Some constructive proposals to overcome the credit crisis

By: Eurointelligence

The credit crisis was probably not caused – in a deep underlying sense – by market failure in the credit markets themselves. It was probably caused by a combination of global macro factors that have acted on the markets for long periods, such as excessively low nominal interest rates in the US and Europe, global imbalances and the associated flows of funds.

 

Fixing the market is therefore not going to be sufficient to prevent a re-run of this crisis. But it may be necessary. Market deficiencies themselves have played an important role in this crisis. There are two types of regulatory fixes that have proposed recently. There are quick fixes, mainly aimed to placate the public but unlikely to achieve much. One of these quick fixes is hedge fund regulation, ever popular in Germany, despite the fact that hedge funds were not the real problem during the last few weeks.

 

Equally, we are not convinced of the need to regulate rating agencies. While there is an obvious conflict of interest, and while we agree that the agencies made silly mistakes, we do not see the need for regulatory action, as there are clearly market-based solutions in sight. For example, less known rating agencies exist who provide services paid for by the buyer of the securities, and not the issuer. This would remove probably the biggest conflict of interest. Obviously, if any breaches of the law were to surface, as the Securities and Exchange Commission has hinted at, then that situation may change. But even then, the barriers of exit and entry into this market are relatively low, especially now since the agencies have lost much of their repution. While change is important, if not criticial, regulatory change may not be warranted.

 

There are three categories of regulator change, however, we believe should be explored in greater depth, and which as of yet do not surface highly on the G7 agenda.

 

1. The first, and possibly most important, is a revision of the Basel I and II arrangements. Professor Charles Goodhart and his colleagues at the London School of Economics have argued, in our view rightly, that the present framework is procyclical in that it encourages banks to take on ever more risks during upturns. There should be a review not only of the capital adequacy requirements themselves, but also about how banks are legally able to circumvent them by setting up conduits, special investment vehicle and other structures. In the finance literature there are tomes of textbooks devoted largely to the question of how to get around the 8% capital-to-credit ratio ceiling imposed by Basel I. We think it is time for reflection about whether and how this framework can be improved to achieve a more stablising result.
2. The second proposal we find interesting is from Stephen Cecchetti, at Brandeis University, who has argued that many of the technical problems that we have observed result from the fact that there is no oderly market in many of the products in the credit market. While it may be impossible to shift the entire market onto an exchange, that may still be possible for some sub-segments of the market, for example for interest rate swaps, the largest segment. Also, it is worth contemplating whether the European attempt to create an orderly market in credit default swap indexes, could be extended.

There is an important issue at stake for clearing and settlement. In its earlier days, the CDS market has experienced many technical problems, legal disputes about what constitutes a default and order backlogs that have only been resolved after a gigantic industry effort. If we are going to experience a sharp recession, and an increase in corporate defaults, these problems may resurface again in the future. Many investors have not probably accounted for the risks of writing CDS contracts, and once the corporate defaults are rising, so will be compensatory payment demands on some investors. It is also important that this infrastructure is working.

3. The third interesting proposal came from Jan Krahnen, of Frankfurt University, in the Financial Times. Krahnen proposes that originating banks should, or must, keep the owernership of the junior, or equity, tranches of CDOs, to prevent moral hazard. That alone, he argues would fix many of the problems. Part of the crisis was caused by the fact that conduits agressively sold the equity tranch to third-party investors, such as hedge funds, which has created a permanent division between the originating bank and its creditors, and the credit market. It is important that this link is reestablished.

 

We do not pretend that this relatively short list is the answer to all our prayers, nor that it will prevent future bubbles, which may well arise in other sectors of the market, and for other reasons. There is always a tendency for regulation to fight the last war, rather than to focus on the problems right now. But we feel this would be a useful start.

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