
De Larosière for long-term value and economic stability

One of the underlying themes that comes from analysing the present crisis is that the policing of the financial system in the broad sense, - ie, including fiscal and monetary policies, regulation, accounting rules, risk assessment and management -was dominated by short-term incentives, and had lost sight of the medium to long term.
I shall try to illustrate how this theme prevailed in four spheres:
- the global financial setting,
- prudential regulation,
- accounting standards, and
- governance.
The global financial setting
For the past 20 years or so, the world has built up large current-account imbalances. The structural deficits of the US - reaching some 5-6% of GDP - have been financed by the surpluses of emerging-market countries which have - through exchange-rate intervention - accumulated vast foreign-exchange reserves. This phenomenon, which that led to a skyrocketing increase in liquidity and in US indebtedness, was not sustainable.
How did fiscal and monetary authorities react? Did they put in place policies that would have moderated the pace of indebtedness? No. On the contrary. As consumer-price inflation did not appear to be a problem, interest rates were kept low - hovering around zero in real terms - and nothing was done to curb credit expansion.
The consequences of this absence of reaction are well documented: leveraging ballooned, bubbles appeared in asset prices (bonds, equities, real estate etc.) As a result the overextended financial system, in the broad sense, became extremely vulnerable to a downturn and to an inevitable fall -- in asset prices.
Policy favoured short-term expansion over the long lasting stability of the financial system. We are all paying a very high price for this short-sightedness.
Prudential regulation and solvency ratios
How many times did I hear, over the past ten years or so, these words: "We know that the macro imbalances are not sustainable, but, at least, we have a strong and resilient banking system."
That perception was based, to a large extent, on the apparent progress in prudential regulation. Indeed, the Basel Committee standards greatly refined the notion of "risk sensitive" capital requirements. But there was a flaw in the implementation of that concept. Regulators relied excessively either on risk assessments made by rating agencies or on banks' own internal risk models.
It became apparent, after the crisis erupted, that rating agencies had not been able to adequately assess the riskiness of complex structured financial products. Moreover, internal bank models grossly underestimated the probabilities of default and hugely overestimated the ability and willingness of short-term markets to continue to fund the banking and "parallel" systems. These models were based on data that did not extend back far enough in time and that did not sufficiently take into account either the liquidity dimension or the medium-term consequences of a reversal in the fortunes of financial markets.
This prudential risk outlook, that paid too little attention to the evidence from busts past, contributed to procyclicality by fixating on the boom years leading up to the summer of 2007.
In the good years no extra capital requirements were imposed on high asset valuations, but when things reversed, sudden and brutal increases in capital requirements were imposed, forcing banks to sell their assets and hence contributing to the fall in the markets.
Accounting standards
Some 20 years ago, the US adopted the mark-to-market principle. American policymakers were active in exporting this rule to Europe through the Anglo-Saxon-dominated IASB (International Accounting Standards Board).
The IFRS (International Financial Reporting Standards) rules - coupled with the risk-sensitive prudential standards mentioned above - exerted a strong pro-cyclical influence. Indeed, two things went fundamentally wrong:
- First, when markets dried up, assets became very difficult and often impossible to mark to market. In order to avoid the extreme consequences of "fire sales", the IFRS system had to give way to other - imperfect and heterogeneous - measurements that were "model based";
- Second, and more fundamentally, the extreme application of the mark-to-market rule is dangerous. Indeed it leads, in boom times, to asset valuations that are, by definition, high. But no discount is applied to these valuations for future losses that will undoubtedly occur through the cycle. This is a serious methodological flaw that amplifies the credit cycle's peaks and troughs.
It would make more sense to distinguish between trading books (that should be marked to market) and assets that are kept on the banking books for a long period. The latter should be accounted for with amortised costs at original value (corrected, of course, for future impairments).
America has begun to redress these failures. The US accounting board (Financial Accounting Standards Board), in April, corrected the first flaw mentioned above. It has agreed that banks will only have to recognise the definitive losses incurred on debt investments classified as "available for sale". The difference between these incurred losses and the market value will not have to be impaired.
Why doesn't Europe take advantage of this bold decision? Let us not forget that we live in a competitive global world where a level playing field is of the essence. Besides, accounting rules are not just technical standards. They can have a major impact on banking business models and on financial stability in its broadest sense. Hence, regulators should have adequate representation and influence on the IASB.
Governance
It is not surprising that in this dangerous environment and with these often perverse regulatory incentives, financial institutions took advantage of the situation.
We have thus observed over the recent period a number of governance issues, notably:
- the abuse of securitisation which contributed to a worsening of credit standards (since questionable assets could easily be passed on to misinformed investors);
- the abuse of off-balance-sheet operations (SIVS have prospered beyond imagination and were not caught in the regulatory net);
- the abuse of myopic remuneration systems (it seems obvious that bonuses should be calculated on a multiyear basis and not exclusively focussed on short term results).
Regulation, while it is not the only solution to those problems, has a substantial role to play.
It is not the only answer.
Of course, central bankers should always be concerned by excessive credit expansion and asset bubbles.
Of course, multilateral surveillance - the key mandate of the International Monetary Fund - should be more effective in curbing excessive imbalances.
Of course bankers should anticipate bad days and make adequate provisions.
And of course they should focus on the creditworthiness of their clients.
But since this natural governance has been so faulty over the past years, some form of well-designed, prudent and anti-cyclical regulation is important.
This is what a group which I chaired has tried to propose in a recent report to the European Commission.
Click here to read the report
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@centralbanking.com or view our subscription options here: http://subscriptions.centralbanking.com/subscribe
You are currently unable to print this content. Please contact info@centralbanking.com to find out more.
You are currently unable to copy this content. Please contact info@centralbanking.com to find out more.
Copyright Infopro Digital Limited. All rights reserved.
As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (point 2.4), printing is limited to a single copy.
If you would like to purchase additional rights please email info@centralbanking.com
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (clause 2.4), an Authorised User may only make one copy of the materials for their own personal use. You must also comply with the restrictions in clause 2.5.
If you would like to purchase additional rights please email info@centralbanking.com