Procyclicality is used in the context of discussing the effects of Basel II on the financial system. A simplified definition of pro-cyclicality is:

International rules have encouraged banks to act more aggressively when the economic cycle is in the middle of an upswing, when some argue that is precisely when they should be putting money away for a rainy day. The global economy has become more volatile as a result. Source: Thisismoney.co.uk

Claudio Borio, Craig Furfine and Philip Lowe express the same statement in more sophisticated words:

Financial developments have reinforced the momentum of underlying economic cycles, and in some cases have led to extreme swings in economic activity and a complete breakdown in the normal linkages between savers and investors.

These experiences have led to concerns that the financial system is excessively procyclical, unnecessarily amplifying swings in the real economy.

In turn, these concerns have prompted calls for changes in prudential regulation, accounting standards, risk measurement practices and the conduct of monetary policy in an attempt to enhance both financial system and macroeconomic stability. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“

José Viñals, Director General International Affairs at the Banco de Espagna, reminds us that a certain procyclicality of the financial system is wanted, but excessive procyclicality can be a burden:

In the financial sphere, a certain degree of procyclicality is a natural, sensible and desirable outcome as it reflects the extent to which the financial sector is influenced by developments in the real economy and viceversa. The issue is nevertheless to what extent there is an excessive degree of procyclicality. The financial system is excessively procyclical when it unnecessarily amplifies swings in the real economy and/or reduces the stability and soundness of the financial sector. Source: José Viñals in “Procyclicality of the financial system and regulation“

Indicators of pro-cyclicality

According to Claudio Borio, Craig Furfine and Philip Lowe periods of growth are often associated with:

• significant increases in the ratio of credit to GDP
• large increases in equity and property prices
• decreasing bond spreads between corporate and government securities
• credit rating agencies failing to predict changes in the probability of crises
• unaltered bank provisions
• increasing bank profitability and increasing bank equity prices

Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“

Causes of Pro-Cyclicality in the financial system

Nancy Masschelein, from the National Bank of Belgium, has listed various sources of pro-cyclicality. Source: Nancy Masschelein in “Monitoring pro-cyclicality under the capital requirements directive : preliminary concepts for developing a framework“

1. Fluctuations in the quality of banks’ and borrowers’ balance sheets.An increase in bank profits during periods of growth supports the extension of credit, while decreasing bank profits due to defaulted loans reduce this extension of credit. At the same time, a recession causes declining profits, increases demand for new credit and increases the interest rates.Claudio Borio, Craig Furfine and Philip Lowe have labelled this the Incentive Explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“
2. Information asymmetries between borrowers and lenders.During periods of growth, the value of collateral rises and borrowers with riskier projects can find lending. Under recessions, due to the decreased value of collateral, even borrowers with very profitable projects will find it difficult to obtain funding. These cyclical effects are especially relevent for borrowers which are more prone to asymmetric information effects (such as SMEs).Claudio Borio, Craig Furfine and Philip Lowe call this explanation the Financial-accelerator-explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“.
3. Inappropriate responses by participants in the financial system and lack of institutional memory.Euphoric expectations which arise from an investment boom driven by the business cycle or a disaster myopia which shows in a reduced subjective probability of a major shock if the last shock has already a few years past, is another source of excessive lending by banks during periods of growth.Allen N. Berger and Gregory F. Udell raise the problem of a lack of institutional memory. Source: Allen N. Berger and Gregory F. Udell in”The Institutional Memory Hypothesis and the Procyclicality of Bank Lending Behavior“
   

   Under the institutional memory hypothesis, as time passes since the last “learning experience” with problem loans – the last time that the bank suffered a loan “bust” – loan officer skills decline.

   Part of this decline in lender ability is attributable to a proportional increase in inexperienced lenders who have never had such a “learning experience.”

   Part of the decline in lender ability is also due to the atrophying skills of experienced loan officers as time passes since they last addressed significant loan problems.

4. New financial innovative instruments.The use of new financial instruments facilitated the spreading and the diversification of credit risks and increased the possibilities of hedging. In favourable circumstances, banks can easily transfer credit risk using innovative credit risk transfer (CRT) products, which could induce banks to increase lending as credit risk can be transferred.

Regulation and pro-cyclicality

The most important dimension of pro-cyclicality that is being adressed in the remaind of this article is regulation. Minimum capital requirements imposed by regulators to reduce systemic risk from collapse of systemically important financial intermediaries may force banks to reduce lending in an recession, increasing the above pro-cyclical mechanisms of the financial system.

George G. Pennacchi warned that Basel II increases the sensitivity of a bank’s capital requirement to the risk of its assets and creates incentives which make bank lending more procyclical.

During recessions, loan losses reduce bank capital and, even if capital requirements are insensitive to risk, a capital-deficient bank must increase its capital ratio. In addition, recessions tend to raise the default risk of loans, and Basel II’s more refined risk-based standards would further pressure banks to strengthen their capital ratios. This response of capital ratios to default risks can reduce banks’ incentives to lend during a recession and worsen economic activity. Thus, capital requirements as envisioned under Basel II increase macroeconomic instability.Source: George G. Pennacchi, Journal of Financial Intermediation “Risk-based capital standards, deposit insurance, and procyclicality“

Besides miminum capital requirements, there are other ways that regulation can increase pro-cyclicality. Philipp Turner has listed them and discussed their relevance. Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“

1. Timing of tightening of capital rulesDuring and immediately after a financial crisis, policy-makers have large incentives to tighten bank regulation which further curtails bank lending. Turner says that this problem is not that revelant in practice, most countries allow a phase-in period for the tightening of prudential ratios or in dealing with generalised problems.
2. Regulatory bias in favour of short-term lendingUnder Basel I, international interbank lending of up to one year maturity had a 20% risk-weight irrespective of country, but lending of more than one year to non-OECD countries carried a 100% risk weight which would make bank lending to emerging markets “too” short term. According to Turner, Data does not suggest that this effect is important, nevertheless Basel II adresses these ambivalent distinctions.
3. Cyclicality of minimum capital ratiosThis will be discussed later in this article in relation to bank provision and IAS 39, but the general idea is that because of certain minimum capital rations banks will reduce lending to meet the required minimum capital rations, if they have not made sufficient provisions for losses.
4. Cyclicality of capital ratios due to the use of external credit ratingThis will also be discussed later in relation to the impact of Basel II on risk management in banks, but the general idea is that an increased reliance on external credit rating in determining risk weights can lead to the necessity for increased capital ratios in times of recession.

Basel II, Credit Rating Agencies and Pro-Cyclicality

According to José Viñals the philosophy of modern monetary politics and approaches to financial stability incorporated in Basel II is quite similar:

• both are forward-looking in nature and have a medium-term horizon
• both have an anticipatory character that seeks prevention rather than cure
• both attempt to incorporate market views through the role played by expectations and market discipline.

He argues that Basel II reduces pro-cyclicality by improving banking supervision.

By contributing to a better assessment and management of risks, Basel II should reduce the scope for surprises and thus for procyclicality.Source: José Viñals in “Procyclicality of the financial system and regulation“

The influence of Basel II on the real economy would work along the following mechanism

Basel II would increase the risk-sensitiveness of minimum capital requirements which, in turn, would lead to higher cyclicality of the overall regulatory capital and to more procyclical capital. Consequently, this would be reflected onto more procyclical lending and onto a higher degree of procyclicality in the real economy.Source: José Viñals in “Procyclicality of the financial system and regulation“

The influence on Basel II on the real economy through capital requirements is the reliance on external credit assessment for calculating risk weights. Philip Turner states that under Basel I, risk weight for sovereign and corporate debt were based on OECD membership wich was not sufficiently responsive to risk. Basel II relies more on “credit assessment agencies”, so not only credit-rating agencies, but also export insurance agencies, credit registers, market data.

However, credit rating agencies are often more backward-looking rather than forward-looking, their assessments are strongly negatively correlated with the real effective exchange rates, even though depreciation in the wake of a crisis should not lead to a downgrade but to a recognition of medium-term strenght due to a more competitive exchange rate.Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“

Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos more specifically identify the choice of rating system as an important element in pro-cyclicality:

The proposed new Basel Accord, in contrast to the Current Accord, makes provision for time varying risk weights for individual loans. Although the Basel Committee will set fixed weights for loans with a given probability of borrower default, banks will choose the probability of default band into which a loan will be slotted.

It then becomes very important how the banks carry out this ‘slotting’. When banks assess a borrower’s probability of default the assessment can be based on current economic conditions (where the rating will be conditioned on the point in the cycle) or can take into account the effect on the borrower of a possible adverse change in the climate. [...] The new element under Basel II is the additional procyclicality which will come from the latter element. [...]

Strongly procyclical capital requirements could cause severe macro economic effects by creating credit crunches in recessions, thereby exacerbating the economic downturn. They could also encourage excessive lending in booms. An important policy issue is therefore whether banks would choose to adopt more stable ratings across the cycle, which would moderate the procyclical effects, or whether they would adopt ratings conditioned on the point in the cycle even though this could lead to an inability to meet demands for credit in a downturn.Source: Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos in “Procyclicality and the new Basel Accord–banks’ choice of loan rating system“

Procyclicality, bank provisions and IAS 39

In addition to the minimum capital requirements, the role of bank provision is important. Turner argues that the ideal response to procyclicality is for banks to make adequate provisions for possible loan losses. Often however, he says, tax laws limits the tax deductibility of precautionary provisioning because loan loss provisions increase internal funding for the bank only to the extent that they reduce taxes. Furthermore, securities authorities like the SEC have argued that precautionary provisioning distorts financial reports and may mislead investors. The building up of provisions may conflict with the demand for well-document accounting. Philipp Turner in “Procyclicality of Regulatory Ratios?“

More specificially, the introduction of International Accounting Standard 39 requiring fair-value accounting make bank provisions more pro-cyclical, as José Viñals discusses:

IAS39 adds to procyclicality in the financial system through the introduction of fair-value accounting. [...] There is also a serious risk that, if the new rules are interpreted too rigidly, they could discourage, complicate and even prevent the implementation of some solutions to the procyclicality problem such as forward-looking provisioning.

Consequently, IAS39 might not only exacerbate procyclicality but also make it more difficult for regulatory policy to deal with procyclicality. In particular, Basel II is mainly about capital (to cover unexpected losses) and thus does not deal in depth with provisions (e.g. to cover expected losses, as in the case of forward-looking provisions). In turn, IAS39 contemplates only ‘incurred losses’ as far as provisions are concerned. Hence, under a rigid interpretation, IAS39 would not be compatible with a system of forward-looking provisions.

Solutions for Pro-Cyclicality

The problem of pro-cyclicality reflects a deeper problem of financial regulation. On the one hand, financial regulation for banks under Basel II was made more sensitive to the business cycle by relying on external credit assessment (in pillar 1 of Basel II) and fair-value-accounting (in pillar 3 of Basel II). The motivation behind these changes was to move away from the often arbitrary risk-weights assigned in Basel I. However, with more risk sensitivity of financial regulation, banks amplify the business cycles and contribute to systemic risk. In other word, the methods to avoid systemic risk are contributing to increase systemic risk.

There are a handful of proposals to change various aspects of Basel II. George G. Pennacchi, for example, suggests moving to a risk-based deposit insurance system which encourages less procyclicality of bank loans then risk-based capital ratios. In a policy brief from the FSA, the authors discuss between adjusting “Pillar 1″ or “Pillar 2″ approach to counter procyclicality. “Pillar 1″-approach would be the modification of rating methodologies for capital requirements, “Pillar 2″-approach would mean relying increasingly on procyclicality stress tests to increase, if necessary, regulatory capital. The authors argue that the “Pillar 2″-approach is politically more feasible while the “Pillar 1″-approach would make more sense.

Several authors call for a more comprehensive approach to tackle the problem. In a speech given by William R White, Economic Adviser and Head of Monetary and Economic Department of the Bank for International Settlements, advocates a “new macrofinancial stability framework” which encourages regulators and central banks to resist the pro-cyclicality of the financial system.

Such a system would pay attention to the impact of systemic shocks, a close cooperation between central bankers and regulators in assessing the build-up of systemic risks, and a countercyclical use of policy instruments. Monetary policy and regulation would push in the same direction: credit tightening in times of growth and credit expansion in recession would go together with a biased regulatory policy of risk spreads (for expected losses), provisioning (for subsequent changes in expected losses), and capital (for unexpected losses) being increased in good times and decreased in bad times. He proposes to alter the capital required for credit risk with a formula based on estimates of system-wide increases in exposure. The formula could make use of the rate of growth of aggregate credit and asset prices from longer-term trends.

White advocates a international agreement for such a framework and improving risk management procedures under Basel II. The biggest impediment against moving towards such an international agreement, assuming consensus on the causes of the crisis and availability of the appropriate tools, is the act to will. Policy makers face the bureaucratic inertia and vigorous lobbying (against reacting) from the many people being made rich by the crisis. Central bankers face the problem that counter-cyclical regulation and tightened credit could strangulate an economy more than necessary. Regulators face the problem of not having long cultural tradition of concern for macroprudential issues and not seeing the big-picture of macro-financial stability. White suggests to include an automatic response to the procyclical tendencies of the financial system. (See also Whites paper “Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?” and the similar suggestions by Claudio Borio, Craig Furfine and Philip Lowe).

Conclusion

Business cycles are a necessary characteristic of an open economy. The fact that the financial systems moves along with the business cycle is a necessesary consequence of the fact that the actions of the financial system reflect the underlying changes in the real economy.

Regulators, central banks and policy-makers have a natural tendency to dampen the business cycle: through the use of fiscal, monetary and regulatory policy. To some extent it is however not possible to get rid of both things at the same time: financial instability and pro-cyclicality.

Financial stability rests on using the information about the state of risk provided by the market, but at the same time pro-cyclicality is increased by relying to heavily on the market for providing information about risk. Pro-cyclicality and financial stability are two sides of the same coin.

Bloomberg writes on the difference between writedown and credit loss:

Investment banks and the investment-banking units of financial conglomerates mark their assets to market values, whether they’re loans, securities or collateralized debt obligations, and label that a “writedown” when values decline. Commercial banks take charge-offs on loans that have defaulted and increase reserves for loans they expect to go bad, which they label “credit losses.” Commercial banks can have writedowns on holdings of bonds or CDOs as well.

• European banks whose losses are smaller than $1 billion each are in this group: ING Groep, Allied Irish Banks, Bradford & Bingley, Aareal Bank, Deutsche Postbank, Lloyds TSB Group, Standard Chartered, Northern Rock, HBOS, Dexia, WestLB, Commerzbank, NordLB, Rabobank, HVB Group, Sachsen LB, Intesa Sanpaolo.
• Asian banks with writedowns smaller than $1 billion: Mitsubishi UFJ, Shinsei, Sumitomo Trust, Aozora Bank, DBS Group, Australia & New Zealand Banking Group, Abu Dhabi Commercial, Bank Hapoalim, Arab Banking Corp., Fubon Financial, Industrial & Commercial Bank of China, Citic International, BOC Hong Kong, Bank of East Asia.
• Canadian banks included in this group: Bank of Montreal, National Bank of Canada, Bank of Nova Scotia, Royal Bank of Canada.

It certainly makes sense to involve private bodies and the representatives of business when creating standards. The technical expertise of these bodies is valuable for ensuring that the goals of the regulation are feasible and achievable.

However, standards are not neutral, they not only provide a public good of a market framework which lowers transaction costs and deters fraudulent behaviour, they also serve those who are setting the standards. One interest of a private body could be to exclude competitors from gaining market share by obligating standards which these competitors can’t fulfill.

In the debate on the causes of the sub-prime crisis, media and academia are discussiong the incentives set by standards. They claim that Basel II has encouraged pro-cyclicality of Bank lending, or that reliance on Credit Rating Agencies in regulation has reduced the banks effort to conduct their own diligent risk management. The overall criticism is levered at governments, central banks and regulators for setting up the wrong system of financial regulation.

Attached to this criticism is the challenge that the current system of co-ordinating financial regulation is not working. Calls for a World Financial Architecture (see book by John Eatwell and others) are being heard.

However, it is often ignored that for standards to be functional, the private sector needs to be a consistent advocator of good standards. This should be reflected in a financial architecture which involves the private sectors in the crucial decisions on standard-setting, impact assessment, implementation and enforcement. Such an involvement is only possible if the private sector can give a coherent response to the demand for consultation coming from the public sector.

What is most striking is that the private sector does not speak with one voice. With ICMA, SIFMA and the IIF there are three private institutions speaking on behalf of the capital market. The G30, as a quasi corporative think-tank, ammends these views on serves as a coordinating body between highly influential individuals in the international financial institutions.

It would be interesting to have a closer look at this network of institutions and individuals:

• Which companies are members of which institution?
• Which individuals are members of which institution?
• Which companies and which individuals are key nodes in this network?
• Is there an overlap of tasks of the private institutions?
• Which formal and informal coordination groups exist between the bodies representing the views of the financial actors?

Would financial institutions disclose this kind of information?

• Eric Englund writes in April 22nd 2006 the article “The Federal Reserve and Housing: A Cluster of Errors?” warning about the link between interest rates and housing prices:
  

  The hyperreality conjured by the Federal Reserve’s relentless inflation of the money supply is characterized by a populace which believes that a permanent plateau of prosperity has been attained. This is the boom phase of the trade cycle. [...] When the bust phase of the trade cycle materializes [...] then the real horror show will unfold. Let’s face it: highly leveraged Americans have little to no chance of ever paying back their enormous mortgage debts. [...]

  The Federal Reserve “engineered” America’s housing bubble. [...] [I] quote from page 1 of a September 2005 study sponsored by the Board of Governors of the Federal Reserve System titled House Prices and Monetary Policy: A Cross-Country Study [...]: “Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission.”

  With the bursting of the NASDAQ bubble signaling that the U.S. was heading into a recession – not to mention the shock of 9/11 – the Federal Reserve took desperate measures by goosing the money supply and driving the Fed Funds rate down to 1%. These monetary central planners knew that housing demand was very much interest rate sensitive, and they were counting upon the opiate of easy credit, at remarkably low interest rates, to stimulate the “animal spirits” of Americans in order to set the housing market ablaze.

• Robert P. Murphy writes an article on April 4th 2008 stating that the Fed’s role in the housing bubble is a classic illustration of the Austrian business cycle theory of the economy:
  

  [The] Figure [on the right] seems to be the textbook illustration of how the Federal Reserve conducts its open market operations: When it cuts the federal funds target rate, it pumps reserves into the system, i.e., expands the monetary base. On the other hand, when the Fed raises interest rates, it slows the rate of monetary expansion. Except for the large blips due to the Y2K scare — when the Fed flooded the system with liquidity and then sucked it right back out — the early 2000s fit the pattern perfectly. That is, when Greenspan cut the target rate from January 2001 through June 2003, the monetary base grew rapidly. Eventually the base growth came back down to moderate territory, but that was when the Fed was ratcheting up interest rates, just as we would expect.

  Image from Mises.org

• Ben Bernanke is quoted in an article in the Washington Post on October 27th 2005 written by Nell Henderson to doubt that the housing bubble burst:
  

  Ben S. Bernanke does not think the national housing boom is a bubble that is about to burst, he indicated to Congress last week, just a few days before President Bush nominated him to become the next chairman of the Federal Reserve.

  U.S. house prices have risen by nearly 25 percent over the past two years, noted Bernanke, currently chairman of the president’s Council of Economic Advisers, in testimony to Congress’s Joint Economic Committee. But these increases, he said, “largely reflect strong economic fundamentals,” such as strong growth in jobs, incomes and the number of new households.

  “House prices are unlikely to continue rising at current rates,” said Bernanke, who served on the Fed board from 2002 until June. However, he added, “a moderate cooling in the housing market, should one occur, would not be inconsistent with the economy continuing to grow at or near its potential next year.”

• When the Housing Bubble burst, Alan Greenspan on 8th of April 2008 in an interview on CNBC defends the role of the Fed in the housing bubble:
  

  More than two dozen economies have had housing bubbles and all are related to the dramatic decline in real long-term interest rate that occured from the 1990ies onwards. [...] You can fully explain the bubble by what is going on globally.

  A paper by Christian Upper and Andreas Worms from the Deutsche Bundesbank explains the connection between monetary policy and long-term interest rates.

  Two blog-posts (from 2005) discussing Greenspans views on the Long-Term-Interest-Rates are “Greenspan on interest rate mystery and the “Long-Term-Interest Rate Mystery” by Kash Mansori.

• Jeffrey Rogers Hummel and David R. Henderson write that they “Blame Federal Gov’t, Not The Fed, For Subprime Mortgage Problems“:
  

  The better way to judge monetary policy is by the monetary measures: MZM, M2, M1 and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20% to nearly 0% by 2006. During that time, M2 growth fell from over 10% to around 2%, and M1 growth fell from over 10% to negative rates. [...] Monetary policy was not expansionary.

  First, the federal government contributes to what economists call moral hazard. [...] [P]eople who buy their repackaged loans [...] assume an implicit federal government guarantee. [...]

  The second way the feds contributed to the subprime mess was with a little-noted change in regulations by the comptroller of the currency in December 2005 that acted as the trigger. [...] The comptroller started requiring banks to require minimum payments on credit card balances, causing increases of at least 50% for most cards and as much as 100% on others. Many people who hold subprime mortgages are people for whom a higher monthly payment on a credit card would be a problem. [...] With the new regulation, you instead make your credit card payment but miss your mortgage payment, a widely observed transformation in the traditional American delinquency pattern. [...]

  The third federal contributor to the subprime crisis is the Community Reinvestment Act. This act, first passed in 1977 and beefed up in 1995, requires banks to lend to high-risk areas that they otherwise would avoid. Those banks that fail to comply pay fines and have more difficulty getting approval for mergers and branch expansions.

• Unfortunately, there is not enough time to go deeper into the debate, but it should be pointed to these links: Greenspans Article in the FT from March 18th 2008 “We will never have a perfect model of risk”, criticism and his response.

(This skepticism edges on the border of radicalism, for instance when he assaults the environmentalist movement and compares them to communism and nazism, without understanding the political economy governing global environmental regimes.)

In his article, he calls for a return to the Gold Standard. The standard argument against a return to the Gold Standard is that the volume of gold does not grow fast enough as the volume of money that is needed for the economy to grow. To fix that problem, Reisman proposes to set the price of Gold held at the reserve at about 12.700 US-Dollars and then assign this gold to the banks holding deposit accounts and other type of highly liquid assets.

Unfortunately, he does not discuss one prominent problem with the Gold Standards: most of the US-Dollar-Reserves are not held by commercial banks inside the USA, but by Central Banks outside the USA. Would the Fed really hand over their gold (even if it stays in their vault) to the Chinese Central Bank, for instance?

Reisman also discusses the vicious circles of highly-leveraged financial markets and how deflation can spread through an economic system. What is particular interesting are how the losses occured from loans in subprime mortgage market can have a more detrimental effect on the economy as whole (his full argument is present in the CMAP, click on the picture).

First, from bond-insurers to credit-rating-agencies to banks:

[B]anks’ capital now hinge[s] on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars. Collapse of the bond insurers would mean that credit-rating firms [...] reduce the ratings of all the bond issues [...] deprived of insurance coverage. [...] [L]ower credit ratings would make them ineligible for purchase by numerous investors, such as many pension funds. [If these] bonds were owned by banks, the value of the banks’ assets would be correspondingly reduced [...]

Secondly, from banks to prime-mortgage-lenders:

As the result of losses sustained in subprime mortgages, banks and other lenders could no longer provide funds as readily for the purchase of prime mortgages. The resulting few percent drop in the value of prime mortgages has served to wipe out the entire capital of prime mortgage lenders whose capital was so highly leveraged that it constituted an even smaller percentage of the value of their assets than the few percent drop in the price of those assets.

Thirdly, from the prime-mortgage-lending market to government-sponsored lending market:

The liquidation of the assets of such lenders, which consisted mainly of prime mortgages, has meant a further fall in the price of prime mortgages, to the point where the credit even of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into question. [...] The Federal Reserve’s rescue of Bear Stearns can be understood in part in the light of its desire to avoid further declines in the assets and capital of Fannie Mae and Freddie Mac, which would have resulted if Bear had had to sell off its holdings of mortgages.

Fourthly, from banks to the business needing credit:

The decline in the assets and capital of banks [...] reduce[s] the ability of banks to lend money to borrowers to whom they would otherwise normally lend. The effects of such credit contraction [...] be seen in the growing difficulty even of sound firms to obtain financing required for expansion.

Fifthly, from the banks credit contraction to a multiple credit contract because of minimum capital requirements:

[R]eductions in the capital of banks can result in multiple contractions of credit. [...] [B]anks are normally required to possess capital equal to five percent of their outstanding loans and investments. [...] [R]eductions in banks’ capital below the five percent level have the potential to result in contractions of credit twenty times as large, in efforts to reestablish the five percent ratio.

Sixthly, from multiple credit contraction to reduction of money supply

Credit contraction by banks [is 9reducing the outstanding volume of checking deposits in the economic system and [...] the quantity of money in the economic system. [...] If those banks do not then make equivalent new loans, accompanied by the creation of equivalent fresh checking deposits for new borrowers, the amount of the checking deposits used to repay the loans simply disappears.

Seventhly, from money supply to business earnings to business spending to wages to private consumption:

Such contraction of credit and money operates to reduce the amount of spending in the economic system. Money no longer spent is business sales revenues no longer earned. A drop in business sales revenues, in turn, causes a drop in spending by the firms that would have earned those sales revenues. This further drop in spending reduces both the sales revenues of other firms, namely, those that would have supplied the firms in question, and wage payments to workers, as employees are laid off in the face of declining sales. And, of course, as wage payments fall, so too does the spending of wage earners for consumers’ goods.

Eightly, from decreased spending of businesses and consumers to banks:

As the sales revenues of business firms decline, so too do their profits and their ability to repay debts, including debts to banks. The resulting further declines in the value of bank assets further reduce the capitals of banks, causing more credit contraction, further reductions in the quantity of money and volume of spending, and still more reductions in the asset values and capitals of banks, on and on in a self-reinforcing vicious circle.

The message is clear: a small loss in a small share of the market can result in a contraction of the whole economy through various feedback loops.

It is so far the most comprehensive review of the International financial architecture. John Eatwell, one of the authors, is using the book for advocating strongly for a World Financial Authority. In the light of recent turmoils in the financial markets, the books focus will help to reassess the proposals made for reform of financial regulation.

An interesting story is the cover of the book. It shows the painting “The Two Tax Gatherers” (ca. 1540) by Marinus van Reymerswaele. Superficially, the painting would fit the topic of the book because it shows two people counting money.

On the other hand, Flemish Renaissance painters often sold their paintings to the same people they mocked for their greediness and desire for money: wealthy merchants and traders. Maybe unintentional the authors of the book are also mocking those which are supposed to read the book: financial regulators.

To assess the impact of the report on the global financial architecture and the responses to the credit crisis in the financial markets, it is worthwhile recalling the original demands of the G7.

In essence, the FSF was asked to look at the underlying causes of the credit crisis (which it did) and make proposals for tackling the problem. Quite clearly the FSF concentrated mostly on the micro-economic implications of Financial Regulation and not so much on more macro-economic developments, such as global interest rates, exchange rate movements or the role of new actors like Sovereign Wealth Funds as (de-)stabilizing force in the Financial Markets.

The general message of the report cam be summarized as follows: Blame the banks, blame the credit rating agencies, blame national supervisors! There is very little blame directed at the political level, the central banks or the international bodies coordinating supervision.

This however was expected, given that G7 wanted the conduct of business by the banks (especially the business of off-balance-sheets-vehicles which speculate heavily in structured products) and the credit rating agencies (which are involved in analysing and rating structured products, but also in giving advice on how to set-up structured products) to be at the heart of the global regulatory response.

The FSF reponse shows a tricky balance when it comes to the global framework for Banking Regulation. On the one hand, the FSF wants to increase the scope of Basel II and encourage more countries to adopt the framework, on the other hand Basel II has some deficiencies which have worsened this crisis, that a reform Basel II will undergo a scrutinous review.

The report addresses the fields where Basel-II will undergo a review:

• Increased minimum capital requirements for capital requirements for complex structured credit products (such as Colleratlized Debt Obligations of asset-backed securities) when they are in the balance sheets of financial institutions, especially taking into account liquidity risk when the secondary market for these products evaporates.
• Increased minimum capital requirements for the so-called off-balance-sheets vehicles.
• Less reliance on the ratings of credit-rating agencies when assessing the liquidity risks of securities and less reliance on the ratings of monoline-insurers in Basel II.

The main task of reforming Basel-II will reside in the BCBS, but it seems that other organisations such as IOSCO and IAIS will provide guidance. Furthermore, the FSF will provide guidance for the national regulators to improve their supervision and enforcement of the Basel-II-rules and ensuring that the financial institutions have adequate risks management models.

The enforcement of the national supervisors is also crucial when disclosing losses, which the FSF has enphasized in quite drastic words. The FSF has put out the mid-year reports as a condition for the banks to disclose their losses for two reasons:

• firstly, it wants to overcome the prisoner-dilemma of banks which are faced with the problem that a joint disclosure of losses in the long-term leads to increased trust in the interbank-lending-markets, but in the short-run represents a punishment by the markets when share prices drop.
• secondly, disclosing the losses will be a precondition for a bail-out through lower interest rates by the central banks which the financial institutions could use to recapitalize themselves.

Interestingly, also the IAASB is called upon for to improve the auditing standards, despite the fact that at least in the public mind, incorrect auditing was not the big problem of the credit crisis. The IASB is also called upon to update International Accounting Standards, especially for structured products. Finally, markets are urged to implement better settlement standards for OTC-derivates. All three events point to the problem that underlying causes of the credit crisis is really market information.

The heavy attack on the Credit Rating Agencies follows the market information perspective, but seems to be politically motivated. The internal code of conduct of Credit Rating Agencies does minimize conflict of interests and the IOSCO-2004-Code for CRAs (which is called for an update by 2009) is too vague and general as to really provide some substantial guidance.

Most likely there will be regulation calling for internal firewalls between the departments dealing with the consultancy for structured products, and the analysts rating structured products. As the FSF indicates, there will also be regulation that the CRAs have to introduce differentiated rating schemes for structured products.

Yet it is not clear that all of these measures will help to tackle the fundamental problem of the global financial market, which is an often incoherent and overlapping financial architecture regulating financial markets.

For large financial conglomerates, the regulatory landscape is very complex. The FSF proposes to introduce “Colleges of Supervisors” from the main jurisdictions. This is an interesting idea, especially because such “Colleges of Supervisors” are also going to be introduced for Cross-Border Financial Institutions.

It is also to be welcomned that the international bodies are encouraged to develop more closer cooperation, especially the IMF and the FSF are moving closer again. Whether this is motivated by the idea of strengthening the role of the IMF or linking macro-ecnomic and micro-economic aspects of Financial Stability, can only be speculated.

In any case, there is no central, singular, international, supervisory authority and given the complexity of the problem, it is unlikely that such an authority will emerge any time soon. But until then, the reform of the financial architecture will be patchwork – and the FSF Report is a good example of this principle.

The G7 finance ministers asked the FSF at their October 2007 meeting (statement) to analyze the underlying causes of the turbulence, which the FSF did in the first chapter of the report.

The G7 also asked the FSF to offer proposals for liquidity and risk management; accounting and valuation of financial derivatives, role of credit rating agencies in structured finance; supervision of banks and the treatment of off-balance sheet vehicles.

At their February 2008 meeting, they redefined the agenda of the FSF. They urged financial institutions (especially the banks) to disclose their losses. They called for a better liquidity risk management inside Basel-II and to address the problem of off-balance-sheet-vehicles. The G7 Finance Ministers said they were not hostile to a reform of the Basel II capital adequacy framework. They wanted to change the incentives of the originate-to-distribute-modell and address the conflict of interests in the credit rating agencies. They also called for a review of national and international supervisory mechanisms.

Prudential Oversight

Basel II and Minimum Capital Requirements

The report of the FSF calls for a timely implementation of the Basel-II-framework, despite its deficiencies. In 2006 in a response to a questionnaire by the FSI, 95 countries indicated plans to implement Basel II in their jurisdiction (for members of the European Union, Basel II is mandatory). National supervisors are called for evaluating the impact of Basel II and adjust minimum capital levels accordingly.

The BCBS is called to reform Basel II by increasing capital requirements for complex structured credit products such as Colleratlized Debt Obligations of asset-backed securities (ABSs). Together with IOSCO, the BCBS will propose regulation for a better representation of these structured credit products in the trading books of banks and securities firms. The BCBS also wants to strengthen the capital treatment for banks’ liquidity facilities to off-balance sheet asset-backed commercial papers (ABCPs).

On the national level, supervisors are called for to continue to develop the risk assessment framework inside Basel II and the compliance of the banks. One main debate in the financial world is whether the risk-based mininum capital requirements in Basel II encourages procyclicality and supervisors are called to address that.

The role of monoline insurers and financial guarantors is going to be assessed by the IAIS and regulation to be introduced to reflect their relation to structured credit products.

Liquidity risk and liquidity management

Regulators are urged to be more strict in enforcing adequate liquidity risk management. Supervisors and central banks are called to examine an internationally consistent liquidity approach for cross-border banks. Pillar 2 (supervision) is strengthened to avoid that banks build up excessive exposures to liquidity risk.

The BCBS together with national supervisors is going to reassess the use of internal risk-models to ensure comparability between financial institutions. One priority is the guidance relating firm-wide risks, including concentration risks. Again, this includes liquidity risk associated with off-balance-sheet-vehicles, securitisation business and exposure to leveraged counterparties (such as Hedge Funds). Institutional investors are urged to be more cautious when investing in structured products.

Regulators are also called to review compensation models to avoid giving incentives for inappropriately risky conduct of financial business and more focus on long-term, firm-wide profitability.

Over-the-Counter Derivatives

The FSF calls for Market participants to improve the standards for credit derivative trade documentation in accordance with the not yet implemented cash settlement protocol. Standards for the accuracy and time lineless of trade data submissions for OTC derivatives should be improved. The financial industry as a whole is urged to develop reliable operational infrastructure supporting OTC derivatives.

Transparency and Valuation

Accounting, Disclosure and Auditing

Financial institutions should disclose their risks aand supervisors should enforce risk disclosure requirements under Pillar 3 of Basel II (with the help of the BCBS). Financial institutions are encouraged to disclose their losses in their upcoming mid-year 2008 reports.

The IASB is asked to propose an international disclosure standard for off-balance sheet vehicles and strengthen the standards to achieve better disclosures about valuations, methodologies and the uncertainty associated with valuations. The IASB is also called to improve its guidance on valuing financial instruments when markets have dried up (an advisory panel will be set up for that). The BCBS is called to enhance the supervisory assessment of banks’ valuation processes and help supervisors reinforce sound practices.

The auditing of complex or illiquid financial products needs to be improved. Therefore the International Auditing and Assurance Standards Board (IAASB) and major national audit standard setters are required to rexamine the standards in that area.

Transparency in securitisation processes and markets

Securities market regulators and the securities need access to more information on securitised products and their underlying assets. Originators, arrangers, distributors, managers and Credit Rating Agency need to be more transparent at each stage of the securitisation chain by standardising information about assets underlying structured credit products. Securities market regulators will set up a comprehensive system for post-trade transparency of the prices and volumes traded in secondary markets for credit instruments.

Changes in the role and uses of credit ratings

Rating process

Credit Rating Agencies (CRAs) should improve the quality of the rating process and manage conflicts of interest in rating structured products. IOSCO will revise its Code of Conduct Fundamentals for Credit Rating Agencies and CRAs will revise the implementation of this code.

CRAs are called to differentiate ratings on structured finance from those on bonds, and expand the initial and ongoing information provided on the risk characteristics of structured products. They should expand the information on the risk characteristics of structured products.

CRAs should enhance their review of the quality of the data input and of the due diligence performed on underlying assets by originators, arrangers and issuers involved in structured products.

Uses of ratings by investors and regulators

The over-reliance on ratings by investors needs to be decreased. Ratings should not replace appropriate risk analysis and management on the part of investors.

Authorities will also review the use of ratings in the regulatory and supervisory framework. by checking the roles assigned to ratings in regulations and supervisory rules and their consistency with theobjectives of having investors make independent judgment of risks and perform their own due diligence.

Strengthening the authorities’ responsiveness to risks

Translating risk analysis into action

The FSF criticizes that Supervisors, regulators and central banks need to have adequate resources and expertise to oversee the risks associated with financial innovation and to ensure that firms they supervise have the capacity to understand and manage the risks. They should communicate to firms’ boards and senior management at an early stage their concerns about risk exposures and the quality of risk management and the need for firms to take responsive action.

The FSF will increase its own risk analysis and recommendations, both directly and through the actions of its members through a mechanism for regular interaction at senior level with private sector participants, including investors and CRAs, for prompting mitigating actions to identified risks and weaknesses.

The use of international colleges of supervisors will be expanded so that for each of the largest global financial institutions a college of supervisors exist.
To increase the speed of supervisory responsiveness to developments that have a common effect across a number of institutions, supervisory exchange of information and coordination in the development of best practice benchmarks needs be improved at both national and international levels.

To facilitate central bank mitigation of market liquidity strains, large banks will be required to share their liquidity contingency plans with relevant central banks.

International regulatory, supervisory and central bank committees will strengthen their prioritisation of issues and, for difficult to resolve issues, establish mechanisms for escalating them to a senior decision-making level. As part of this effort, they will establish timetables for required action and action plans for addressing delayed or difficult issues.

National supervisors will, as part of their regular supervision, take additional steps to check the implementation of guidance issued by international committees.

The FSF will encourage joint strategic reviews by standard-setting committees to better ensure policy development is coordinated and focused on priorities.

The FSF and IMF will intensify their cooperation on financial stability, with each complementing the other’s role. As part of this, the IMF will report the findings from its monitoring of financial stability risks to FSF meetings, and in turn will seek to incorporate relevant FSF’s conclusions into its own bilateral and multilateral surveillance work.

Robust arrangements for dealing with stress in the financial system

Central bank operations

Central bank operational frameworks should be sufficiently flexible in terms of potential frequency and maturity of operations, available instruments, and the range of counterparties and collateral, to deal with extraordinary situations. To meet an increased but uncertain demand for reserves, monetary policy operational frameworks should be capable of quickly and flexibly injecting substantial quantities of reserves without running the risk of driving overnight rates substantially below policy targets for significant periods of time.

Policy frameworks should include the capability to conduct frequent operations against a wide range of collateral, over a wide range of maturities and with a wide range of counterparties, which should prove especially useful in dealing with extraordinary situations.

To deal with stressed situations, central banks should consider establishing mechanisms designed for meeting frictional funding needs that are less subject to stigma.

Central banks should have the capacity to use a variety of instruments when illiquidity of institutions or markets threatens financial stability or the efficacy of monetary policy.

To deal with problems of liquidity in foreign currency, central banks should consider establishing standing swap lines among themselves. In addition, central banks should consider allowing in their own liquidity operations the use of collateral across borders and currencies.

Arrangements for dealing with weak banks

Authorities will clarify and strengthen national and cross-border arrangements for dealing with weak banks. Domestica authorities will review the division of responsibilities of different national authorities for dealing with weak and failing banks.

National authorities should agree a set of international principles for deposit insurance systems. National deposit insurance arrangements should be reviewed against these agreed international principles, and authorities should strengthen arrangements where needed.

For the largest cross-border financial firms, the most directly involved supervisors and central banks should establish a small group to address specific cross-border crisis management planning issues. Authorities should share international experiences and lessons about crisis management. These experiences should be used as the basis to extract some good practices of crisis management that are of wide international relevance.

In summary, Banks take the blame for the credit crisis by saying that lending standards declined, securities were not sufficiently underwritten, structured products not fully understood, liquidity risks (when markets dry out) not anticipated and because of poor management reputational risk (which result in the stock prices of bank going down) not foreseen for the banks.

The IIF suggests a code of conduct for the major financial institution. The motivation is twofold: such a code of conduct should send a signal to the regulators that the financial industry does not need new regulation. It is questionable though, whether regulators continue to rely on voluntary standards, such as the IOSCO Code of Conduct (2004) for Credit Rating Agencies or the Hedge Fund Code of Conducts (2007).

The second motivation is toward the markets: a code of conduct can be a signal to the markets that certain risks are being addressed. However, markets are more difficult to fool than regulators: if a code of conduct is simply a piece of paper which does not reflect the practices of financial institutions, then markets won’t take the bait.

One weakness of the proposal by the IIF is already included in the proposal: because of the diversity, there will be no single standard for the whole industry. The report says:

Because there are substantial differences in business models, mix of business, exposures,
regulatory oversight and culture, there is unlikely to be a single solution to any issue that would be optimal for all firms and all circumstances. Thus, “best practice” as used here is not a legal obligation but a high standard for firms to apply in developing solutions appropriate to their own situations.

The IIF report calls for improved standards in areas: risk-management governance; technical risk-management issues; and stress testing. They admit that questions have been raised about…

…the ability of certain Boards properly to oversee senior managements and to understand and monitor the business itself.

The report wants to establish a “risk culture” and “three lines of defense” (business management, risk management, audit and control functions). The problem however is not so much that the existing regulation did not already establish these mechanism. The problem is that often the management encouraged the taking of excessive risks claiming that their competitors did the same. This “herding” led to the problem of prudent banks such as the German Landesbanken or the IKB speculating heavily with products they did not fully understand.

In essence, it is doubtful if voluntary standards will satisfy the regulators, but the debate between regulators and industry surely has taken an interesting turn.

(Will be continued)