounting rules. “What all this suggests is that America, Britain and continental Europe have a thinly capitalised banking system that is being allowed to earn its way back to health on the back of taxpayers – with ominous effects on the increase of national debts in Western nations, whose interest payments will weigh heavily on future state budgets.”
Overcapacity in banking
Of significance is the insight in the book that governments have not explored the hypothesis of overcapacity in the banking industry. “The entropy associated with overcapacity is one of the key reasons which brought down the former ‘big three’ of Detroit. In a similar manner, there are simply too many banks in the global economy...”
The author sees a parallel between the glut of a global manufacturing capacity of motor vehicles (which along with aloofness and mismanagement have brought Detroit into real difficulties), and the plethora of financial companies (both at the international investment banking, trading and wealth management level, and at the national, regional and local level).
He refers to the view of the IMF that the US and Germany have more than twice as many banks relative to their population as Britain, Canada and Japan, with France and Italy falling in between. “The intense competition for customers means that they are far less profitable than they might have been and, over and above that, they are weakening their financial staying power by warehousing worthless paper in a vain effort to improve their income.”
For a sombre study.