You can regulate smartly, or you can over-regulate stupidly. Knee-jerk reactions like we are seeing at the moment inveiably seem to fall in the second category. Create two new problems trying to fix one sort of thing…
A serious blog from a less than serious Ibiza, where the recession doesn’t seem to have taken too much of a hold, yet.
I read something like this on the blog of a greatly respected American economist I know personally and who always manages to explain economics in plain English, which make them more understandable to lesser brains like me. He will forgive me where I paraphrase, but it explains quite well where political incomprehension of economic and accounting principles has unforeseen consequences on a week financial system.
You can regulate smartly, or you can over-regulate stupidly. Knee-jerk reactions like we are seeing at the moment inveiably seem to fall in the second category. Create two new problems trying to fix one sort of thing…
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An additional measure was taken by banking regulators a few months ago that just struck him as one of the possible reasons for the current economic setback.
This is best illustrated first by an example.
A bank holds securities in its ‘hold to maturity’ account. If these securities become ‘impaired,’ as defined by regulation, they are marked to market and capital adjusted for that loss.
But recently an additional measure was taken by the regulators. If these securities are downgraded to below ‘investment grade’ they are not only marked to market for net capital calculations, but also treated as a ‘charge off’ for capital ratio purposes.
For example, if we have $1 million security that is downgraded below investment grade and has a current market value of $500,000, we reduce our stated capital by $500,000, as had previously been the case. But now, even that $500,000 remaining value, is, for all practical purposes, counted as 0 for purposes of determining the bank’s capital ratio.
The capital ratio is the important calculation as it determines how many assets a bank can carry for a given level of capital. This means, for example, that if a bank had securities that were below investment grade with a market value equal to all its capital, it could not carry any other assets or deposits.
They call this ‘super risk weighting’ or something like that. More details to follow, and any additional info welcome, thanks!
Meanwhile, this has resulted in a sudden drop in the all important capital ratios, and with every downgrade below investment grade by the ratings agencies, a much larger capital reduction takes place than under previous rules.
And, equally important, all banks holding any securities are at risk of losing all ‘credit’ for even the fair market value of their securities for purposes of determining their capital ratio compliance.
Additionally, this can force sales of these securities as the proceeds of a sale at least add that much capital back to the capital ratio determination. And the forced sales, of course, drive prices down below even today’s depressed market values. This provides high yielding securities with little or no risk at the now lower prices for unleveraged buyers, at the expense of the banking sector. Lots of invetors and HFs rubbing their hands there.
Banks are now in many cases public private partnerships, and it looks like the public partner is shooting itself in the foot contrary to any notion of public purpose. Regulators have said there is no chance for this rule to be altered. How unsurprising as it would be an admission of stupidity or accounting ignorance.
And as an aside, I know of a bank who had a security that was simultaneously downgraded by one ratings agency and upgraded by another. Interesting how after all the criticism of ratings agencies, the US government has increased its reliance on them for purposes of public policy. As I mentioned in another piece a long time ago, they are really the guys who should be taken over by government and forcibly shut down, to be replaced by a fully government funded single independent rating entity…
Anyway, my friend always says that the financial sector is a lot more trouble than it’s worth…
Watch this space for more on this… or contact me by putting your email address in the comments box below if you want to read more from him and I will direct you to his blog.
Happy holidays.
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