2012: Easing Credit in the Real Economy or ‘why risk opacity has damaged confidence’

How to make a simple task complex

“Our capital markets and much of the ‘plumbing’ of the financial system … rely on confidence in the integrity of the assets being traded,  in the robustness of counterparties, in the reliability of infrastructure. Crises nearly always involve that confidence sliding away.”

Paul Tucker, Deputy Governor for Financial Stability Bank of England April 2011

The New Year offers an opportunity to provide you not with another forecast of what may happen during 2012  but to outline what can be done now to protect  against further growth degradation and make credit easier to access. I read a great deal of opinion but little provides real and actionable advice that can help Real Economic activity. I’ll go through some background, what’s gone wrong and how credit is being eased. Links provide further background and reading to the major points.

The financial infrastructure connecting creditors and debtors is broken. Many of the methods, tools, assets and instruments used to intermediate liquidity to borrowers in the Real Economy have lost the trust of investors. Growing doubts about the ability and willingness of Private Non-Financial Corporations (PNFC’s), Financial Institutions and Sovereigns to meet their future payment obligations has turned a systemic liquidity crisis into one of general solvency and confidence, depressing growth in advanced economies. There are now signs of emerging market contagion.  The background to the crisis is well summarized here:-

This is indeed a credit crisis, in two senses. First, its most urgent symptom is banks’ inability to continue their social function of providing credit to society: there is a liquidity crisis. But underlying this symptom, there also is a credit cause for the crisis. This is the neglect of the basic accounting fact that every credit is accompanied by a debt. In that sense, the credit crisis really is a debt crisis. Society has neglected to ensure that credit would be directed towards self-amortizing investment, with real returns that would allow the paying off of debts. Instead, credit flows have led to the accumulation of debt, balanced for a time by rising asset values. Their plunge left the banking sector with a large net debt, ruined balance sheets and incapacitated to serve the economy well.

Over the last 30 years, consumption, investment and growth became increasingly dependent on credit. Following the introduction of the 1988 Basel Accord, Credit Intermediaries (CI’s), mainly banks at that time, were required to hold minimum levels of regulatory capital. The commercial banking model built around accepting deposits  and extending loans became increasingly costly as loans were essentially assets retained on the balance sheet.

Fortunately for Financial Institutions, growth in structured finance (and shadow banking) enabled assets (or synthetically contrived derivatives of underlying asset pools)  to be packaged into credit instruments. These comprised tranches with different seniority of claims on the cash-flows of the assets referenced by the instruments. Each tranche had a risk profile that enabled sophisticated market participants to match a yield with their growing risk appetite. These methodologies enabled banks to “de-risk” their balance sheets with both legal and audit approval and provided an additional and valuable source of fee income; intra-financial credit. However, the de-risking was make-believe. When liquidity dried up in 2008, contingent liquidity support from sponsoring funders was called upon by “orphan” vehicles engaged in ‘off balance sheet’ (IAS 39 under IFRS and FIN 46R, FAS140 under US GAAP) transactions where crystallizing losses on triggered credit events would have fallen on the balance sheets of sponsoring funders.

However, the gap between the cost of credit and price of debt  grew. Asset price growth was increasingly driven by complex debt issuance rather than underlying performance. This complexity meant that modest imprecision in evaluating the underlying risks and their exposure to systemic risks caused fragile ratings to implode and the financial infrastructure to collapse in 2008.

Complexity and personal incentives for CI’s and market participants created risk myopia to modeled reality. This reality was based on information generated by the CI’s themselves using Advanced Internal Ratings-Based credit models (or national supervisors under Standardized and Foundation- IRB models) and the credit rating agencies paid by the Security issuer.

The failure of the system to adequately price credit and therefore debt has resulted in speculative and productive credit ‘sliding away’. The priority of governments is to fix the latter; the former comprises considerable financial sophistry of questionable merit to Real Economic activity. This can be highlighted by the fact that in the US alone, from 1952-1990, $1 of debt created around 70¢ of GDP growth. During the 1990‘s this fell to 33¢ and then 22¢ by 2007. The financial sector grew from being the same size as the US Real Economy in 1952 to nearly five times GDP by 2007. Real Economy credit, on the other hand, has supported self-amortizing production and consumption of goods and services, and left no net debt growth beyond the nominal growth rate of the US economy.

However, there is now a dangerous dependence on Central Banks to ease bank solvency concerns. Easing credit therefore cannot solely be the responsibility of funders, politicians or regulators. PNFC’s must prepare for further economic turbulence by creating robust funding structures supporting trade and growth that:-

  1. Improve Capital allocation and returns: Shareholders and capital market investors demand higher risk premia and granularity in securities in return for liquidity.
  2. Reduce Credit risk: both real and perceived affect confidence. Improving the timeliness of data is essential.

Better Financial Market collaboration

The regulated insurance sector can play a far bigger role in funding the Real Economy. They have risk absorbing balance sheets and have to date avoided financial contagion with one notable exception. However, the sector faces it’s Basel III moment with the rollout of Solvency II regulation in Europe.

Financial Institutions willing to remove themselves from life-support must use more precious capital to tailor better offerings that fit clients needs whilst meeting their own commercial interests. This does not mean “lending less” as so many bankers have suggested. Proven solutions are currently in use that can help PNFC’s bring forward future investment and reduce the likelihood of credit events affecting solvency helping to restore trust between borrowers and funders. These solutions necessarily blend insurance and banking techniques as routes to capital markets continue to converge for sophisticated financial market participants. Bankers not au fait with Solvency II are unlikely to propose solutions that use insurance techniques at the expense of existing  relationships within the non-insurance financial sector.

PNFC’s are reducing costs in order to maintain or  increase operating margins. Optimising operating cash flow value is critical to survival. However, as macro-economic conditions deteriorate across Europe, and the banking system relies on the ECB, financial covenants for some sectors will undoubtedly come under increasing strain through 2012.

There are real concerns about systemic banking stability and the lack of credit. Very simply,  PNFC’s must optimize internal funding costs if they are to minimize external funding requirements and costs. The traditional funding structures, vehicles and mechanisms used by PNFC’s must evolve.

Abundant secured and unsecured bank debt  contributed positively to global trade, social well-being and GDP growth following WWII. However, as debt becomes harder to access, funding structures must adapt. They should rely less on illiquid, deflating assets. They should, ideally, support Real Economy growth by focusing on addressing the following key areas:-

  1.  Non-bank credit (PNFC – to – PNFC): Approximately twice the value of bank and non-bank debt owed by PNFC’s. Outstanding invoices account for ~60% of working capital needs & are a $18 trillion asset value in US alone or ~$70 trillion worldwide.
  2.  Better allocate  capital for all transaction parties.
  3.  Forecasting and valuation models which proved less than robust prior to ’08, should rely on timely and verifiable data.
  4.  Clearer Financial reporting, supporting independent audit and internal control procedures.
  5.  Redefinition of financial claims upon the Real Economy which reduces potential for a future crisis.

Trade receivables are a PNFC’s contractual promise to pay a fixed amount at a future date. Again, from here:-

“All money is credit. Money is the expression of an accounting relation of liability and asset, created as one agent extends credit to another, who assumes a debt. (Therefore the study of money and credit is au fond a study in accounting.) Such IOU’s are monetized and made into a tradeable instrument typically backed by the state’s authority; in other words, money is ‘transferable debt’.”

Trade invoices are a real asset second only to property and their portfolios are significantly under-valued by as much as 20% in funding transactions. Funders treat them extremely cautiously as they are highly granular and change daily, making the tracking of credit risk (systemic and individual) very hard. This is reflected in inflated risk premia in funding margins charged by funders and in also in conservatively over-collateralized advance rates.

Trade invoices are a corollary of productive credit and economic growth; a financial asset that can support far greater diversified non-bank funding in the US & EU, already used widely by US PNFC’s. Updating existing financial infrastructure and methodologies reduces risk premia and increases the quantity of credit extendable. Tailoring better financial transactions for PNFC’s unlocks economic capital, removes significant valuation uncertainty and mitigates funder credit risk more effectively than existing methods (invoice discounting, factoring, trade receivables securitisation, ABCP programs,  Revolving Credit Facilities and orthodox ABS & ABL) at lower all-in cost. This is achieved by addressing credit opacity; a central cause of the financial crisis. Uncertainty about a PNFC’s exposure to their debtors or its location are one part of the problem associated with tracking systemic credit risk as Lehman proved. The other is monitoring any portfolio with granularity that changes daily. These problems reflect in unrepresentative Probability of Default and Loss Given Default calculations used to price credit. The credit study linked to earlier suggests:-

“Credit is, of course, vital to any economy, enabling households and firms to make choices about whether to spend now or delay for a future time.  There are conditions in which it would play no active role, passively reflecting cyclical fluctuations in output, employment and inflation. In a world of more or less complete transparency between borrowers and lenders, very low transaction costs, and very low risk aversion, access to credit would not be rationed; and ex ante yields on financial assets, including loans and bonds, would not embody risk premium.  So if households and firms wanted to bring forward spending in the face of shocks to the economy, they would be able to do so restricted only by their need to remain solvent.”

Increased visibility of granular credit risk exposures enhances decision-making under uncertainty for PNFC’s and financial counterparties, reducing risk premia and transaction costs, enabling credit to be eased.  National banking supervisors will
show sensitivity
to banks attempting to meet increased capital requirements whilst maintaining lending, particularly in Europe. New funding methodologies that increase transparency reduce complexity and opacity. To suggest opacity is good for economic development is to miss the contractual heart of the relationship between debtors and creditors that has been broken; a promise. What is more, most of these ‘promises’ were made between ‘sophisticated’ financial professionals in a culture that didn’t question  epistemic arrogance; a culture led by a few confident -but risk myopic- executives loosely controlled by passive investors; Main Street played little active part. However, we should avoid the ‘blame game’; our role in asset inflation was passive. We allowed our savings to be invested by a system of professional investors without sufficient checks and balances in the Principal/Agent relationship. We are paying for it now.

Information asymmetry cannot be eliminated from finance. However, egregious systemic failures can be designed out with with more progressive regulation. Those holding important public or private roles should operate within decision-making frameworks defining clear risk authorities contractually bound by employment and remuneration contracts. A fair system ‘incentivizes’ through bonuses and maluses, particularly when the costs of these risk failures fall on society disproportionately.

As an ex-catastrophe underwriter I discussed corporate governance and risk management with Energy company CFO’s. Some would say, and I am sure believed, that their company had a ‘zero tolerance’ policy for loss of life. However, as so many man-made disasters prove, few executives were subject to Hammurabi’s code.

It is unsurprising social cohesion has become strained since 2008 in many economies. The banking crisis has exploited an obvious fault-line. Rewards for taking risks with positive economic outcomes were paid to individuals. Yet when risks crystallized into losses with high economic and social cost, they were borne by society. This situation is not unique to banking.

Blending Insurance and Funding processes to ease credit
The funding process begins by creating timely risk information, adding external finance functionality and updating it daily. The PNFC (entities with a turnover of £5m+) then assesses it’s own credit risk appetite and tolerance. A transaction is structured that achieves the desired accounting treatment and outcomes for the PNFC and funder. Credit risk intelligence supports a transparent funding process for investors/funders. The structures and instruments achieve far stronger and more visible protection of principal/capital at yields that reflect more timely and granular risk transparency and improved PNFC corporate governance and risk management.

Risk management and corporate governance therefore become a source of competitive advantage. This flies in the face of the popular narrative that it is “risk-takers” who create wealth. Those who take it with their own money, yes, that is true. But there are fewer of those than the popular narrative suggests. Return on Capital is not the same as Risk-adjusted Return on Capital.

Insurers already support Risk-Weighted Asset optimisation through the provision of eligible (N.B. not traditional trade credit insurance) Credit Risk Mitigants to funders.
In exchange, an insurer assumes the buyer credit risk (with conditionality written to the funder) for 100% of monies advanced against eligible invoices. Increased risk transparency enables advances to increase and/or expected funding margins to be reduced by more than 1%.

Bank Internal Rating Based Models are currently unable to sufficiently optimize Risk-Weighted Asset exposure amounts for Real Economy assets. Improving banks credit risk monitoring and expected loss forecasting methods with better risk transfer structures improves PD, EAD and LGD verification and asset valuation methodologies. These funding methods are adaptable for large PNFC’s or to attract private funds for SME PNFC’s funding facilities as insurance risk can be effectively transformed into capital markets risk. Swiss Re’s Crystal transaction is one such example. Each Credit Instrument is underpinned by a credit tool that uniquely improves credit risk underwriting for banks, insurers and investors.

Financial infrastructure must evolve and track debt and credit values at a granular asset level if skeptical investors are to be assuaged. Mitigating credit risk effectively is vital, as traditional CRM tools are scrutinized for regulatory arbitrage.

Clearer documentation and funding structures can reduce complexity if underpinned by a highly visible and shared credit risk monitoring platform. Each transaction participants capital more effectively reflects their explicit credit risk appetite with the credit platform helping set initial transaction parameters. Legal Entity Identifier risks  reduce and the transaction is supported by daily credit risk monitoring, reporting and valuation at granular, entity and portfolio level. Participants share a single view of trade credit risk presented in a timely manner. This addresses a serious fault line of the financial crisis, information asymmetry.


  1. Reduce “all-in” funding costs and Improve Returns on Equity/Capital.
  2. Improve credit access by allocating transaction capital based on clear risk appetite.
  3. Reduce reputation, liquidity & systemic risk.
  4. Improve cash-flow forecasting, financial reporting & Internal Controls.
  5. Enhance Enterprise-wide Risk Management.
  6. Diversify funding and create a more sustainable approach to funding.
  7. Expands funding capacity for clients exporting to overseas customers.
  8. ‘Joined up’ approach to the internal and external management of credit risk for funding tailored to PNFC’s with greater resilience to external funding shocks.
  9. Create new, transparent asset pools that can be structured to attract private sector investment and bank funding that, in Eurozone, can act as collateral for ECB funding.

In 2001, the Bank of England studied risk transfer between banks and insurers. However, little developed given abundant availability of bank credit to the Real Economy before 2008. Basel III and Solvency II now enable insurers and funders to materially improve funding outcomes for PNFC’s with turnovers of £5m+.

The balance sheets of PNFC’s, insurers and reinsurers can collaborate better and more transparently to reduce funding liquidity risk and increase liquidity and credit.
Risk-Weighted Assets are the denominator for regulatory capital calculations. Their impenetrable complexity can be simplified. Evidence of better risk intelligence compared with existing bank portfolio credit assessment methodologies, helps differentiate effective bank and transaction risk management to prospective bank investors.  These solutions reduce the regulatory capital charge of a funding transaction for a non-investment grade PNFC by 50%+ subject to individual credit underwriting judgement. However, central to each underwriting judgement is higher quality initial and ongoing risk information supporting higher quality PNFC risk management, financial reporting, audit and corporate governance structures. Society wins.

  1. Ellie K said:

    Credit, and thus debt, is necessary for real economic growth. Which you don’t deny! You made a very convincing case for the problem, not with capitalism per se, but with distortion (and abuse?):

    in the US, from 1952-1990, $1 of debt created 70¢ of GDP growth. During the 1990‘s this fell to 33¢ and 22¢ by 2007. The financial sector grew from…the same size as the US Real Economy in 1952 to 5x times GDP by 2007. Real Economy credit supports production & consumption of goods & services… with no net debt growth.

    Yes! Better risk assessment and bank internal rating models are first order of business. There needn’t be huge technological barriers due to “big data” issues, either. Sadly, most of the best efforts at development and innovation, whether quantitative methodology or computing, have been in prop. trading and off-balance sheet activity. A relatively modest effort by banks and regulatory entities will yield large benefits in capturing risk more accurately. Also, collaboration exchange of risk intelligence between insurers and banks, insofar as it effects common credit concerns (but NOT as a precursor to consolidation of banking and insurers as single firms!) is good. It will mitigate financial institutions’ exposure, and benefit retail and merchant customers as well.

    So, Credit Plumber. How do we make it happen?

  2. You have done a masterful job here outlining the problem, its cause, and even propose a sensible solution. That’s something to be proud of.

    But the next time I visit, we’ll need to work on this site to make it really spectacular 😉

    • Ellie K said:

      Professor Pinch:
      It seems like you, or someone, have been busy. This site has morphed dramatically since my last visit. The fonts, colors, images are perfectly suited to the content. New and improved Credit Plumbing blog looks great!!!
      ;o) 🙂 😉

      • Thanks Ellie. Took the Prof’s comments to heart & decided a redesign was critical!

  3. hyip said:

    2012: Easing Credit in the Real Economy or ‘why risk opacity has damaged confidence’ The Credit Plumber I was recommended this web site by my cousin. I’m not sure whether this post is written by him as no one else know such detailed about my trouble. You’re amazing! Thanks! your article about 2012: Easing Credit in the Real Economy or ‘why risk opacity has damaged confidence’ The Credit Plumber Best Regards Yoder Rolf

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