This is the second edition of the Wizards of Money, your money and financial management series… with a twist. My name is Smithy and I’m from the Land of Oz.
Introduction
In this second edition of Wizards we are going to take a look at Financial Risk Transfer. How do the risks of the big gamblers of the financial system, like the Wall Street firms and the currency speculators, get transferred to the public who have no say or gain in these gambling adventures? How does this risk transfer work to increase income and wealth gaps globally, which then further increase financial risk, which in turn exacerbate global income inequality, and the cycle starts over again.
We will first look at how and why bodies like the International Monetary Fund (IMF) facilitate such risk transfer, a timely issue given the upcoming protests set to take place at the IMF/World Bank meeting in Washington, DC soon. Then we’ll see that these two bodies are simply a necessary evil of a much bigger financial infrastructure.
Presently the big financial players are merrily increasing the financial risk to be transferred to the public and the public is not noticing all that much. Rather, what many are noticing are the consequences of risk transfers that have happened in the past and materialized through such things as the IMF bailouts. Not too many concerned citizens are noticing the risk transfers that are being set up right now for the public to digest in the future. This is not really their fault as the mechanisms through which all this is done is not only shrouded in wizard secrecy, it is also something of an Alice in Wonderland world once you get past the hurdles and pop in for a visit yourself.
The financial instruments through which speculators gamble are getting more and more complex, and layer upon layer of instrument is forming. This surreal speculator world requires a whole new vocabulary – things like options, swaps, naked calls, floors, caps and collars. Then they seem to mate and have offspring like – swaptions, captions, knock-out options and roller coaster swaps. Not even the players themselves really know what’s going on. They are just there for a quick profit, and have stolen the best mathematical minds money can buy to help them do this. Lets not go into the details of how these multiplying and magical instruments work. Rather we note that their growing use makes economies more wobbly everyday, and that these financial markets are becoming too complex to regulate. On top of this, for every regulation curtailing speculator activity a new instrument materializes to circumvent it. In this way speculator instruments multiply like new strains of bacteria, gaining resistance to the old treatments.
In Wizards 2 we’ll be taking a look at some of the ways banks are likely to further increase the riskiness of their activities and be able to transfer the costs of those risks to those who can least afford it. In this context it will be appropriate to look at the supervision of banks and we’ll ask the question “Who is supervising the banks anyway, or are they just supervising themselves?” The latter seems to be becoming more and more the reality. And at a time when the Wonderland of Finance is becoming ever more complex and in need of supervision.
Finally we’ll take a look at some arrangements being made under the new Basel Capital Accord, an effort sponsored by the Bank for International Settlements in Switzerland, to address the issue of bank and speculator risk. The Bank for International Settlements (BIS) might be considered the third arm of the major global financial institutions, the other two being the World Bank and the International Monetary Fund, which have achieved widespread fame in recent years. In comparison the BIS seems to be quite shy and gets very little public attention, which might make one suspicious that it is up to no good. The BIS is owned by the central banks of the richer countries.
Central banks in other countries are like the Federal Reserve here. That is, they are responsible for monetary policy or, as we saw in Wizards 1, responsible for creating base money out of thin air. The real activities of the BIS are extremely well shrouded in secrecy, as is the fine tradition of the banking sector. I do not know anyone who knows what they really do. But one thing we do know is that they host the discussions and rule-making about how countries should supervise their banks to make sure they are not getting into too much mischief, which might in turn upset the global financial system. While they host the international bank supervision meetings (closed to the public, of course) the BIS says they are not responsible for the Basel Accords, which set international bank supervision standards. This is most probably because supervision is much despised in banking circles, and the banks would rather get rid of it so they could just supervise themselves.
Capital Buffers in the Global Casino
Recall that in the first edition of Wizards we spoke about how money is created and who creates it. In that edition we discussed that all money is created “out of thin air” through the loan creation process. For every amount of money there is a corresponding amount of debt owed to the banking system.
But how much money can a bank create through the lending process? A lot of that depends on how risky its loans are. Banks can create new loans (or bank money) up to a certain maximum multiple of their shareholder capital – that is, the amount shareholders have invested in the bank, which is also the excess of the bank’s assets over its liabilities. Remember a banks assets are its loans to the public, and its liabilities are deposits of the public. Capital for a bank can be thought of as a safety net – the more capital a bank has, the safer it is. That multiple of shareholder capital that banks can create as money will depend on how risky the loans are they choose to make. If they are very risky the multiple will be lower. Put another way, a bank that makes risky loans will have to hold more capital (i.e. more of a safety net) as a percentage of total loans than a bank that makes less risky loans.
Risky loans in this context means loans that are more likely to not be paid back in full, and this is the financial risk “created out of thin air” we spoke about in the first edition of Wizards. If lots of risky loans end up in default (that is, not paid back) then the bank reports this as a loss and people start to lose confidence in the financial system, which can ultimately lead to financial crises and sometimes collapse. So, although these risks are created “out of thin air” they can create very real consequences because our whole global economy is tied to the financial system and therefore is completely dependent on continued confidence in it.
Holding more capital for risky loans makes sense because capital is a buffer against unexpected losses. If a financial risk results in a loss – just like if you lost at the roulette wheel – then you have to dip into your capital (or safe money) supplies. Even if you love to gamble, when you go to the casino, you don’t bet all of your life savings. You leave some of your money at home or in your bank account so that if you lose all your bets that day, you will be able to tap into your untouched savings the next day to buy food, pay rent – i.e. conduct business as usual. This is exactly what banks must do to make sure they can remain viable entities in the long run. The more risks you take with your money the higher a capital buffer you need because more risks mean a higher probability of loss. For many banks these “risk based” capital levels were set under the Basel Capital Accord of 1988. These capital accords are now being revised, and the banks are complaining that they have to hold too much of a capital buffer.
Banks want to hold as little capital as possible, so that they can create a maximum amount of loans (or money) that can bring in higher profits. From their perspective a safety net has an “opportunity cost” which limits the profits they can make. “But aren’t they worried about not having enough of
a safety net if their bets go bad?”, you might ask. Well, not if they are “too big to fail” and the public will be called upon to bail them out if their bets go bad. This is where a growing danger lurks for all of us. From a public interest perspective conservative (higher) capital levels are a good thing. They help to prevent banks from taking excessive risks which often lead to publicly funded bailouts to rescue them from insolvency.
Risks Taken By Speculators and IMF Bailouts
Banks and other gamblers take excessive risks, of course, because higher risk investments bring in higher returns. This means more profits for shareholders and higher bonuses for the CEO and others. The disincentive for higher risks is that a risky investment is more likely to fail and you could lose some or all the money you put in. High risk investing is exactly like gambling – in fact it is gambling. Such speculation is of concern to the public because the gamblers are playing with the financial system and currencies upon which all real economies are dependent, and because the public is often called upon to bail out speculators to avert financial and economic crises.
As income inequality grows, fewer people have more and more money to play with and so financial activity becomes increasingly about speculation in the markets, through the Alice in Wonderland world of speculative financial instruments alluded to earlier, rather than purchase of real goods and services. Hence financial risk increases as income inequality grows. As we shall see, this risk taking then often leads to devaluation of foreign currencies against the US dollar, and publicly funded bailouts, whose costs fall disproportionately on the poor (or those who are not major players in the global financial system). This widens the income and wealth gaps even more, and further increases speculative activity and financial risks that will later trigger another bailout. And so the cycle continues. This positive feedback loop has set the world on a very dangerous path – dangerous to everyone.
As a key part of this feedback loop very serious problems have arisen because certain players in the market know they will always get bailed out if the losses on their risky investments get too big. This is known as “moral hazard” and many economists and business commentators have noted that the International Monetary Fund poses such a moral hazard to the world’s largest financial institutions who are now “too big to fail”.
This problem is compounded further because the big players are getting even bigger through global mergers and acquisitions in the wake of global financial deregulation. Furthermore, the Asian crisis, caused by excessive financial speculation in the first place, bankrupted a slew of Asian (including Japanese) banks. Many of these were then sold off (fully or partially) at fire-sale prices to Western financial institutions who were just as responsible for the crisis due to their unchecked speculative activity and who did not go bankrupt because they were key beneficiaries of the IMF bailouts. It is ironic that these beneficiaries were the very same players who instigated so much of the excessive risk taking that caused the crisis. This shows you just how much the moral hazard of bailouts can distort what is supposed to be a “free market”.
As noted, the public should understand how banks and other gamblers increase the risks in the financial system, since the public always pays the price for excessively risky bets that go wrong through various bailout mechanisms. This is exactly what happened during the US Savings and Loans crisis of the 1980’s. Also, the public of effected countries pays for the IMF bailouts which always come as a result of excessive risk taking in the financial markets and the realization that some of the risk takers/gamblers (generally those on Wall Street) are just too big to fail. Compounding this problem is the fact that speculators trade against other countries’ currencies and thereby instantly devalue the hard won earnings of many of the local people.
In what is probably a less understood and less publicized financial crisis, but one that recently almost took down the entire US banking system, the Federal Reserve had to step in and arrange a bail-out of the Long Term Capital Management Fund in 1998. While the public did not have to fund this one, it came very close to this. The LTCM crisis revealed a shocking level of risks taken by the US banks, and worse, a shocking lack of supervision of their gambling activities. It is not comforting to know that the type of risk taking prevalent in the LTCM case is increasing, and the supervisory bodies are doing little to stop it. These types of funds like LTCM, known as “hedge funds”, are the new trendy playthings of the wealthy – why, even Barbara Streisand is in one! But they are completely unregulated on the premise that they involve “sophisticated” investors, you see. This is exactly the reason they need regulation – for it’s this very same sophisticated speculation that later triggers bailouts. And its seldom the sophisticated speculators who pay for the bailout mess they create.
Banks are supposed to manage risks to prevent themselves from going insolvent or losing market confidence. Regulators and supervisors are supposed to be watching to make sure they actually manage these risks both in their own interests and to avoid broader financial crises. In this fashion the regulators should represent the public interest to ensure that banks are not taking such excessive risks that the public may eventually have to bail them out to avert a financial disaster. But more and more it seems that crisis prevention and exercise of the precautionary principle are being pushed out the back door in favor of the wishes of a global finance sector that wants less supervision. It prefers a system of cure (in the form of bailouts) after risk taking gets out of hand, to the publicly preferred system of prevention whereby financial players take on less risk and accept lower returns.
This preference for cure over prevention is encouraged by the bailout mechanisms.
One “cure” (or bailout) leads to another crisis down the track, leading to another bailout, another crisis and so on. For every bailout income and wealth gaps increase, because the funding of the bailout must come from places that are not accounted for in the financial system. This is simply because the financial system would be put at risk if the full costs of the risk taking were born by it. Then investors would lose confidence and the whole financial system may collapse. The costs that do not appear on financial accounts are additional burdens to the poor and excessive natural resource extraction. In effect, that is what funds bailouts so that the cost of the bailout will not hit the books of the financial system. This is the mechanism whereby risk takers do not take full responsibility for the risks they assume but rather pass that responsibility on to those outside the financial system. This system of cure over prevention obviously provides higher overall returns to the banking system than would a corresponding regulatory regime focused on prevention.
Risk Transfer in Action – Asian Financial Crisis
To better understand risk transfer let’s look at some of the aspects and drivers of the Asian financial crisis.
Many identify the trigger of the crisis as the devaluation of the Thai Baht (the Thai currency). This had been pegged to the US dollar, so that the baht would move in parallel with the US dollar. At that time 25 baht was about the same value as 1 USD and the Thai Central bank was trying to keep this exchange rate constant. A devaluation would mean that the value of 1 baht would be worth less than 1/25 US dollar, or conversely a USD would buy more than 25 Baht. Prior to this devaluation currency speculators (many of whom were with the big Wall Street firms) were having a whale of a time performing what is known as arbitrage in transactions involving the Thai Baht. Arbitrage means that speculators can make profits without taking risks. For example in this case arbitrageurs were able to borrow money in US dollars at a low rate of 6%, change them into to Thai Baht and invest the Baht at a much higher rate of 12%. Because the Thai Central Bank was trying to peg the Baht to the US dollar, after a certain time, the Western gamblers could take their proceeds from the 12% investment, and exchange them back at the original exchange rate into US dollars. Then they paid off the lower 6% loan and pocketed the profits. I say that no risk was taken to get this return because no money was put at risk, it was all borrowed and then guaranteed to be returned in full dollars by the Thai Central Bank. This type of speculation puts pressure on, and drains, the reserves of the central bank whose currency is being “attacked” and increases pressure for devaluation.
As noted, the Thai Central Bank was on the other side of all these bets trying to prop up the baht, so that when the baht finally collapsed, in part due to this massive speculation, the central bank was in very bad shape. Confidence is Asian markets fell and neighboring economies starting falling like dominoes. When I say that the baht collapsed I mean that its value versus hard currency, like the US dollar, fell dramatically. It is the local people of Thailand who then got hammered by the subsequent devaluation. Their hard earned money was worth less when it came to any goods or services made from imports.
The US dollar is the hard currency or reserve currency of the world now that the gold standard has collapsed. Everything is measured in terms of the US dollar. And whereas banks once held gold in their vaults to back their currencies, now they generally hold US dollars. This US Dollar standard of money means that if the value of the US dollar ever collapses relative to other currencies, it probably will result in collapse of the global financial system. This point might be of interest to some anti-globalization activists, who might want to see if they can think up a clever way to instigate massive trade against the US dollar. This method is very slick because it’s perfectly legal, nobody has to get arrested and it doesn’t require any police beatings. But just a word of warning before you try this – make sure you have another system of trade ready on the sidelines!
Now, Back to the Asian Crisis: Around the time of this Thai baht arbitrage feeding frenzy JP Morgan was, on the one hand, advising the Thai’s to devalue. But they were was also operating in Malaysia and selling financial instruments to Korean banks that would lose money if the Thai baht was devalued! So that’s how the Korean banks got immediately walloped by the devaluation. The Koreans banks then started dumping a bunch of Brazilian bonds that they’d been holding since one of the deals that ended a previous speculator induced crisis – the Latin American debt crisis. The cost of borrowing shot up in Brazil and this stripped Brazil of a quarter of its bank reserves in a single month. So then Brazil had a financial crisis on its hands. And so on, and so on, the crisis spread. Meanwhile JP Morgan seemed to get out of everything just fine. This interesting little story from the Asian crisis came from the book called “The Fed” written by Martin Mayer and recently published by Free Press.
The western financial institutions were also over extended in loans to Asia because the 1988 Basel Capital Accord did not adequately set capital requirements for loans to banks in these countries. They also did not differentiate between various types of commercial borrowers. Hence the banks were incented to lend extensively to foreign banks where they could get higher returns, and to more risky corporate ventures. Central banks of these Asian countries were putting their countries financial reserves at risk by allowing their banks to invest them in high risk, high return investments. And much of the loan activity of the time was around over-priced real estate ventures, similar to what happened in our own Savings and Loan crisis. In summary the financial risks taken by banks world over were huge, and the distribution of bank capital could not bear the brunt of the costs if those risky bets should go bad.
As we know the bets went bad and various economies almost collapsed. Many of the financial players did suffer huge losses and those losses were born by both Western financial institutions and foreign players. However, as usual, the Western institutions escaped the gambling extravaganza bearing a disproportionately small share of the costs. While a myriad of Asian banks were allowed to collapse, not a single Western financial institution went under. At the end of the crisis most major Japanese banks (and insurance companies) were technically insolvent and later dependent on these western institutions to inject capital through acquiring ownership rights – something the Japanese never welcomed to their banking system before. Banks collapsed throughout the rest of Asia, the most dramatic case being Indonesia where we still have images of the physical run on banks fresh in our minds.
The western institutions were not allowed to fail (as in the S&L debacle) because if they did, the entire global financial system would go down with it. To prevent such a collapse the IMF bailouts primarily work to ensure that the market does not lose confidence in the financial system. Generally this translates into making sure that the larger financial system players are not hit with large enough losses that could cause them to drop below minimum capital requirements, go insolvent, or suffer a loss of confidence in them by investors and depositors. When the press speaks of the bailouts they often say that this country or that got an IMF bailout package. This really means that they receive funds from, or their debt is consolidated by, the IMF so that they will not default on loans made to them by large western investors. In a true “free market” those western institutions would bear those defaults and suffer the consequences, which would be consequences for all of us, because we are dependent on the financial markets they dominate.
It is at this point that the IMF as loan consolidator, or lender of last resort, steps in with its structural adjustment programs to somehow make the country generate the hard currency needed to pay back the western investors who had loaned them hard currency. Because hard currency is needed to repay the loans the country’s activities get directed toward exports and other things that will bring in hard currency from those that have some – i.e. western investors and consumers. The things that generate hard currency the quickest to repay these loans are the exploitative labor and natural resource extraction practices that we see resulting from IMF policies. These problems are compounded by the fact that the local currency has dropped in value against the hard currencies.
IMF Bailout Prevention Solutions
The above gives an overview of how very abstract, seemingly innocent, risky financial transactions end up as costs born by those pretty much outside the financial system. Surely the solution lies in the people creating their own monetary and trade systems and weaning themselves away from dependence on the very risky, and destructive global financial system of today. Why continue to trust in, and be a part of, a system that works against you?
Should the current global financial system collapse tomorrow the world would have no back-up mechanism for continuing trade, and in all likelihood the resulting confusion and collapse of order would result in massive catastrophe, maybe worse than Germany in the 1930s, and on a global scale. The risk of global financial collapse continues to increase with increasing income inequality. This leads to an increasing amount of financial activity being driven by those who have so much excess money that the bulk of their transactions are speculative. This inequality and these risks increase with each publicly funded bailout, which then further increases income and wealth gaps. And so the cycle continues, with this positive feedback built in to make the whole system more and more unstable.
Those who are currently actively involved in setting up alternative economies are actively hedging their bets that the dominant system will eventually fail. They are certainly providing hope for a more promising future.
Bank Supervision and the Basel Capital Accords
However, setting up alternative financial and economic systems in a meaningful way will take a lot of time and effort. The existing global financial order will be with us until it either collapses or people come up with an alternative, or both. In this time it’s important for activists to challenge the financial world on their trend towards increasing speculation and reliance on cures for financial crises. Along this line of thinking it might be more fruitful to work towards reducing the need for IMF bailouts, rather than just worry about them once they already exists. That is – maybe people should also be focused on prevention as well as the specific nature of the cure. Otherwise increasing speculative activity may end up increasing the frequency and severity of IMF bailouts.
One of the best means of prevention of financial crises (and therefore IMF bailouts) is stricter supervision of banks and other financial services companies, so that they don’t make too many risky bets that destabilize the markets. This is in the best public interests of a public that depends on stability of the banking system, and doesn’t have an alternative monetary system to fall back on. Let’s just talk here about supervision of banking institutions and leave other financial institutions to later editions of Wizards.
One would think that bank supervision would be done under the guise of a government body so that there could be some democratic accountability of the supervisor, and some representation of the public’s interests. Think again – Under the Gramm-Leach-Bliley Financial Services Reform Act of 1999 the regulator of all bank holding companies in the US is the Federal Reserve. They are also the supervisory body which will monitor bank’s risk taking activities and their associated capital buffers under the new Basel Capital Accord. As we saw in Wizards Part 1 the Federal Reserve is 100% owned by the private banking industry. So the banks seem to be supervising themselves!
This doesn’t bode well for the idea of getting banks to behave better with respect to risk taking. Apart from the issue of ownership, the conflicts of interest with respect to the “central bank” of a country also supervising the banks are so profound that no other major industrialized nation has dared to do it. In most other countries the central bank – the driver of monetary policy – and the bank supervisor – trying to make sure the financial system is safe – are two entirely different bodies.
One the hand, the Fed, when it wants to increase the money supply would encourage banks to take more risks to achieve this monetary goal. For example William McDonough, the president of the Federal Reserve Bank of New York, is documented to have told an audience at a Group of 30 meeting at the IMF/WB meeting ,in 1998 in the midst of the worry about the Asian crisis, according to Martin Mayer in “The Fed”:
“If you’re a banker, go out and lend – you don’t have to cross every i and dot every t. If you’re a bank supervisor, don’t criticize your banks for making loans, even if they’re loans you might not have approved just a little while ago.”
He was speaking there as a key player in monetary policy, not as a supervisor who should be concerned about risks in the financial system. Mr. McDonough, as the head of the New York Fed is also vice-chair of the Fed’s Open Market Committee, responsible for the creation of base money out of thin air, as we saw in Wizards 1. Now, not only is Mr. McDonough now responsible for supervising the activities and capital levels of the New York area banks, he is now also the chair of the Basel Committee on Bank Capital requirements! In many cases his role as central banker (and driver of monetary policy) will conflict with his role as both supervisor of banks and chair of this capital committee – both of which SHOULD be representing the public’s interests in bank risk taking.
Alan Greenspan, the Governor of the Federal Reserve Board, that overseas all the Federal Reserve Banks, said in his bid for being the bank regulator of choice, that regulation by a separate government body (such as the Office of the Comptroller of the Currency) devoted only to managing safety and soundness of the banking system would “inevitably have a long term bias against risk taking and innovation”. He forgot to mention that these risks are usually born by the public, so that such a focus of a supervisor would be quite appropriate. Unfortunately, Mr. Greenspan, being raised as a prodigé of, and assistant to, author Ayn Rand – during her Atlas Shrugged phase – often forgets that there is a public to worry about. That is, until a public bailout is needed of course.
The conflicts of interest and evidence of the “fox guarding the hen house” does not stop there. The Board of the Federal Reserve Bank of New York always has the biggest New York bankers on it. So it is not surprising that Sanford Weill, CEO of Citigroup is on the Board of the Federal Reserve Bank of New York. The Federal Reserve Bank of New York is the Supervisor of CitiGroup! As noted, the president of the NY Fed is also the chair of the Basel Committee setting capital requirements that are supposed to protect the public from banks taking excessive risks for excessive profits. So the supervisors and the supervised are pretty much one and the same.
The latest draft of the Basel Accord was released in 2000 for public comment until May 31, 2001. Around this time Mr. McDonough took over as chair of the Basel Committee coming up with these capital (i.e. safety) requirements. Evidently the American bankers were starting to get cheesed-off at some of the conservatism and safety margins proposed by the European supervisors. So they thought they better step in and take over, as is the American way.
This change at the helm will probably bode well for the big bankers whose comments on the proposed accords can be pretty much summed up as whining about how the proposed capital (or safety) levels were just too high and how this would eat into their profit margins. It is especially illustrative to look at Citigroup’s comments since, as noted, Citigroup is supervised by the Federal Reserve Bank of NY, whose president chairs Basel, and on whose board CitiGroup has representation. In this way it could be construed that, unless pressure is applied otherwise, CitiGroup’s desire for holding less capital, and making the financial system more volatile and risky will become a reality. The following is a quote from the response by Jay Fishman, COO of Citigroup to the new proposed Basel Capital requirements for banks:
“We urge the Committee to keep in mind that although capital has an important role to play in assuring safety and soundness by supporting a banking organization’s assets, it has a significant opportunity cost”. This means lower profits. This “would effectively translate into higher costs to users of funds and/or lower returns to investors in organizations subject to the New Accord”. He goes on to say that this would end up “reducing competition and choice for customers of banks”. This is rather laughable given that the multitude of recent acquisitions of banks by Citigroup all across the world has done more to reduce competition and choice that any capital requirement could.
Furthermore in appealing to competition, that bastion of the free markets, Mr Fishman forgets to point out that his organization is a primary beneficiary of the IMF bailout mechanism, which is more of a threat to competition and free markets than any supervisor could dream up.
Mr. Fishman, in his May 31st letter, calls for capital requirements to be primarily set by the banks themselves, especially those “sophisticated banks” with “sophisticated risk management techniques”. Mmm – there’s that sophisticated word again – its seems to be synomous with regulation-free in the financial markets. Fishman forgets to point out that these fancy risk management models failed completely to manage the risks of their bets in Mexico, Asia, Latin America and Russia during the 1990’s.
Finally he argues that the increased disclosure requirements of the proposed new Basel Accord will increase the costs to banks, and only serve to confuse everybody.
The comments of a bank that has the highest degree of moral hazard posed by the Bretton Woods institutions, and hence the biggest incentive to take excessive financial risk, must surely be taken with a grain of salt. However I fear that without the involvement of the NGOs fighting these institutions the new Basel Accords and associated capital requirements will slip through with exactly what the banks want. That is – more profits through higher financial risk taking that will only serve to increase the frequency and severity of publicly funded bailouts and further compound the transfer of wealth from the poor to the rich.
A full copy of the current Basel Accords and all public comments can be found on the Web at www.bis.org. Only one anti-globalization NGO (that I can tell) submitted a comment with public interest concerns. That was the Inner City Press/Communities on the Move, based in the Bronx, NY. You can visit their Web sites at www.fairfinancewatch.org
That’s all for Wizards of Money Part 2.
