Friday, 17 October 2008

Two sensible comments

The first from Clusterstock:
Many of our financial institutions are insolvent. They aren't healthy victims of bank runs. They are ailing institutions barely kept alive by frantic rounds of capital raising. The lessons of the Great Depression simply don't apply here.

In fact, we're probably making things worse. Allowing insolvent institutions to fail and requiring worthless and worth less assets to be fully written down would provide transparency to the market. Instead, we're dedicated to the post-Lehman proposition of "Never Again." The various programs of our government continue to obscure asset pricing and conceal insolvency. This means that you can't trust the market to tell you which firms are failing.

Twisting the arms of bankers to lend to institutions that may be insolvent is a recipe for deepening the crisis. We've just been through a period of malinvestment--we spent too much borrowed money on junk. Borrowing more to spend on junk only digs us in deeper.

Bank lending won't get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won't help. More transparency, which means more write-downs and failures, is probably necessary if we're going to get through this.
I don't think we know enough about the current situation to know if this is true, but it certainly could be. Unfortunately the recent accounting changes make it harder to find out, too. The Japanese lost decade certainly suggests that keeping failed institutions on life support is the wrong approach - but equally Lehman showed that letting firms fail in the wrong way is catastrophic for market confidence. We need banks to be able to prove to the market's satisfaction that they are solvent, and prove that fairly soon. If the government recap gets us there, then fine. If not, even more drastic remedies are going to be needed.

Second, from an interview by Lord Turner in the FT:
Lord Turner said regulators would also now have to examine mark-to-market accounting, bankers’ bonus structures, the way in which financial institutions transfer risks, and the frameworks for regulating banks’ liquidity and capital.

He said the capital reserves imposed on banks last weekend were necessary to restore short-term confidence, and that the watchdog would have to work on a longer-term framework for setting capital.

He warned, however, that it could be some time before an international agreement could be reached.
Some regulators believe it is necessary to scrap the Basel II framework, while others believe it can be adapted.
[Emphasis mine.] It is most reassuring to see that the new head of the FSA is willing to contemplate scrapping Basel 2. The Basel 2 capital regime has served us very badly: it's pro-cyclical, imprudent in places and aggressively conservative in others, full of model risk, and far too complicated. Let's start with a clean sheet of paper, and demand that the rules be simple, demonstrably prudent but fair across risk types (and accounting methods), and as little dependent on models as possible.

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