Home » Opinion » Foreign Views
In praise of old-style case-by-case lending
By Amar Bhide |
July 7, 2011, Thursday
|
Print Edition
Print Edition
IMAGINE that the arguments triggered by the Hindenberg disaster were about the fire extinguishers and parachutes that airships should carry, rather than about the design flaws that might cause them to ignite. Unfortunately, today's debates about banking reform have just this character.
Reversing the robotic gigantism of banking ought to be the top priority for reform. Bankers were once supposed to know every borrower, and to make case-by-case lending decisions.
Now, however, banks use models conjured up by faraway financial wizards to mass-produce credit and a range of derivative products. Mass-production favors the growth of mega-banks, so, unlike the misjudgments of lending officers, these behemoths' defective models have had disastrous consequences.
Radical proposals that would help restore a more resilient system, offered by the likes of Governor of the Bank of England Mervyn King, have been smothered by noisy discussion of measures that do nothing to address modern banking's fundamental defects.
Consider the seemingly heated debate over how much capital banks should hold. Regulators have proposed steep hikes: a Bank of England study, for example, suggested a more than three-fold increase.
Bankers, who may really be worried about their own bonuses, warn that higher capital requirements will force them to curtail lending, thus impeding economic growth. In fact, this is all a pointless charade. Yes, the principle of regulating bank capital seems sensible. Borrowing increases risk in any business: you can't go bankrupt if you have no debt. Heavy borrowing also encourages owners and managers to go for broke, because it's the creditors who bear most of the downside risk. Prudent lenders therefore try to limit both how much a business can borrow and the other risks it can take.
But creditors don't have an incentive to place tough limits on banks. Because runs on banks can trigger distress, governments explicitly guarantee insured deposits and implicitly guarantee all the other debts of mega-banks. Governments that guarantee bank liabilities, however, must also demand that bankers exercise more prudence than they might on their own.
Yet focusing mainly on how much banks borrow while ignoring other, more serious recklessness is a bad regulatory bet. Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans.
Wishful thinking
Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks.
Regulators then shifted to edicts requiring banks to maintain a specified capital cushion, thick enough to cover potential losses. This approach presupposes that bank assets and exposures can be accurately measured. In fact, the financial statements of mega-banks are impenetrable works of fiction or wishful thinking.
The problem goes beyond deliberate obfuscation. J.P. Morgan and Deutsche Bank have paid substantial sums to settle charges ranging from bribery to illegal foreclosures to abetting tax evasion.
Ruling out the connivance of top executives raises an alarming question: Does Jamie Dimon, J.P. Morgan's highly regarded CEO, have as little grasp of the exposures embedded in his bank's nearly US$80 billion derivatives book as Tony Hayward, the hapless ex-CEO of BP, had of the hazards of his company's ill-fated rig in the Gulf of Mexico?
Indeed, ignorance about what is actually at risk makes debates about the right formula for capital buffers surreal. Moreover, the use of mechanistic rules to determine capital adequacy has inadvertently encouraged systemic imprudence.
Banks naturally avoided traditional business loans (which would have to be backed by more capital), and instead loaded up on the highest-yielding - and thus riskiest - AA or AAA mortgage- backed securities that they could find. The global banking system and economy was thus vulnerable to the mistakes of the main rating agencies and their flawed risk models.
Smarter capital requirements - better Basel rules - aren't the answer. Bank lending and regulation must incorporate local knowledge, because, in a dynamic, unregimented economy, each borrower, loan, and bank is different (though some general guidelines can help).
The seemingly objective top-down approach ignores the idiosyncratic nature of risk and assumes that one mortgage loan is like the next.
We can no longer afford to rely on old-fashioned examination for mega-banks loaded with mass-produced risks.
And because stockholders or raiders can't force streamlining, governments must require these banks to shed activities that no one can manage or regulate and stick to hands-on case-by-case lending.
(The author is a professor at Tufts University's Fletcher School of Law and Diplomacy. Copyright: Project Syndicate, 2011.www.project-syndicate.org. Shanghai Daily condensed the article.)
Reversing the robotic gigantism of banking ought to be the top priority for reform. Bankers were once supposed to know every borrower, and to make case-by-case lending decisions.
Now, however, banks use models conjured up by faraway financial wizards to mass-produce credit and a range of derivative products. Mass-production favors the growth of mega-banks, so, unlike the misjudgments of lending officers, these behemoths' defective models have had disastrous consequences.
Radical proposals that would help restore a more resilient system, offered by the likes of Governor of the Bank of England Mervyn King, have been smothered by noisy discussion of measures that do nothing to address modern banking's fundamental defects.
Consider the seemingly heated debate over how much capital banks should hold. Regulators have proposed steep hikes: a Bank of England study, for example, suggested a more than three-fold increase.
Bankers, who may really be worried about their own bonuses, warn that higher capital requirements will force them to curtail lending, thus impeding economic growth. In fact, this is all a pointless charade. Yes, the principle of regulating bank capital seems sensible. Borrowing increases risk in any business: you can't go bankrupt if you have no debt. Heavy borrowing also encourages owners and managers to go for broke, because it's the creditors who bear most of the downside risk. Prudent lenders therefore try to limit both how much a business can borrow and the other risks it can take.
But creditors don't have an incentive to place tough limits on banks. Because runs on banks can trigger distress, governments explicitly guarantee insured deposits and implicitly guarantee all the other debts of mega-banks. Governments that guarantee bank liabilities, however, must also demand that bankers exercise more prudence than they might on their own.
Yet focusing mainly on how much banks borrow while ignoring other, more serious recklessness is a bad regulatory bet. Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans.
Wishful thinking
Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks.
Regulators then shifted to edicts requiring banks to maintain a specified capital cushion, thick enough to cover potential losses. This approach presupposes that bank assets and exposures can be accurately measured. In fact, the financial statements of mega-banks are impenetrable works of fiction or wishful thinking.
The problem goes beyond deliberate obfuscation. J.P. Morgan and Deutsche Bank have paid substantial sums to settle charges ranging from bribery to illegal foreclosures to abetting tax evasion.
Ruling out the connivance of top executives raises an alarming question: Does Jamie Dimon, J.P. Morgan's highly regarded CEO, have as little grasp of the exposures embedded in his bank's nearly US$80 billion derivatives book as Tony Hayward, the hapless ex-CEO of BP, had of the hazards of his company's ill-fated rig in the Gulf of Mexico?
Indeed, ignorance about what is actually at risk makes debates about the right formula for capital buffers surreal. Moreover, the use of mechanistic rules to determine capital adequacy has inadvertently encouraged systemic imprudence.
Banks naturally avoided traditional business loans (which would have to be backed by more capital), and instead loaded up on the highest-yielding - and thus riskiest - AA or AAA mortgage- backed securities that they could find. The global banking system and economy was thus vulnerable to the mistakes of the main rating agencies and their flawed risk models.
Smarter capital requirements - better Basel rules - aren't the answer. Bank lending and regulation must incorporate local knowledge, because, in a dynamic, unregimented economy, each borrower, loan, and bank is different (though some general guidelines can help).
The seemingly objective top-down approach ignores the idiosyncratic nature of risk and assumes that one mortgage loan is like the next.
We can no longer afford to rely on old-fashioned examination for mega-banks loaded with mass-produced risks.
And because stockholders or raiders can't force streamlining, governments must require these banks to shed activities that no one can manage or regulate and stick to hands-on case-by-case lending.
(The author is a professor at Tufts University's Fletcher School of Law and Diplomacy. Copyright: Project Syndicate, 2011.www.project-syndicate.org. Shanghai Daily condensed the article.)
- About Us
- |
- Terms of Use
- |
-
RSS - |
- Privacy Policy
- |
- Contact Us
- |
- Shanghai Call Center: 962288
- |
- Tip-off hotline: 52920043
- 沪ICP证：沪ICP备05050403号-1
- |
- 互联网新闻信息服务许可证：31120180004
- |
- 网络视听许可证：0909346
- |
- 广播电视节目制作许可证：沪字第354号
- |
- 增值电信业务经营许可证：沪B2-20120012
Copyright © 1999- Shanghai Daily. All rights reserved.Preferably viewed with Internet Explorer 8 or newer browsers.
