IMF Questions Raise Questions

The IMF is discussing many questions in the Global Financial Stability Report – Responding to the Financial Crisis and Measuring Systemic Risks April 2009 © IMF. I here bring up two of them being of significant importance. You find them in the report in pp112-

Question 1: "What were common factors among the financial institutions (FIs) that have required public intervention? Did traditional financial soundness indicators (FSIs) provide meaningful warnings?"

My comment: Putting this question can only an academic or public servant do. Someone who still has the belief that social engineering is an exact science that should be performed only by scholars and the elite. There is nothing replacing experience and common sense. Experience from running businesses and the common sense developed in the process focusing on the survival and growth of the company. Only being exposed to true competition can develop it. The problem with the banking system is that it is not a competitive system forcing survival of the fittest. It is a protected system based on survival of those who conform and those who do will always enjoy government or rather taxpayers' protection. You cannot find a set of indicators to run an enterprise remotely. The conditions change constantly and only flexible minds managing to make investments with relatively low risks will survive over time. And then there is the element of luck that always has to be on your side to win. The aspiration of social engineering and banking supervision and regulation tries to disregard those facts or natural laws if you wish. Risk management cannot be 100% automated, you need to add people with integrity, experience and common sense to have the final word. The IMF is on the wrong path. Social engineering and industry protection leads to moral hazard or plain corruption. The banks have to be exposed to full competition and regulation shall protect society from banks' defaulting, not the other way around.

Question 2: How can one determine which FIs are systemically important? Can one shed light on whether allowing Lehman Brothers to go bankrupt was or was not a policy “mistake” exante?

My comment: There are probably ways to define which FIs being most important. But why do we have these giant FI? Why not consider a system which does not allow any FI to be systemically important?

The problem with Lehman Brothers was not that it was allowed to go bankcrupt. The problem was instead that the Fed did not have any tools to save it, so Fed had no other option than to let it go. The Fed hadn't prepared for a potential failure of a FI! They have actually admitted that fact (see my blog from May 6 2009 "Fed Lacked Tools"). Read also the Letter to Shareholders by JP Morgans' Chief and get some valuable insight on the chaotic acquisition of Bear Sterns. I'm still amazed that the Central Banking system was so unprepared to handle the crisis.

Health of European Banking System

This is an extract from FT dated June 12 2009. Copyright The Financial Times Limited 2009.

"Alistair Darling, UK finance minister, told the Financial Times this week that a failure by other European countries to clean up their banks could hold back economic recovery.” They continue:

“The euro has been laid low by fears over bad loans, with concerns over the exposure of banks in the region to a potential meltdown in the Baltic states and central and eastern Europe weighing on the single currency. Many commentators expect that trend to intensify. Maurice Pomery at Strategic Alpha says the eurozone banking system is in denial over the extent of toxic assets on its balance sheet. “We still don’t know the full story,” he says. Mr Pomery doubts that German banks have been operating on vastly different business models over the past five years than their peers in the UK, US and Switzerland, which have revealed their high degree of vulnerability to the financial crisis. “I think they have significant exposure,” he says. “Central banks are worried about opening Pandora’s box and when they do it will impact on the euro.” Analysts say the problems in the eurozone’s banks are likely to be swept under the carpet ahead of the German general election on September 27. Hans Redeker at BNP Paribas says there is no incentive for the German government to raise the issue ahead of the vote. But whoever wins will want to get the problems out of the way as soon as possible. He regards the German and Austrian bank sectors as the weakest in Europe. But falling real estate prices and rising unemployment will also weaken bank balance sheets in Spain.

The low transparency of the banks’ accounts is a great worry for corporates and other investors. Probably there is more to it than meets the eye. If the FT is correct than the European governments are hiding very crucial information from us. That would not be ok! How can we know which banks to trust with our cash?

Second Engine Implosion

I hear from treasury peers that the credit market is returning gradually. That is comforting but we are still far from the credit expansion bonanza that ended 2007/08. JP Morgan has a very well written paper on the reasons behind the crisis from where I have borrowed (and revised) this picture.

Prior to the Basel Accord the banks did basically all lending to corporates and individuals. Boosted by Reaganomics and the Basel Accord the second engine (in the picture "bond market" and "securitization") took over the lion share of the lending. The purpose of the second engine was to support credit expansion and create a protective shield for the banks.

Now the second engine is working at reduced capacity and regardless if the banks increase lending there remains a huge credit gap. This picture made me understand how vast the financial collapse actually is and that it will take a long time to return to status quo. I believe this picture also shows that high leverage will probably not be the strategy for the imminent future.