It’s been a while since I last posted. You have enough to read. But sometimes issues are so fundamental to a debate – and get such little airing – that I must make the point. And twitter, whilst my preferred medium, isn’t sufficient. So, whilst carrying on my day job of re-plumbing some elements of the credit system, I’ll write the odd blog. More importantly, I want to engage constructively in the ongoing debate about financial regulation which will include the odd comment on other blog posts. This is partly because the debate  and our regulators have a bank bias whilst fairly ignorant of insurance regulation.

Regarding the point of this particular post, there has been some comment following suggestions last week that policymakers are actively seeking a reduction in the size of the OTC derivatives markets. I offer my thoughts in the comments section of the Streetwise Prof’s article.

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Statue of Achilles.

David Murphy (Deus Ex Macchiato)  & I exchanged some views on his helpful series on Credit Valuation Adjustments on FT Alphaville this week which is a minefield to me.However, risk transfer and corporate funding are not. So this passage caught my eye (my emphasis)

There is another area where the CVA rules produce undesirable behaviour: smaller corporates. These firms trade derivatives to hedge their own bond issuance — corporates tend to issue fixed rate bonds but prefer to pay floating, hence entering interest rate swaps – or commodity prices, but they often don’t have large pools of cash that they’re willing to tie up as collateral. Thus they generate reasonable CVAs.

However, such corporates are often not themselves liquid in the CDS market, so banks can’t buy protection to reduce their CVA capital. Thus they have to charge the corporate more on the derivatives that they want to enter into.

That wouldn’t be so bad if the corporate had a rational alternative, but they don’t. Central clearing is also expensive, and that requires that someone post collateral, either the client or their clearing member. If the client hasn’t got the money, or doesn’t want to fork it over for this purpose, then they will have to pay their bank to do it for them. The net result of these increased costs is likely to be that corporates hedge less, and keep more risk. This is viewed as enough of a bad thing by the European Parliament that their current version of the EU rules implementing Basel contains an exemption from the CVA rules for some corporates.

There are alternatives. However, they require a re-plumbing of the methodologies corporates as well as bank and non-bank funders use to manage corporate credit risk and liquidity. That point was outlined in my opening comment:-

Another very helpful explanation. What I found particularly interesting is you say corporates have “no rational alternative”. I would suggest that the passive role corporates have played in the creation of credit risk transfer structures for their funding purposes is changing.

Corporate treasury are aware they do not want to be caught again as they were in 2009 by outsourcing funding liquidity risk (and ultimately their reputation and solvency) to their liquidity providers. As the financial infrastructure reforms after the GFC, corporate liquidity risk management – an understandable concern of any funder as part of their continual “Going Concern” assessment – is unlikely to rely to the level it did on the failed credit structures created by traditional credit intermediaries.
This will mean corporate treasury teams increasingly see value in building credit impairment reserves within formal captive insurance structures rather than simply held informally on their balance sheet. These enable corporates to better manage operating cash-flow, payment obligations and credit impairment as receivables fall due. By optimizing internal liquidity, such an approach also reduces demands on external funding. If the CRT mechanism also de-risks collateralised/sold assets within an ABL/ABS transaction, the banks RWA exposure amount improves as PD & LGD reduce, eliminating the need to charge the corporate for more CDS.

Of course, this solution isn’t favoured by banks with falling revenues and lower margins. But that is not an immediate concern for Real Economy mid-Cap CFO’s receiving terms sheets offering poor advance rates on short-term assets at funding margins that do not fairly reflect risk. Many corporates must therefore become their own credit risk underwriters as they can no longer rely on their banks or rating agencies methodologies or often generic credit risk data.

It’s no silver bullet but then, life is never that simple!

David’s response (again with my emphasis)

Thank you, that is a fascinating comment, and I agree with it.

One extra riff, if I may. You talk about corporate liquidity risk management moving away from the pre-crisis models, and I would agree with that. But right now there are three sides to that. First, where to get long term funds/manage their traditional cashflow (e.g. receivables, trade finance). You cover that admirably.

The second is managing short term liquidity in a world where there are more demands (such as clearing) and fewer supplies. Part of the answer to that will be collateral swaps and such like, but part of it will also be developing non-intermediated sources of contingent liquidity from non-banks (and possibly even non-financials). That brings me to the third part; surplus cash investment. With liquidity premiums as rich as they are, there must be sensible low risk ways for corporates to monetise these. It’s not obvious that banks will be able to monopolise these flows…

Again, David raises critical questions for any treasury team. I responded

Thank you for the generous words. You raise good additional points.

My first reaction to this is to turn to Supply Chain Finance. This model has developed significantly recently and can now be applied (with some help) by corporates with surplus cash flow (for example surplus cash impairment reserves within a captive/ ICC/PCC structure) into discharging their liabilities for purchases early, thus earning yield through discount benefits. The supplier equally benefits from improved cash flow and this virtuous circle potentially dis-intermediates the banks and monetizes the significant liquidity/collateral that exists outside the formal financial system for the benefit of the Real Economy, increasing the velocity of liquidity through the broader system.

What this exchange supports is a critical factor (and I would add financial asset) missed by most commentators. There is an abundant source of potentially ‘de-riskable’ short-term assets, that are often significantly  underfunded. These assets – in many instances – are “promises to pay” that can be transparently structured and support faster Real Economy growth. However, they are a granular, dynamic, hard to track and unsexy asset. They require bank resource to manage. With Real Estate, bankers don’t have those worries. Yet trade receivables  comprise around $20 trillion of Balance Sheet value in the US alone. By “underfunded”,  for every $100 of a short-term trade receivables asset portfolio, corporates generally receive around $70 of liquidity with the remaining $30 sitting dormant as encumbered capital on each corporates balance sheet. In Europe the position is even worse given a much smaller proportion of non-bank corporate loans (EU 10-20% versus US 80-90%) and the role of the large European trade credit insurers who continue to sell a model to their clientsthat failed so spectacularly in 2007/8/9. Trade receivables are central to working capital and therefore essential to economic growth. Yet, there is almost no mention of this abundant asset in financial commentary.

Understanding how to improve the funding process requires knowledge of  both the liquidity and risk management requirements of non-financial corporates. Most banks failed in these areas themselves,  so their advise to corporate clients lacks credibility.

Banks should be acknowledging to clients that the financial world has irreversibly changed since the global financial system begun its slow collapse in 2007. Such acknowledgement, as with alcoholism or substance abuse, requires the financial system to admit that :-

  1. investors will no longer easily commit their funds to transactions or securities. They will not only want evidence high quality and granular credit risk analysis of referenced assets has taken place in a timely manner. They will also want to ensure it continues to take place on an ongoing basis.
  2. Information asymmetry creates mistrust. Traditional credit intermediation and rating methodologies must be rebuilt to eliminate it.
  3. Outsourcing financial risk management to banks has failed. Non-financial corporates are beginning to take greater control of the collation and supply of high quality, timely and granular credit risk information that is shared with key counterparties to maintain systemic confidence. This data underpins collaborative – not adversarial – funding methods and structures that funders historically offered as part of their service. Information asymmetry is no longer smart.

We are leaving a financial world where banks essentially sold more and more liquidity to customers only if  the vehicle they used were bank-sponsored. Changing liquidity providers was extremely expensive when  services and funding were bundled with one relationship bank, especially in Europe. The time it took and costs of renegotiating a new (complex) service and credit agreement were too onerous. A few years ago when liquidity was cheap  funding costs were manageable. When the economy was good bundling mattered little.  Corporates had  appreciating assets, a thriving economy and importantly credit.

Things have changed. Clients are now getting wise to the service bundling and pricing tricks banks use. Increasingly, customers are a little more critical of the value for money.  As for the price of liquidity now….well , the client receives a bundled price for all their services so it’s difficult to tell how much each service costs but they are smart enough to know one price may subsidize another.  The clients income and ROCE are reducing (more encumbered capital, lower asset value, more credit risk uncertainty in a more volatile economy &  higher liquidity costs thanks to general inflation). They’re not keen to see  their funders pass on their increased costs to them.

Given further damaging allegations in the UK that banks mis-sold swaps, corporates will  increasingly focus on protecting themselves from an imploding financial system, outsourcing less financial control to bank risk advisers and protecting their precious capital better. They can no longer accept their traditional funders shrugging their shoulders as they charge ever-increasing prices blaming “The Markets” or “increased regulation”.

It is also a fertile fallacy that corporates cannot do more to reduce funding costs. Many commentators and Financial journalist miss this point when often deferring to the financial lobby perspective. And those that are critical offer anger and vitriol rather than forensic alternatives.

Yet, for years, banks have been able to support overall corporate cash flow through their considerable influence over two of the three  sources of cash flow you’ll see on any financial report ; cash flow from financing activities and cash flow from investment activities. Any weakness in operating cash flow could be supported by priming these other two sources. This not only enabled bonus pools to benefit;  it also hid any fundamental weakness in the core business models of corporates. For well remunerated Executive Boards able to use funding & investment income to support the share price, procuring the services banks offered generated considerable benefits to financial metrics driving executive remuneration. Now the music has stopped,  protecting and optimizing operating cash flow is critical to survival.

Corporates are focusing  on the fundamentals:-

  1. Improving liquidity risk management
  2. finding new sources of contingent non-bank liquidity
  3. enhancing own credit risk management through the construction of  formal credit impairment reserve structures available to support liquidity shortfalls that threaten the corporates ability to meet obligations as they fall due; obligations a phone call to the bank would have once solved.
  4. finding effective non-speculative uses for surplus cash.

All of these potentially undermine the ability of banks to generate fees. Banks would far prefer it if corporate treasury just swept each days surplus cash into banks overnight deposit accounts. At least that could support the banks own funding liquidity  needs. And in this dilemma is the banks Achilles’ heel. Many bankers are too focused on maintaining their roles within a broken system to see what’s happening in the wider world. They fumble for soothing words and rationales to explain their recent behaviour as an errant partner would when they say “It’ll never happen again”.  However, when trust has been broken it is very difficult to restore. The banks continue to engineer methodologies that generate short-term speculative financial value using complex chains and what are likely to be ineffective or unenforceable risk mitigation techniques;  the ability to create credit with only a tenuous link to real assets that has been a feature of finance over the last twenty-five years has declined. What has emerged is a divergence between the imperative of many financial market participants and that of (most) corporates seeking to create sustainable economic and social value.

With this in mind corporates of all sizes must review their funding strategies and take greater ownership of the process. On the eve of the centenary of the sinking of the Titanic, corporates can no longer rely on being passengers. Outsourcing responsibility for their corporate wellbeing as a ‘Going Concern’ to those who have not only let them down, but fail to acknowledge their mistakes, is a situation no Executive Board can afford to repeat.

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Deus Ex Macchiato provide a link to one of the finest summaries of the financial crisis I have read ; “Choosing the Road to Prosperity”  by Federal Reserve Bank of Dallas Director of Research  Harvey Rosenblum.

Preceding it is a letter from the Dallas Fed President, Richard Fisher, quoted as being “one of the more hawkish and conservative Fed Presidents”. Even this description begins to show how the old political pigeon holes really have such little meaning now.

Some of the choicest quotes:-

As a nation, we face a distinct choice. We can perpetuate too big to fail, with its inequities and dangers, or we can end it. Eliminating TBTF won’t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance.

In 2010, Congress enacted a sweeping, new regulatory framework that attempts to address TBTF. While commendable in some ways, the new law may not prevent the biggest financial institutions from taking excessive risk or growing ever bigger.

When competition declines, incentives often turn perverse, and self-interest can turn malevolent. That’s what happened in the years before the financial crisis.

The financial crisis arose from failures of the banking, regulatory and political systems. However, focusing on faceless institutions glosses over the fundamental fact that human beings, with all their flaws, frailties and foibles, were behind the tumultuous events that few saw coming and that quickly spiraled out of control.

Greed led innovative legal minds to push the boundaries of financial integrity with off-balance-sheet entities and other accounting expedients. Practices that weren’t necessarily illegal were certainly misleading—at least that’s the conclusion of many post-crisis investigations.

With size came complexity. Many big banks stretched their operations to include proprietary trading and hedge fund invest- ments. They spread their reach into dozens of countries as financial markets globalized. Complexity magnifies the opportunities
for obfuscation. Top management may not have known all of what was going on—particularly the exposure to risk. Regulators didn’t have the time, manpower and other resources to oversee the biggest banks’ vast operations and ferret out the problems that might be buried in financial footnotes or legal boilerplate.

These large, complex financial institutions aggressively pursued profits in the overheated markets for subprime mortgages and related securities. They pushed the limits of regulatory ambiguity and lax enforcement. They carried greater risk and overestimated their ability to manage it.
In some cases, top management groped around in the dark because accounting and monitoring systems didn’t keep pace with the expanding enterprises.

Complicity extended to the public sector. The Fed kept interest rates too low for too long, contributing to the speculative binge in housing and pushing investors toward higher yields in riskier markets.

Hindsight leaves us wondering what financial gurus and policymakers could have been thinking. But complicity presupposes a willful blindness—we see what we want to see or what life’s experiences condition us to see. Why spoil the party when the economy is growing and more people are employed? Imagine the political storms and public ridicule that would sweep over anyone who tried!

Easy money leads to a giddy self- delusion—it’s human nature. A contagious divorce from reality lies behind many of history’s great speculative episodes, such as the Dutch tulip mania of 1637 and the South Sea bubble of 1720.

In the financial crisis, the human traits of complacency, greed, complicity and exuberance were intertwined with concentration, the result of businesses’ natural desire to grow into a bigger, more important and dominant force in their industries. Concentration amplified the speed and breadth of the subsequent damage to the banking sector and the economy as a whole.

It concludes

The road to prosperity requires re- capitalizing the financial system as quickly as possible. The safer the individual banks, the safer the financial system. The ultimate destination—an economy relatively free from financial crises—won’t be reached until we have the fortitude to break up the giant banks.

If only other regulators and central bankers had the guts and balls to write so clearly, unequivocally and honestly without fear of their legal officers or political masters, the recovery process could have truly begun in earnest.

Here’s the link to the article in case you haven’t already got there.

Sober Look and I had an online discussion regarding his post about the hidden pitfalls of Basel III. He suggested there had been some interest in my comments and could I provide a case study. I duly did this evening (finally)  and sent him a simple version of a generic case which I have amended here to include the commercial objectives a typical corporate would be very keen to achieve in the current market conditions.

Case Study

Commercial Objectives

  • European multinational with Head Office in Eurozone“periphery”
  • More robust funding structures and to adapt their debt repayment profile to their expected cash flow generation.
  • Minimize funding liquidity risk and improve advance rate achieved for their assets.
  • Sale rather than Financing accounting treatment. (IAS 39)
  • Greater certainty of trade credit insurance cover through the economic cycle.
  • Achieve commercial outcomes without increasing administrative burden on treasury.
  • Improve credit risk management for both trade and finance purposes.

Financial background

  • Operations in Europe, Africa, Latin America & Asia.
  • 2010 turnover > €1,000m, ROCE 5%, EBITDA < €100m.
  • Total Trade Receivables portfolio €150m.
  • Working Capital needs €125m (2011) and €150m (2012).
  • Concentration risk – 22 major buyers with sales > €7m p.a.
  • Increasing counterparty credit risks within EU.

Existing Funding

  • Funding via Bonds, Revolving Credit and Asset Backed Commercial Paper.
  • €120m ABCP program funded by UK bank through Jersey-based SPV.
  • Advance rate 79% on €150m driven by Rating Agency Criteria (unrated buyers, country limits, loss history, stress)
  • The daily information feed from client sales ledger to the Bank Funder however failed to:-
  1. offer granular detail or “static pool data.”
  2. offer detailed ageing profiles.
  3. Effectively track concentrations/customer aggregation, credit notes, dilution and disputes.
  4. Help reduce reporting requirements/costs for treasury resource.
  5. Enhance confidence in data flows and consistency.
  6. Support holistic Credit Risk Management
  • €27m “allowance for doubtful debt” (creating “Going Concern” issues)
  • Credit insurance purchased separately in each territory. No benefit to external funding cost.

Solution

  • Improved risk analytics (points 1-6 above) benefits Company and Funder.
  • Committed facility of €150m (additional headroom) & reduced all-in funding costs by 25 Basis Points.
  • Advance rate on total trade receivables portfolio lifted from 79% to 95%. Increased cash available for investment and growth plans by €15m p.a. (additional €45m over a 3 year term).
  • Reduced Bank Funder Risk Weighted Assets for transaction by approx. 50%.
  • Sale treatment achieved for transaction under IAS 39.
  • Cell captive established to build cash allowance for doubtful debts and support funding.
  • ROCE improved by 110 Basis Points.
  • Improved Enterprise Risk Management and Internal Controls supporting Corporate Governance.

Example Structure

Structure diagram

 

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I was a catastrophe underwriter for  over 20 years. I therefore find the starting point of this Telegraph article on health and Safety typical of the journalistic and (sometimes understandable) broad public view on the issue. It is representative of a willful blindness that has created the  corporate culture we have today; a blindness that actively encouraged through weak risk mgmt, incentive misalignment, outsourcing and Free Market Globalisation, the kind of  catastrophic life-ending and economic and social  damage inducing events such as  Aberfan, Piper Alpha, Bhopal and the Gulf of Mexico oil spill (to name a few though plenty more here) .

Wobbly ladders are really not the underlying point being made  here. In fact, it is quite laughable that £133/hr be used here as the representative cost here particularly when compared to the cost of an average lawyer. They will charge more for drafting a “my client” response to a safety rule infringement that a company’s own half decent internal controls would have  picked up. And let’s not compare that with the cost of a 100 page legal opinion from a  law firm regarding a legally marginal activity. Some lawyers have essentially become no more than glorified corporate bodyguards.

The critical point is that we’re moving into an era where the States willingness to ‘turn a blind eye’ to their assumption of Business Risks and the taxpayers ability to assume it it are increasingly conflicted. Poor employee protection and inadequate provisioning for pensions or accidents at work are a social cost. These costs of private wealth creation or entrepreneurial risk taking are a wealth transfer society is questioning harder. Companies doing things roughly right should have little to fear.  Yet executives set risk management processes and internal controls cognizant they are within the law or rules if not its spirit. This for many is the language of the “red-tape-benefit-sponging world that holds back wealth creation” . For others, it is simply language manipulation. When the risk/reward proposition benefits the risk seller  (see banks apology to the FSA) at the expense of those unconsciously assuming them, executives can no longer avoid the cost. Health & Safety is a subset of this bigger issue.
It is wholly  understandable businesses should be burdened by compliance costs. Equally, governments  must ensure there is a legislative framework that encourages growth and entrepreneurialism without ‘turning a blind eye’ to safety inadequacies and wealth transfers that cost lives as the mining tragedy in Wales suggests last year. This is an issue both main political parties must address as part of the ‘responsible capitalism’ agenda.

However, as a pragmatist, accidents do happen. There is also significant red tape. Government departments or agencies can be inflexible, rule-driven, under-staffed and distant. This creates challenges.  As a  voter and taxpayer, I expect governments of all colours to ensure those responsible for weak internal controls so obvious in industrial and financial accidents (let’s not forget the financial crisis) are accountable financially, policed by the equivalent of a vice around their (usually) male genitalia. Whilst talk of “dead wood” and “incompetence” fills the soundbites of the coalition’s ongoing review of the public sector, there is plenty of dead wood in executive suites up and down the country. Unfortunately for the vast majority of those in the public sector, they don’t necessarily have the education, connections or manners of those in executive suites that enable luck to be passed off as skill.

As an underwriter I met  many executives of Mining and Energy companies who would claim they had “zero tolerance” for loss of life and safety infringements. I have no doubt they believed what they said. Daniel Kahneman has taught us much about over-confidence. However, few pay the price for foreseeable accidents where causation can be attributed to budgetary considerations, weak project oversight or lack of executive accountability. We now know that financial – not safety-  metrics dominated executive key performance indicators for compensation (see Harvard Business Review’s : The Incentive Bubble) . This is one reason shareholders will focus on risk-adjusted returns in an era of lower credit.

Truth is, the Real Economy will only grow faster and more fairly when those asked to pull hardest know those asking them to pull harder will pay a price if the rope breaks.

 

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The Breedon Taskforce into UK non-bank funding released their findings on Friday. Whilst it’s recommendations are fine as far as they go, there was little  likely to alleviate immediate funding needs for many companies. My latest technical paper, published on Asymptotix website (with thanks) addresses the mechanics of how many companies ( mainly mid-sized+ ) globally (particularly in peripheral Eurozone countries) who are finding themselves closed out of the banking market are considering and adopting more robust and transparent alternatives that are less risky and reduce costs for them and bank and non-bank funders.

Importantly, these solutions put greater control of the funding process under the non-financial company’s control. Rather than allowing their pledged/encumbered or  sold-into-a bankruptcy-remote-SPV assets and credit risks to sit redundantly on the balance sheet eating capital or played with by bank and non-bank funders who may cut, bundle, wrap, rate and sell them as esoteric securities, non-financial companies want and deserve more. This is because there remains a fertile fallacy ignored (invidious) or simply not understood (suggesting the effects of the Lobby) by those charged with fixing the Financial System. The Financial Economy is a subset of the Real Economy. Over the last 25 years politicians and regulators have allowed the dog to savage it’s owner.

There has been plenty of financial innovation within and across financial markets over the last forty years. However, little of this has created better products and services for non-financial corporates. Boards now need products and services that improve Risk Management and corporate governance. Financial sophistry hasn’t paid off (at least for those who pay for it). The Goldman Sachs furore this week highlights what many corporate treasurers and CFO’s already know; bankers and their advisors are thinking  “how can we offer this client products that they will think offer them a good risk/reward proposition.”  “Think” ….. It gives the game away rather well.

In 2009,  many non-financial corporate CFO’s talked of near death experiences. Once bitten, twice shy. They need to understand the means to the end; how products and services offer them more sustainable value. Ultimately they want better value for money and better funding processes that ensure if the dog tries to bite them again, it’ll be the dog ending up worse off.

In banking, sophistication and innovation are not necessarily synonyms for 'effective'.

“Regulators have to recognise that the rules of the game failed to keep up with the progressive fusion of banking, capital markets and insurance.” Bank of England Deputy-Governor Paul Tucker

Forgive the title. However, given my nom de plume and the bank named below, it was hard to resist. It’s inspiration was a recent article in the Financial Times (£) one of an increasing number of stories about “new funding models”. This one just happens to have been adopted by Credit Agricole.

The justification for the new approach – for which it is reasonable to assume Credit Agricole Corporate and Investment Bank CEO Jean-Yves Hocher and his team will earn better than execrable fees on relatively large transactions (doing little for smaller french exporters then?) – was described thus:-

his model – which should be in place by the end of the year – will be different from the heavily criticised US version, since he is creating a new organisation within the investment bank in charge of both originating and distributing. The bank will also remain an interested party in the loans by keeping 20 per cent of them.

It may be a step in the right direction (assuming a 20% quota-share retention through the life of the transaction by the bank). But let’s be frank; one step is a short-distance in a marathon.

The methodology is unlikely to improve ‘all-in’ funding costs significantly for the vast majority of corporate customers. ‘Better than bad’ is not exactly a winning line. And it is hardly news that banks are seeking to shift assets off their balance sheets to reduce Risk Weighted Asset exposure amounts. Nor is ‘risk sharing’ through syndication or risk participation agreements a new or innovative methodology.

In reality, we are currently at an economic point where it almost doesn’t matter what funding methodology is proposed by sophisticated [sic] market participants to non-financial corporates seeking to access liquidity. Methods suggested could be bank or non-bank funding; secured (highly likely)  or unsecured (highly unlikely) debt, recourse or non-recourse, ABS or ABL, Revolving Credit Facilities, Bond Issuance, Invoice Discounting, overdraft, credit card, private placement or ABCP just for starters. The underlying problems that caused the global financial crisis remain. Credit flow has been slowed by a loss of trust in the quality of existing funding processes and the motivations of credit intermediaries and the uncertainty that Principal will be returned.

This is why it is vital that credit intermediaries begin to address some of the problems that precipitated the collapse in confidence. This means they will need to make more effort to prove how they add value to the funding process rather than extract value from it. It also means they should improve the quality of disclosure to investors (bank and institutional) that moves some way towards establishing that :-

  1. the gross and net financial interests of transaction participants are – and are likely to remain – reasonably and fairly aligned for the transaction term.
  2. transaction risks can be monitored and operationally controlled in a timely manner by all transaction participants.
  3. the Marked value of granular assets – rather than a  portfolio of often ineligible assets (aka “a sack of shit“) – used to collateralise funding can be crystallised wherever located (assuming that information is known) on the occurrence of a default event (assuming that has been clearly and legally defined) or the loan successfully repaid if unsecured which may ultimately rely on
  4. truly effective credit risk mitigation. (see Greece CDS & BIS paper)
  5. Credit Risk and counter-party data that is high quality, reliable, available to all transaction participants and that supports regulatory oversight of systemic risk. It also enables national supervisors to look inside the ‘black-box’ used to calculate Risk Weighted Asset exposure amounts, funding margins calculated and credit risk monitored on an ongoing basis.

This extract from a BusinessWeek  article written by the noted economist Hernando de Soto explains why these issues are so important:-

When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the “troubled assets” held by the world’s financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them, or who was holding the risk. These securities had slipped outside the recorded memory systems and were no longer easy to connect to the assets from which they had originally been derived. Oh, and their notional value was somewhere between $600 trillion and $700 trillion dollars, 10 times the annual production of the entire world.

Without addressing these currently unresolved issues, many of the so-called new funding methodologies won’t support the funding pace necessary for Real Economic recovery. The cost of capital will rise as trust in bank-modeled reality slips further.
Without banks fixing the causes of increasing risk premia, the restoration of market confidence will lack resilience.

Whether banks use money-market funds, repo markets, Central bank discount windows, Central Bank artificial respirators, qualifying institutional buyers, other financial institutions, pension funds, insurance companies or retail depositors to provide the necessary liquidity required for transactions to the Real Economy, investors will demand greater returns to replace diminishing certainty.

The challenge for banks is to prove to investors that there is value in investing in bank equity or debt supporting sustainable business models that serve the Real Economy. If there is the faintest whiff that the greater purpose of direct investment in a bank is to create “innovative” solutions that fund bonus pools without offering real social value, commercial banking will simply become value-destroying conduits.

The financial sector must address the clarity and effectiveness of the financial infrastructure they build to connect investors and borrowers. Without doing so, much of their innovation will be seen as sophistry which much of it has been. To survive, winning banks will drop their epistemic arrogance and reliance on structuring complexity and look beyond their own skill-sets for solutions. As Paul Tucker suggests, the financial sector is fusing.

Sadly, the opinions of many of those at the wheel of the school-bus when it crashed are still sought by policymakers. The lack of understanding about the broader role of financial markets (which includes the role of regulated insurance in providing economic safety nets and social value for hundreds of years)  is limiting the effectiveness of policymakers responses. As a result, progress through the sludge of reducing global economic activity will remain slow. Moreover, the medicine the banks prescribe which is  “more-of-the-same-but-repackaged-and-more-expensive” remains the drug of choice for policymakers and opinion formers but may end up killing the patient.

 

 

 

 

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