Fri Mar 28th, 2008 at 06:12:32 AM EST
I had this article published today in the compliance industry resource site Complinet
I'm using the material as source for a series of articles aimed at newspapers.
The Future of Compliance: Part One - Peak Credit
Mar 28 2008
Surveying the aftermath of JPMorgan's dramatic acquisition of Bear Stearns and the impotence of the Federal Reserve's "conventional" monetary solutions, it is clear that dramatic, and unprecedented, events are unfolding. Since this is a dynamic process, any commentary is subject to be contradicted within 24 hours, resurrected as conventional wisdom in a week, and dispatched to the outer darkness of history within a month. Whatever the outcome, however, some of the regulatory issues have been evident for some time and others are now emerging.
This article is the first of two concerned with the effect of current developments upon the world of compliance. Despite the kind of special pleading currently seen from the likes of Alan Greenspan, the former chairman of the US Federal Reserve, the effects of this regulatory disaster can only be a call for a retreat from the process of deregulation many commentators regard as responsible.
To predict where the compliance industry goes from here it is necessary to outline the events and trends which constitute almost tectonic movements in the financial markets. To do so, compliance is approached as an essential form of market "quality control".
The subject of "peak oil" is usually misrepresented to mean "oil is running out" but in fact means that, "while there may be plenty of oil in the ground, there is a maximum (peak) level of production which we may even have reached". Peak oil has gradually evolved from a wild "crank" theory to the relative respectability of -- a well-known phrase -- an "inconvenient truth".
The consequences of peak oil are not within the scope of this article but serve as an analogy for another phenomenon -- peak credit, which, like peak oil, may in fact already have occurred.
A bank is a credit institution with a monopoly privilege to create credit backed by an amount of regulatory capital set by the Bank for International Settlements (Basel Accords I and II). The interest-bearing loans or credit which banks create is actually the money we use, and this keeps the economic world turning on its axis. Credit institutions create this money which is then instantaneously re-deposited back into the banking system. Without this flow of new credit there would be no development and no economic growth.
It should be noted at this point that most people -- even the most financially sophisticated -- are under the misapprehension that what banks do is to first take in deposits (i.e., pre-existing money) and then, second, loan them out again. This is actually what credit unions do and what "licensed deposit takers" (prior to the Financial Services Act) used to do. The fact is, however, that credit institutions (aka banks) actually create loans first as new money which become deposits second. There is intense competition among banks to gather in these deposits at an advantageous rate of interest.
There are two types of credit:
* "Trade" credit -- extended by a seller to a buyer and familiar to anyone involved in bilateral over-the-counter markets.
* "Bank" credit -- extended by a bank to a borrower and by a depositor to a bank.
The economic role of a bank is to stand between or "intermediate":
* Borrower -- someone who is receiving something of value from the bank and promising to provide something of value in the future; and
* Lender -- someone who is giving something of value in exchange for a promise from the bank to provide something of value in the future.
If we deconstruct this relationship we see that the bank is guaranteeing the credit of the borrower. The charge the bank makes for doing so (interest) must cover interest paid to depositors, the bank's operating costs and the costs of defaults, and will hopefully thereby provide an additional margin as profit.
In other words, the credit itself does not cost anything to create. It is the guarantee function that is the economic value provided by the bank and this implicit guarantee is supported by the pool of "regulatory capital".
Asset-based and deficit-based finance
As credit involves a "promise to pay" and as "debt" constitutes one of the "twin peaks" of financial capital, credit may be thought of as "deficit-based" finance. The other peak is "equity", which involves actual "ownership" of productive assets in legal vehicles.
Historically, this has been the "joint stock limited liability company" or "corporation"; however, there are an increasing number of alternative vehicles such as trust and partnership-based vehicles, which together may be thought of as "asset-based" finance. The problem is that the bulk of financing of productive assets globally has been a hybrid,
i.e., for the most part, it consists of credit that credit institutions have created and secured by a legal claim over productive assets that the borrower owns.
Deficit-based finance that is "property-backed", i.e., mortgage loans, underpins in excess of two thirds of the money which the Federal Reserve Bank and the Bank of England issues.
The first credit-fuelled "bubble" was the one that the remarkable Scot, John Law, instigated in France, when he created the first example of a central bank in recognisably modern form in 1718 -- the Banque Royale -- and used it to fuel a massive speculative bubble in the share price of the French Mississippi Company (Compagnie des Indes).
Since then, a never-ending series of financial bubbles has been a recurring phenomenon in the financial markets and all bubbles have involved the excessive use of deficit-based finance by investors to buy productive assets.
The result is that asset prices lose touch with the reality of the underlying revenue flows that the assets have generated. Inevitably, the asset price reaches a level at which no further borrowing is possible and the asset price collapses, taking the borrower, and often, the banks which deficit financed the bubble with it.
The pyramid of cheap dollar-denominated credit built in recent years upon US land rental values is such that the current process of "de-leveraging", which has only just begun, is, at worst, in danger of sucking the US into a depression or, at best, a Japanese-style economic stasis.
Some would argue that the credit level created in the US reached an unsustainable peak some months ago and that a fundamental restructuring -- a Bretton Woods II -- is now necessary.
The role of banking innovation
The main issues have been the emergence of new financial techniques, and the re-emergence of old ones, and the regulatory response to these. In recent years banks have been increasingly able to "outsource" to investors the risks of their implicit guarantee. This risk transfer has occurred in three principal ways:
* Securitisation -- permanent transfer.
* Credit derivatives -- temporary transfer for a defined period.
* Credit insurance -- partial transfer.
There has also been a massive growth of complex structured products that involve the "dicing and slicing" of risk.
The regulatory risks inherent in securitisation are not new. These were the principal reasons for the separation by the Glass-Steagall Acts in 1933 of investment banking and commercial banking in the aftermath of the US stock market bubble which led to the 1929 Wall Street Crash.
There have already been calls for the reinstatement of this separation and these calls are likely to grow stronger both as the current crisis unfolds and as lessons are digested in the aftermath, whenever that begins.
Clearly, there will be a reappraisal of the other risk transfer mechanisms as well. In particular, the capitalisation of "monolines" and the risks they undertake in ensuring credit risk will be the subject of intense regulatory scrutiny.
Credit derivatives have proved too useful a tool to be destined for oblivion, unlike most of the financial "toxic waste" now gravitating towards the Fed silo. There may be an increased emphasis on transparency, however, and a drive towards standardisation of terms.
The role of rating agencies and, in particular, the commercial conflicts of interest between the shareholder owners of such agencies and some of the market participants who rely on their neutrality, has already come in for considerable debate and discussion.
This debate is expected to continue and the relationship between regulators and agencies will be reviewed. One radical approach might be to encourage the evolution of a new generation of rating agencies that operate on a not-for-profit basis.
Asset-based finance and 'unitisation'
New asset-based financial tools are continually evolving. For example, the emergence of "income trusts" and "royalty trusts" in Canada has created an entirely new asset class of "units", which comprise rights to part of the gross revenues of listed corporations that have been attractive to long-term investors, such as pension funds who see an advantage in accessing corporate revenues before the management does.
The recent Blackstone IPO was not dissimilar, in that it was not a sale of conventional shares but a sale of partnership interests in Blackstone revenues.
Other growing forms of asset-based finance are: exchange-traded funds; real estate investment funds; and Islamic finance, which is inherently asset-based albeit some of the current generation of "sukuk" vehicles do not necessarily share risk and reward in a way that most Muslims would consider ethical.
Asset-based finance may also be used as a replacement for the increasingly scarce availability of deficit-based, but asset-backed finance. This will continue to be the case at least until banks' balance sheets have been repaired, which -- as we have seen in Japan -- may be a very lengthy process, and moreover, a process that cannot even begin until the market has stabilised.
Governments and guarantees
The contrasting approaches of the US regulatory system, which the Fed drives, and the fragmented "tripartite" (HM Treasury, Bank of England and the Financial Services Authority) approach in the UK have been brought home by the marked difference in the protracted Northern Rock saga and the blitzkrieg approach of the Fed to Bear Stearns.
Decisiveness is all very well of course but the political ramifications, in particular, the democratic accountability and transparency of both the Northern Rock and Bear Stearns "rescues", require careful study.
It is possible to imagine a new approach to the roles and responsibilities of national financial regulators, treasuries, monetary authorities and central banks. Indeed, it is even possible to question the necessity of a central bank at all -- Hong Kong, for instance, has never had one.
The challenge of napsterisation
The next article will consider the continuing and profound changes which flow from the pervasive spread of the internet and, in particular, the effect that the arrival of peer-to-peer direct connectivity ("napsterisation") is already having on the legal and financial structure of markets.
Markets are becoming globally networked; however, regulation remains firmly bound to disparate national jurisdictions. Regulation that is appropriate for intermediaries is entirely redundant for the regulation of "end user" market participants on the one hand and the emerging breed of market service providers on the other.
It is here, in the current transition from "transaction-based" markets that involve intermediaries in a new generation of globally networked markets based upon new forms of service provision, that new opportunities and challenges lie and the compliance industry will be at the heart of this transformation.