By Michael Pomerleano
The regulation and supervision of the banking system rest on three pillars: disclosure to ensure market discipline, adequate capital and effective supervision.
Did the regulatory philosophy governing our financial markets withstand the test of the recent crisis? My conclusion is that all three regulatory pillars failed.
First, let’s look at disclosure. Was adequate information available before the crisis erupted? The information on the subprime exposure was out there for anyone who had the determination to collect and analyse the (sometimes patchy) data from quarterly 10Q reports filed with the Securities and Exchange Commission for US banks, supplemented by rating agencies’ and investment banks’ research reports.
Using public domain data, I developed a fairly comprehensive picture, as early as October 2007, of the exposure to subprime of the top 20 largest banks in the word, the five biggest investments banks, and all the banks that had an exposure in excess of $10bn. The estimated losses were reasonably consistent with the ensuing subprime losses.
For example, Citigroup disclosed the subprime exposure in Form 10-Q for the third quarter of 2007, submitted to the SEC for the public to read. It lists on-balance sheet subprime and off-balance sheet exposure (in asset-backed commercial paper conduits and structured investment vehicles) of $223.4bn.
In this context, it is notable that Citibank’s tier one (equity) capital at the end of the third quarter of 2007 was $92.3bn and the subprime exposure accounted for 242 per cent of tier one capital!
Public information already pointed to the need for major write-offs. For example, on December 1, 2007, Moody’s Investors Service downgraded 20 SIVs sponsored by firms including Citigroup and on December 5, 2007 Markit’s ABX-AAA Index fell to 77.22. Therefore, there was considerable evidence that subprime losses would exceed 20 per cent.
What are the implications for solvency? A 20 per cent loss on subprime will halve capital, while a decline of 41 per cent will wipe out tier one capital. And note that, so far, this discussion has not mentioned other sources of risk for Citi, such as leveraged buyout loans, commercial real estate and credit card debt.
Similar data were available bank by bank to a larger or lesser extent. Invariably the disclosure in the US was far better and more frequent than in Europe, and there was considerable information regarding the subprime exposure of US-based institutions.
Nevertheless, even with the limited disclosure, it was evident that numerous banks, such as HBOS and UBS, were poorly capitalised as a result of the losses. What can we conclude about disclosure based on the information that was publicly available? Several conclusions strongly suggest themselves:
- First, the situation was quite precarious and ample warnings available in the public domain in the autumn of 2007.
- With the resources available to the regulatory agencies, they should have been able to construct the information and react in a timely fashion. Instead, the response was late and haphazard.
- Finally, the fact that the data were publicly available, but not used by investors to value and discipline banks, discredits any shred of trust that markets are efficient.
A second central question to ask is how effective were the regulatory safeguards? Informed analysts knew that Basel I has glaring deficiencies that virtually encourage the creation of off-balance sheet instruments that contributed to the subprime crisis. See for instance “New Bank Capital Requirements Helped to Spread Credit Woes” (David Wessel, The Wall Street Journal, 30 August 2007.
I will not go into technical arguments, but assure the unfamiliar reader that the incentives were similar to the landing strip lights at an airport to guide the banks to create Special Purpose Vehicles off balance sheet.
Until recently I was not fully aware of the glaring deficiencies of Basel II. In December 2008 I read a compelling book written by Daniel Tarullo, President-elect Barack Obama’s nominee to the board of governors of the Federal Reserve.
In Banking on Basel- the Future of International Financial Regulation (Institute of International Economics, October 2008) he points out that: “Thus, there is a strong possibility that the Basel II paradigm might eventually produce the worst of both worlds—a highly complicated and impenetrable process (except perhaps for a handful of people in the banks and regulatory agencies) for calculating capital but one that nonetheless fails to achieve high levels of actual risk sensitivity”.
Tarullo notes as well that the Basel Committee itself implicitly acknowledged in spring 2008 that the revised framework would not have been adequate to contain the risks exposed by the subprime crisis.
To add to the irony, it appears that the institutions that failed were Basel II compliant. I add to Tarullo’s critique, (without going into the gory technical details) that Basel II is basically a form of regulatory forbearance. Intuitively, while Basel II keeps the minimum capital at 8 per cent, while allowing finer granularity via the use of internal models, and therefore lowers capital requirements. It is reasonable to conclude that 15 years of deliberations by the Basel Committee have yielded a poor outcome and soul searching is warranted.
A final question we need to ask is how effective was the supervisory apparatus in this crisis? Based on the discussion in the first section we know that the regulatory authorities in the critical financial centres potentially had information on the subprime exposure (and hence potential losses) on an institution by institution basis.
Equally some organisations warned about the potential losses! For instance in January 2008 the International Monetary Fund published its $1tn estimate for the losses. Equally, some investment banks, such as Deutsche Bank and Goldman Sachs, generated bank by bank estimates. It is reasonable therefore to infer that the regulatory agencies would have taken notice of those estimates as early as the autumn of 2007. For a long time the regulatory and supervisory apparatus was silent.
We need to question why didn’t any regulator add up the potential size of the losses on the sub prime exposure, based on publicly available information, and verify them with on-site examinations?
Why wasn’t there a far more forceful response from the supervisory agencies? Equally, we should have expected credit rating agencies, investment research and investors to respond more forcefully. In this context, one can only express puzzlement and disappointment at the tepid regulatory reaction. Only after the monumental policy mistake of allowing Lehman Brothers to fail, did the authorities grasp the full significance of the problems and we witnessed a systematic effort to manage and contain the crisis.
What is a possible explanation? Martin Wolf’s recent column reminds us of Keynes’ view that there is a safety in collective action, even if it wrong. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Arguably Keynes’ words apply to regulators as much as to bankers.
The conclusion is disconcerting. The entire safeguards system, consisting of disclosure, regulation and supervision failed. I hope that collectively the international financial community will come up with a better approach to financial regulation.
Michael Pomerleano is advisor on financial stability to the Bank of Israel, on external service from The World Bank. Before that he worked for two years at the secretariat of the Committee on the Global Financial System at the Bank for International Settlements
