Conference - Law and the Economy - IDEFF
Panel 3 – Banking
Professor António de Sousa
I would first like to say thank you for the invitation to attend this conference on Law and the Economy today: What Lessons Have Been Learned? What Prospects for the Future? I would like to congratulate the IDEFF on its initiatives in this area, in which it has been a great pleasure for me to participate several times.
After the two presentations that we have heard and that addressed almost all the issues that I was planning to talk about, I'm going to try to summarise what has already been said.
I have divided my presentation into four areas: the causes of the present crisis, how the players or agents behaved, the lessons to be learned and the aspects that we are not taking advantage of.
The two basic causes were clearly easy money and deregulation. Both have their origin in the same person, Alan Greenspan whose name has already been mentioned here and who embodies this expression and this trend. It was obviously not just Mr Greenspan, but the entire US Federal Reserve Federal. I really believe that he did not have to convince his colleagues, because some of them embraced those theories even more than he did, although he played the most emblematic role. In Europe, the United Kingdom was the country that suffered most from this policy. So, what was the result of this policy of simultaneous easy money and deregulation? On the one hand, it was low interest rates. On the other, it was artificial conditions for lowering banks' solvency. Later, I will talk about the disaster that was Basel II, which took so long to discuss but was never properly implemented. The part that actually was implemented turned out to be disastrous. Indeed, at the moment everything that is being done and that has been studied in terms of regulation is exactly the opposite of the provisions of Basel II. Market value or fair value has already been mentioned here, but we have to talk about all aspects of the procyclicality of all these measures. This situation of low interest rates and artificially low solvency (I say artificially low because of the models included in Basel II that some banks began to use and also aspects that have already been mentioned here, such as securitisation and the fact that a good part of the risk goes off balance sheet), obviously ended up being an artificial way of working a solvency that seemed relatively high but was actually pretty low.
Then, as we know, subprime was a detonator of the crisis in practical terms, along with the leverage buyouts that invaded the market and prevailed for most of the time after 2003. The whole investment in terms of buying financial assets, such as shares, loans … well, all the aspects mentioned here, sprung directly from easy money.
Deregulation has a lot to do with financial innovation and deliberate non-regulation of financial innovation. For example, I remember the discussion about the need, or not, for some type of albeit mild regulation, even if only of statistics on hedge funds or special investment funds in general. This was successively shelved by international regulators, even though the European Central Bank tried to encourage regulation. This led to the appearance of a whole series of products that were so complex that their buyers didn't understand them. In fact, I would say that often not even their originators were completely aware of the risks. These complex products are also based on the idea that there is always a price for any product in a risk-return analysis. The problem, however, is when there is quite simply no buyer at any price, because the market has closed down. We saw this a year ago. The lesson to be learned from this crisis is that there's not always a market, whatever the price.
Then, deregulation ended up in a Basel II that, in spite of all the comments that were made, was even more procyclical than I thought when I participated in some of these discussions in the late 1990s. In spite of all the comments, the trend was towards procyclicality, aided not only by the Basel agreements but also by what Carlos Rodrigues called philosophical accounting.
I would say that it is more poetry than philosophy. Some of the rules about which I have the most doubts are surrealistic poetry. I don't understand what most of them mean or the interest of adopting the International Accounting Standards, for example. By trying to make the markets and balance sheets more transparent, they have made them more subjective, as the criteria are based on a subjective interpretation by the author of the accounts. For example, historical value might be completely out of synch with reality, but it was clear what it was. Now, we don't understand what fair value is. And, worse than this, there may be I don't know how many fair values, as has been said. In Portugal, people even argued that fair value for a certain type of asset on several banks' balance sheets was the same for all banks. But no-one could agree even on this as, in the spirit of deregulation, it would be considered an imposition by the authorities, which would not be acceptable or worth considering.
As we know, these two main causes had a lot of consequences. I will only quote two here. There was the speculative real-estate bubbles that we all witnessed (not only the bubble itself but the whole psychological aspect underlying it and what happened after), which very quickly woke up to reality from a kind of collective dream. In other words, as Mr Greenspan said, the bubble resulted in “irrational exuberance” in the different markets. I believe he said this in 1997 or 1998 and claimed not to understand why the stock exchange was rising so much. Well, if we compare the irrational exuberance in 1997 and 1998 with what was happening in real estate and other financial assets such as shares in 2006 and 2007, we see that the situation in 1996, 1997 and 1998 was highly controlled compared to what happened later. It was an apparent effect of wealth that enabled families to buy homes and then disappeared from one moment to the next. Of course it was more important in the Anglo-Saxon countries than in continental Europe, because of the type of guarantee associated with mortgages, i.e. with the debtor. While in Portugal and most other European countries the debtor is the debtor himself, in the United States the debt is linked to the asset, i.e. the home. This is why we see very graphically on television the keys simply being mailed to the bank. The people move out of the home and the bank gets it, because the debt has been paid off, in most contracts at least.
All this resulted in a second consequence, over-indebtedness of households and companies. It is has been mentioned enough here and so I will not talk any more about it. It's a fact and we are all aware of it. I would just like to mention an aspect that I feel is particularly interesting in Portugal, which is the way in which Portuguese households have reacted quickly to the stimuli of monetary policy; in other words, the way in which they have adapted their monthly expenditure. This is what people really care about, not the total debt compared to their disposable income, as we are comparing things with completely different timeframes - a debt payable over 20, 25 or 30 years, like a mortgage, and one year's disposable income. It is much more important to compare the outlay, i.e. the amount that has to be set aside from disposable income to make the repayments. Portuguese households actually reacted to this very quickly. We noticed this first when interest rates went down and disposable income increased, which was why they borrowed so much. Later, when interest rates went up again around 2002, the situation changed very rapidly and it's happening again this year. It also occurred a little preventively in 2008. In other words, there was concern as to how disposable income was going to evolve.
While the causes are known and have been mentioned here several times, how did the players, the market agents behave? The banks basically reacted to the incentives given to them. There was the artificial safety net that had been created for them a long time ago, what we economists call moral hazard conditions. This began with a famous case that we have almost forgotten and that occurred just over 10 years ago, with the bailout of a hedge fund, which even today is incomprehensible. The first large hedge fund, called Long Term Capital Management (LTCM), was set up by two Nobel Economics Prize winners, plus a third person who had not won a Nobel prize but was closely associated with option pricing. Moral hazard has to do with this network that does not really exist, is virtual in practice, though in the United States it was considered very real. This was why everyone was so surprised when nothing was done to save Lehman Brothers, after so many other institutions had been bailed out. It seemed that something very profound had happened. I believe that in a few years' time it will be very interesting to see why Lehman Brothers was not saved. I'm not claiming that it should have been. What I don't understand is why the others were and Lehman was not.
This incomprehensible dual standard also applies in this case. Just as I don't understand why LTCM was bailed out in the 1990s, I also don't understand why they did not save an institution like Lehman Brothers that obviously had much greater systemic impacts than a relatively small hedge fund in the financial market in the 1990s. There is also the idea of 'too big to fail'. In other words, if we are big enough, that virtual safety net is bound to appear. The fact is that it appeared in all the countries in which it happened, in some cases with dramatic effects. I would like to mention a case that has not been referred to today, and that is Iceland. We can compare the assets or size of the Icelandic banks' to the Iceland's GDP in a country that is one of the most developed, whatever yardstick we use, with the best systems of all kinds, ranging from health and education to its actual financial system. The real danger of 'too big to fail' was clear, because the fail was too big to bail. We all witnessed something very interesting. We saw on the news that it was worth going to Iceland, as it was one of the cheapest destinations in the world, while two years before it had been one of the most expensive. There was a radical change because of a systemic failure in this financial area, i.e. the banks.
In my opinion, in most cases the banks reacted as rational economic agents considering the conditions that they found themselves in. They reacted in the right way to the wrong stimuli. And that is an aspect worth mentioning here. Unfortunately, a lot of other things went wrong. Corporate governance did not work well at the banks themselves. Internal audits didn't work. Risk management models were aimed much more at playing with the amount of ratio that they wanted and how that would adjust to the ratio than to actually serve as well-tested risk management models. To make matters worse, there was no time to make this adjustment, because there were not enough observations. There had not been several economic cycles and, furthermore, most of the products had not existed in other cycles and so no comparison was possible. So then banks' own internal systems failed: audits and risk management. But we must clearly point a finger at the agents who are blatantly unable to do their jobs; it is the rating agencies that are still unable to do their job. At the moment they are purely and simply playing an overly defensive game. In other words, just as they gave tens of thousands of AAA ratings to more or less incomprehensible securitisations, they entered into the realm of consultancy, which clearly shows a conflict of interest. The agencies even explained the models that they used so that they could be replicated by the institutions that they rated. This meant that the agents, who obviously wanted to achieve a better rating and so get cheaper finance, were able to adjust their balance sheets and actions to these rating models. A lot has been said about the matter but nothing has been done so far. The rating agencies have not been held accountable and there is still an oligopoly of only three firms, or rather just two. It's almost a duopoly, as there are two global-scale companies that are totally irresponsible. They are irresponsible in the sense that they continue to operate in the market without anyone being able to hold them accountable. Now at the other extreme, they continue to seriously affect the entities that they rate, because their analyses are still the basis for most of the risk models used by investors and financial institutions.
I would not criticise the auditors so much, but they are among the agents involved in this crisis. In this case, my criticism is more because of certain progressive loss of accountability on the part of audit firms, in the kind of defence that they have found, which is legally unassailable. They ask the Board of Directors to confirm that the information that they have been given was correct. This means that they give an opinion on the information and don't have to ascertain whether it is correct. This minimises the value of audits and is something that needs to be analysed. What we want are auditors who check the veracity of the information, not ones who say that the accounts are correct according to the information given to them and the rest is not within the scope of their audit.
If this was how the agents behaved, what have we learned? On the one hand, we know that we must combat the procyclicality of the measures that we take, in terms of supervision systems and accounting models and rules and in terms of incentives given to market operators. This means, for example, that we have to make progress in the field of anti-cyclical provisions that only a central bank can introduce. I think this is important because it was Banco de España that had the courage and ability to do so. I remember the heated discussions because of these measures. The existence of anti-cyclical provisions in Spain was actually considered a lack of level playing field. This was discussed several times in Frankfurt and today, contrary to what was considered at the time, it is regarded as a paladin and trendsetter. One the other hand, things like risk analyses and the types of provisions and capital consumption associated with the loan to value of credit operations are something that has been practically forgotten and has not been included in most analyses, derivatives, share guarantees or the solvency levels that financial institutions have to maintain in order to operate. Fighting procyclicality means creating situations in which capital consumption exists at high moments in the cycle and not only when institutions are weakened. They obviously can't achieve it then and opt for state intervention using taxpayers' money, or we would probably have had large-scale bankruptcies worldwide. In spite of everything, Portugal was bypassed by this crisis though it did not come out unscathed.
The same situation occurs when it comes to accounting rules. There is nothing better for creating procyclicality than market value and mark to market rules without any analysis of these values, any risk weights that consider whether it is a problem with the security or the market in general. I remember having this discussion when the European Central Bank was founded, when it was decided that the figure to be used at European central banks was that at close of business on 31 December. On the afternoon of 31 December, i.e. near to close of business, we have an extremely slim, shallow market, which from time to time could result in somewhat original situations. But I'm not going to talk about IAS 39, which has already addressed several times here.
On the subject of incentives to market operators, not just managers but the people who are working directly in the markets, I would say that it is more important to act at this level than in overall management. That is because it is there that all speculative dynamics and the problems we have seen in recent years appear. They are the cause of this crisis.
There have been improvements in the supervision of financial groups and international cooperation at least in Europe, though there is still a lot to do, and in supervision of behaviour, also in terms of transparency, standardisation, simplification, i.e. a market that may be less attractive from an intellectual point of view, if you like but much clearer and more solid, we hope, in the future.
What prospects do we have in the face of all this? On the one hand, I believe that speakers here have explained at length what we can expect and I agree with most of what has been said. In short, I believe that we can expect a more traditional banking model, banks more as financial intermediaries. We can expect the end of so-called pure investment banks, thought investment banking will still be very important. 2009 was one of the most profitable years ever for investment banking, though in a different relationship, more in an advisory capacity than in taking direct risks and creating toxic products, as they are called.
On the other hand, we can expect mandatory regulation covering more entities and suited to the instruments used, therefore tailor-made rather than standardised. We can expect discussion of the utility of certain practices, such as short selling, which was mentioned such a lot a year ago and that we've all already forgotten, which has the power to bend the market disproportionately, i.e. create additional volatility. We certainly have a situation in which easy money and spreads as payment of the degree of risk will not go back to what they were in a short period before this crisis broke out. In other words, the opportunity cost of capital will certainly be more present. It will be more present because financial institutions' regulation and internal models will not forget what happened, I hope.
One issue remains to be analysed and will be very interesting in the next few years. How are states going to manage to progressively get out of financial institutions? The largest banker in the United Kingdom is the Treasury. The same is the case in Belgium and Iceland. It is less so in the United States, though it is very much present in large institutions like Citibank and AIG, not to mention others that have already been referred to here. This will be a very interesting question. It may go well, like in Sweden as few years ago. In more sophisticated markets, it's going to be a complex matter.
In conclusion, I believe that a number of opportunities are being missed. Carlos Rodrigues just mentioned that control of offshores, which was essential in many of these aspects, has still not been achieved. It is an aspect that people are beginning to forget.
International regulation is still very difficult. While important steps are being taken in this area in Europe, articulation with the Anglo-Saxon world in general and the United States in particular is still very basic. The new role of raters and auditors is not being discussed, now that the phase in which a lot was said about setting up agencies to regulate these institutions is over, though I really don't know how they can be created. It would probably be more a question of direct accountability of these agencies for mistakes they make and not of creating more regulation agencies for only three rating firms worldwide.
Finally, there is a fundamental aspect that I would like to highlight. If we want better rather than more regulation, we have to reinvent or reaccept the tradition of many years of the supervision that the bank of England championed and introduced centuries ago - the fact that regulation is very closely linked to so-called moral suasion and not only rules that are supposed to be broad, standardised, very clear and transparent and end up not covering concrete cases or being able to adapt to reality when necessary. I think that this is an aspect that goes against what has happened in the last 10 or 15 years. In the UK, this model worked well for decades or even centuries but has been practically abandoned in recent years. I think this would mean that better regulation was not more regulation, like that which we will see in the coming months and probably for two or three years.
May 2010, IDEFF presentations – Instituto de Direito Económico, Financeiro e Fiscal, Lisbon Faculty of Law